Netflix's Latest Stock High Reignites Spending Debate

Illustration by: Adam Simpson

At what point does debt and negative free cash flow outweigh subscriber growth and Emmy nominations?

A decade ago, Netflix shares were at $2.77 and investors worried that Walmart would put the subscription DVD-by-mail pioneer out of business. On Tuesday, shares closed at a record $183.60, giving Netflix — now the leader in streaming movies and TV shows — a $79 billion market cap.

Cue the debate (again) on whether the company is overvalued.

The answer is a definite yes, according to Wedbush analyst Michael Pachter, who has been arguing for years that the company's valuation should be tied less to how many subscribers it has (104 million worldwide) or to how many Emmy nominations it has racked up (91 this year alone) and more to its mounting debt ($4.8 billion) and negative free cash flow.

"We don't expect Netflix to become meaningfully profitable on a cash basis for several years, and we don't expect positive free cash flow for the remainder of this decade," Pachter wrote in a research note Tuesday.

On Monday, Netflix reported second-quarter net income of $66 million, up from $41 million a year ago, on revenue of $3 billion, up from $2.2 billion. But its negative free cash flow — which keeps growing due to the billions Netflix is spending on original content — was $608 million compared with $254 million a year ago. Netflix said Monday it expects up to $2.5 billion in negative free cash flow for all of 2017 and added: "We expect to be FCF negative for many years."

Pachter called the $608 million negative free cash flow for a single quarter "staggering," and he added: "The company seems sanguine about burning ever increasing piles of cash each quarter as it builds its content library."

As for subscribers, Netflix on Monday said it added 1.1 million domestically and 4.1 million internationally, numbers that impressed Wall Street and led to a 14 percent rally Tuesday. But Pachter warns that subscriber growth could "eventually decline as competition increases from Amazon and other large industry players, particularly if Netflix chooses to raise its prices in order to absorb rising content costs."

Clement Thibault, senior analyst at Investing.com, notes that Netflix shares usually advance 10 percent on any news that it is exceeding subscriber expectations, though eventually investors will shift their focus to the business itself.

"We are fans of the service Netflix provides, but not so much of its valuation," Thibault wrote in an analysis Monday. 

Thibault notes that Netflix has $14.5 billion in content obligations over the next few years and that the spending must continue, lest it fall behind Amazon, Google and others that are newer entrants to the business.

Thibault also chastises Netflix for encouraging binge-watching by sometimes releasing every episode of a series on a specific date. "Releasing a series over time would prolong the enjoyment and possibly allow Netflix to chill on its rate of expenditure," he wrote.

Still, though, there are many on Wall Street happy to ride out the great Netflix bull run. Canaccord Genuity analyst Michael Graham raised his price target to $200 on Tuesday writing that strong subscriber growth was the result of the company's spending on content.

Also on Tuesday, Todd Juenger of Sanford C. Bernstein raised his price target to $203 and estimated Netflix will have 303 million subscribers in 2030. "The scale advantage of Netflix to other so-called competitors is huge," he wrote.

"Look at it as if Netflix were a household. They're living a $6,500 a month lifestyle but only making $6,000 a month," Pachter added in an interview Tuesday.

With its $79 billion market cap, argues Pachter, Wall Street is valuing Netflix at $790 per subscriber while each sub pays less than $120 per year to Netflix. 

"It's absolutely appropriate to value Netflix on sub growth if you devise a construct where each sub is profitable. With their spending, Netflix just isn't there yet."

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