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The Trouble With Netflix

Netflix is shelling out billions for new programming, but it owns few of its top shows—and the Disney bailout bodes poorly for shares.

Netflix shares fell only five percentage points this past week, even as the company’s key vulnerability was laid bare for investors—twice. Walt Disney , a vital source of Netflix content, said it will pull Disney and Pixar movies and shows after next year to start its own streaming service. And Facebook launched a video service with niche shows covering sports, cooking, reality contests, social-media celebrities, and more. For now, it’s far from a threat to the runaway leader in subscription streaming, but then, when Netflix was founded 20 years ago this month, it was far from a threat to Blockbuster .

One of the all-time great story stocks, Netflix (ticker: NFLX) has a plot flaw, one that could cut its share price by more than half by the end of the decade. It is chiefly a hit-renter, not a hit-owner. Even among the expanding universe of Netflix Originals, top performers like House of Cards and Orange Is the New Black, which have both run for five seasons, are licensed, not owned. There is only one example of an owned Netflix hit reaching a second season—Stranger Things, which returns in October.

There are two ways to accumulate owned hits: Make them or buy them. Both require copious amounts of cash, and Netflix is running low. This year, it expects to burn through $2 billion to $2.5 billion. That’s a remarkable acceleration from the $1.7 billion last year and just over $900 million the year before. For now, it is financing this spending with junk-rated debt. But its long-term debt stands at $4.8 billion.

HOW HIGH COULD NETFLIX push its borrowing? Struggling Viacom (VIAB) makes investors nervous with $11 billion in debt. And it clears more than $1 billion a year in free cash and owns a major studio, Paramount Pictures, which could be worth more than $4 billion in a sale. Surely Netflix’s lenders will want to see free cash flow by the time it amasses $10 billion in debt. But at its current pace of spending, it might reach that level by the end of the decade, and the consensus view on Wall Street is that it will still be burning cash by then and beyond.

One reason lenders consider Netflix a worthwhile risk is its massive equity cushion in the form of its $74 billion stock-market value, versus $12.9 billion for Viacom. If its borrowing power dries up, Netflix can issue new stock.

But therein lays a dangerous piece of circular logic. Netflix’s stock price has multiplied 69 times, split-adjusted, over the past decade, to a recent $171, because its service is so popular, topping 100 million subscribers worldwide this year. The service is so popular because it’s an excellent value, but that’s in part because it’s priced below cost, financed by debt, which Netflix is able to take on because its stock price is so high.

There are other concerns. Netflix is expected to report a paper profit of $1.17 a share this year, up from 43 cents last year. That number, however, is highly dependent on how Netflix treats what it spends on shows for accounting purposes—and its treatment appears aggressive.

FOR EXAMPLE, NETFLIX CANCELED a show called Bloodline last year after three seasons. A common practice when that happens is to write off remaining costs, reducing earnings. Instead, Netflix is holding a chunk of Bloodline’s costs on its balance sheet. Its reasoning is that because the show is still available for streaming, it’s still a going concern. Contrast that with Time Warner ’s (TWX) HBO unit, which took write-downs after canceling Vinyl last year and The Brink the year before, even though both can still be found on the streaming service HBO NOW.

The gaping divide between Netflix’s free cash flow and its paper profits, pegged at more than $2.6 billion this year, suggests investors might not be fully aware of the company’s costs. It shows $13 billion in content assets on its balance sheet, including $9 billion in longer-lived content. To put that in context, Disney (DIS) paid $7.4 billion for Pixar in 2006 and $4 billion apiece for Marvel Entertainment in 2009 and Star Wars–owner Lucasfilm in 2012.

THE LOOMING DISNEY DEPARTURE is troubling for Netflix. There’s no way to tell how much of Netflix’s streaming comes from Disney content. There are popular movies like Moana, Zootopia, and the Star Wars spinoff Rogue One, and a deep roster of Disney Channel shows. A day before Disney’s announcement, Netflix said it was buying comic-book concern Millarworld for an undisclosed sum. Netflix can always find more content to license, but increasingly, that will require fierce bidding, because many of the best content owners already have deals with other streamers. 21st Century Fox , Universal Pictures, and Warner Bros. deal with HBO; Lionsgate, MGM, and Paramount go to Epix; Showtime gets hits from CBS (CBS) and Miramax; Starz has Sony Pictures Entertainment.

Netflix is a so-called FANG stock, a member of a select club known for explosive top-line growth and permission from investors to invest richly rather than maximize current profits. The others are Facebook (FB), Amazon.com (AMZN), and Google, now Alphabet (GOOGL). But look closely, and one of the FANGs appears toothless. Facebook and Alphabet benefit from powerful network effects, and already generate massive sums of free cash, a number that’s expected to approach a combined $70 billion a year by 2020. Both have identified video as a main target of future investment.

And Amazon, the most direct threat to Netflix with its thriving Prime video service, has a reputation for reporting thin profits, but in reality, it has long generated a hefty float of free cash from the retail business by selling through inventory so quickly that it collects from shoppers before it pays suppliers. Now, durable cash cows like Amazon Web Services and online advertising are ramping up. Amazon could top $30 billion in yearly free cash flow by 2020. And just as Netflix rents most of its content, it also rents streaming infrastructure. Amazon is one landlord.

Investors may not care that Netflix could one day take a big charge to earnings for past show costs, because earnings aren’t central to the stock’s story. But growth is, and investors will care in a hurry if membership gains slow or stall. Growth depends on content, and for companies that don’t own much of it, content requires cash. Netflix runs the risk of getting shut out of attractive content in coming years if its buying power wanes.

In last week’s cover story, Barron’s outlined a similar problem facing TV networks, which could one day face bidding wars with dot-com giants for sports rights (“TV’s Sports Problem,” Aug. 5). The networks hold stronger hands than Netflix, since they own content and generate plentiful free cash. Shortly after our story appeared, Disney and CBS announced they had sports streaming services in the works.

A NETFLIX STREAMING SUBSCRIPTION COSTS $7.99 to $11.99 a month, depending on the picture resolution and number of screens allowed. Prices could push higher, but to generate enough cash to make sense of its stock valuation, Netflix might have to charge at least $20 a month, grow its subscriber count to 150 million, and bring spending under control—unlikely, given that its menu of content could become less compelling, not more. There’s always the possibility of a takeover, and having seen some doozies over the years, we can’t rule that out. But only a handful of media players can afford Netflix, and no company on earth can squeeze more economic value out of it than Disney. The fact that Mickey is walking speaks volumes.

A Netflix spokesman says no one vendor accounts for more than a few percentage points of viewing; that its free-cash deficit is due largely to the cost of self-produced shows and films; that it doesn’t sell its service below cost; and that companies can burn cash for long periods and still be successful.

Netflix co-founder Reed Hastings once attributed its market-leading stock gains to “momentum-investor-fueled euphoria.” That was in a shareholder letter nearly four years ago, when the stock was $51 a share. He was right then, and he’s even more right now. Our advice for readers is to enjoy the streaming service while it’s still a bargain, and to stay well clear of the shares.

Email: editors@barrons.com

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