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Netflix Might Be Done Borrowing Cash

The Motley Fool logo The Motley Fool 10/24/2020 Adam Levy
a store inside of a building: Netflix Might Be Done Borrowing Cash © Provided by The Motley Fool Netflix Might Be Done Borrowing Cash

The days of Netflix (NASDAQ: NFLX) borrowing billions of dollars or euros to fund its massive content spending are coming to an end. "Our need for external financing is diminishing," management wrote at the conclusion of its third-quarter letter to shareholders. Not only is the company forecasting $2 billion in positive free cash flow this year -- due mostly to content production suspensions -- it thinks it could potentially reach break-even cash flow in 2021. 

a store inside of a building: Exterior of an office building with Netflix logo above the entrance. © Netflix Exterior of an office building with Netflix logo above the entrance.

Reaching break-even

Netflix expects free cash flow to range between -$1 billion and break-even in 2021, with continued improvement in 2022 and beyond. There are a combination of factors leading to improved cash flow at Netflix.

First is the amount of money coming in from subscribers. Netflix's revenue increased 22.7% last quarter on the strength of its subscriber gains earlier in the year. Management expects subscriber growth to slow, facing tough comparable quarters in the first half of next year, but it should stabilize in the second half of the year.

What could drive revenue growth in 2021 and beyond is further price increases. Netflix recently increased the price of its service in Canada and Australia. If those price increases go well, it could lead to price hikes in bigger markets like the U.S., which would have a meaningful effect on revenue growth.

The second factor is Netflix's expanding operating margin. Historically, Netflix has been able to manage its content spending to achieve its operating margin goal. This year it's going to overshoot its 16% margin goal due to delayed productions.

Management reiterated its expectations for 19% operating margin in 2021, but warned results may be lumpier than in the past. It doesn't expect to manage its content spending as tightly in the future, instead focusing on longer-term trends. "By moving to this multi-year model, we'll be able to manage our short term expenses more smoothly as well as grow slightly more efficiently than in the past," management wrote in its letter to shareholders.

The final factor is Netflix's spending on in-house productions. Over the last few years, Netflix has produced more and more of its originals in house. These require a bigger upfront cash expenditure than licensing content from other production companies, even if those productions are made exclusively for Netflix. Management sees the transition to Netflix productions reaching maturity in the next few years, which means the amount of additional cash for the same level of content output will fall to zero.

Not slowing down releases

Netflix isn't planning on keeping its content output stable, though. 2021 will see more releases than 2020 despite the production shutdowns earlier this year. Everything the company planned to release in 2021 will come out next year, with just a few exceptions. CEO Ted Sarandos warned the content slate may be a bit more weighted toward the back half of the year, though.

"We're confident that we'll have an exciting range of programming for our members, particularly relative to other entertainment service options," management wrote in the letter to shareholders. Netflix's ability to churn out content while competitors are slower to ramp back up should allow it to prove its value to subscribers.

The key metrics Netflix is looking at include: What percentage of time are viewers spending with Netflix versus other entertainment options? How often do subscribers watch Netflix on back-to-back days? Those more detailed engagement metrics help inform its ability to raise prices, which could play a meaningful role in its revenue growth in 2021. More original productions mean more opportunities to engage Netflix subscribers night after night.

Plans for capital allocation

For the past ten years, Netflix's decision on where to invest excess capital has been pretty easy: Expand the service. But it's quickly reaching the point where it can self-fund any further expansion of the service -- more content, more marketing -- while still leaving some cash left over.

When CFO Spence Neumann was asked what his plans are for capital allocation once the company achieves positive free cash flow, he didn't have a precise answer. "It's probably a little too early to call our long-term capital allocation approach," he said during the company's third-quarter earnings call. "We're going to take an approach that we believe will maximize the long-term value for our shareholders." That could be anything from accelerating the paydown on its existing debt -- which currently totals around $16 billion -- to buying back shares, acquiring other companies, or even paying a dividend.

After having reached peak cash burn just last year, the potential for consistent positive free cash flow in just a year or two shows the massive potential for Netflix to see a lot of excess capital hitting its balance sheet in just a few short years. One way or another, investors in the FAANG stock should see positive value from it.

Adam Levy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Netflix. The Motley Fool has a disclosure policy.

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