3 Things To Watch When Netflix Reports Earnings On Monday

Though originally a movie service which delivered DVD content by conventional mail, Netflix has shifted its core business to become a video-on-demand, streaming service. The transformation has been so pervasive that currently, Netflix lives and dies by its original content. The company is heavily invested in producing its own material, to the tune of $6 billion spent last year. It will continue to invest further in order to expand its customer base and appeal. This strategy is a classic example of the good, the bad, and the ugly.

The Good: Netflix produces high quality TV series. Some of its productions remain powerhouses: House of Cards and Orange is the New Black were each renewed for a fifth season, both scheduled to premiere in the next couple of months, and Black Mirror is in its third season. Its newest offerings, such as Stranger Things and Marvel's Luke Cage created a lot of buzz in 2016, along with critical and viewer acclaim. However, TV production is a means to an end rather than the goal itself. The goal, of course, is continually increasing subscriber numbers.

Luckily, good content is a key driver of subscriptions, which in turn drives revenue growth, something we'll touch on below. Netflix also made an impact at this year's Academy Awards, where its 40-minute film, The White Helmets, won an Oscar for Best Documentary in the short-subject category.

The Bad: Just about every important global player with media aspirations, including Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOGL) and AT&T (NYSE:T), now has—or is creating—some kind of internet TV or movie production capability. Indeed, Netflix was one upped this year by Amazon's original movie Manchester by the Sea, which walked away from the same Academy Awards ceremony with two Oscars versus Netflix's one. And not just any Oscars, but in two of the most high-profile categories: Best Actor for Casey Affleck and Best Original Screenplay.

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We've mentioned this growth in competition in previous posts, but it looks like it will remain a growing problem for some time; Amazon is now matching Netflix's international footprint: both services are now available in over 200 countries; Google is slowly expanding and enhancing its YouTube Red by encouraging creators of original content to publish on the service while at the same time dipping its toes into a pay-per-view model; even Apple (NASDAQ:AAPL) is looking to create video for its Apple Music platform. While Apple's plans are still young, the expectation is that it too will eventually reach Netflix's level of spending on original content, which, as mentioned above, today stands at $6 billion annually, thus adding another deep pocketed, high spending competitor to the group in the medium term.

The Ugly: And speaking of that $6 billion, Netflix is plowing through an astounding amount of cash. The company's Free Cash Flow in 2016 was negative $1.7 billion dollars. If you think 2017 will look better in that regard, think again. Netflix itself has predicted upwards of negative $2 billion in cash flow for 2017. Netflix's operation is currently financed by debt, with another billion raised in late 2016. We wouldn't be surprised to see Netflix's cash flow dip even further into negative territory since the company's executives seem extremely confident in their strategy of creating and owning unique content.

Evaluating Netflix on a quarterly basis is difficult. Investors place greater weight on subscriber growth rather than the more traditional revenue growth – yet subscriber growth is a metric that's much harder to predict, as was evident by the massive 7-million subscribers added in Q4, compared to the 5.2 million expected. Netflix's revenue has been growing steadily, something that's expected from a subscription-based business.

There are, however, a few less prominent positives that should not to be overlooked. First, Netflix's net margins have increased every quarter over the past year, showing a positive multi-quarter trend, from 16.2% in Q4 2015 to 20% in Q4 2016. This is a direct result of the company putting effort into improving efficiency and deliberately growing margins as part as of their long-term business plan. Next quarter's margins are expected to be exceptionally high, at 24.8%, but should shrink to more realistic growth the following quarter. Reed Hastings, Netflix's CEO, described variations in results as 'lumpiness' coming from the timing of releases and payments.

Second, Netflix's international streaming operation is expected to return a profit in Q1, the first quarter it has been able to do this, which is great news for the company. And because Netflix now has almost the same number of domestic and international subscribers (49 vs. 44 million), a profitable international segment is crucial for the company's overall, bottom-line growth.

Still, a note of caution is warrented: we've mentioned Netflix's outsize expenditures on content creation, which were financed through bond issuance. Netflix's current, long-term debt load stands at $3.3 billion. The company's EBIDTA over the past 12 months is $612 million. Clearly, Netflix is becoming significantly leveraged, a fact that should be on every investor's mind.

Netflix also has $14.5 billion in streaming content obligations, contractual commitments that represent future licensing arrangements. Similar to multi-year TV deals for sporting events, these will show up as content costs on income statements in the coming years, at the time when they will actually paid. Nevertheless, it means Netfilx is on the hook for $14.5 billion in content over the next few years which leads us to believe the company is in an even more precarious position than a quick scan of their balance sheet would indicate.

Netflix's valuation is extraordinarily high. Because many see the company as the future of television, it has a P/E ratio of 332 and a one-year forward P/E of 72 (reflecting the P/E expectation a year from now, if price stays the same and analysts' predictions are correct). As internet speed and availability improves, so too will Netflix's user base and revenue. The competition is a concern, but at the current entry-level, single digit price point of $7.99 for a starter subscription, compared to Amazon Video at $5.99 and HBO now at $15 annually, it's not necessarily a hardship for consumers to have subscriptions to multiple streaming services.

Conclusion

At Netflix's current $143 per share price, alongside its elevated P/E ratio, we believe the market hasn't factored in enough of the long-term concerns, particularly regarding the way the business is financing its content, choosing instead to focus almost exclusively on the positives. Netflix is expected to stick its toes yet more deeply into the debt markets in the coming year, with additional bond issuance the likely choice. Consequently, we wouldn't be surprised to see Netflix increasing the price of its subscription to compensate, at least in part, for some of its major content expenditures, though the company denies having plans to do so.

For those already invested in Netflix, or looking for high growth at all costs, keep an eye on debt levels, be patient, and prepare for a relatively bumpy ride. Netflix—similar to a few other publicly traded companies (Tesla (NASDAQ:TSLA) comes to mind) which are viewed as extremely forward-looking, almost futuristic—attracts a core group of investors that are often willing to pay a premium for a chance at owning a piece of the future.

At its current level, Netflix is already priced for just about its best case scenario. We believe that means now would be a risky time to open a new position. Consequently, we find it impossible to recommend Netflix as a sure pick right now.

Written By: Investing.com