The biggest story today for video rental/video streaming company Netflix was not its parabolic move higher on earnings that left many scratching their heads, but that the company's exposure of just how vulnerable, and potentially unprepared, to growing pains it is, after its website suffered a multi-hour outage preventing clients (both paying and free) from accessing any streaming movies. And the company, which is betting if not the ranch, the definitely its cash flow on the transition to streaming (in Q3 it spent $115 million on video streaming rights, an 11-fold increase from the same time last year) may very well be unprepared for the priced in exponential growth in new users (even more so since as we pointed out earlier, the bulk of the expansion is to non-paying customers). The reason, as AP pointed out earlier, is that Netflix's streaming service has become so popular that it is now the largest source of U.S. Internet traffic during peak evening hours. Streaming by Netflix subscribers accounted for about one-fifth of that peak-time traffic, more than double the volume flowing from Google Inc.'s YouTube. And this massive infrastructure is supported by... $120 million in PP&E!? Indicatively Google is almost $5 billion. And since the market is expecting continued parabolic growth to its existing customer base of 15.9 million paid users to validate the new business model to which it attributes a lofty 30x+ PE of 2012 Earnings (a deja vu of the dot com days of "story stocks"), the company will soon have no choice but to actually expand its seemingly underfunded infrastructure, which it currently carries at $125 million on its books. Unless, of course, it wants to lose exasperated clients with an ultra short attention span who demand instant gratification and who can easily find substitute streaming providers in these days of Hulu (which itself is about to IPO), and numerous cable channel hosted alternatives. The big problem is that with $8 million of non GAAP free cash flow as disclosed in its Q3 earning release, there is no way this expansion can be funded organically. Furthermore, as the company is currently below its self-disclosed cash floor level, is the only option for Netflix to come out with a follow on offering, and fast? What that would do to a stock that has under $200 million in book equity and almost $9 billion in market cap we leave to our readers' imagination.
Why would NetFlix need to do an offering? As management disclosed on page 6 of its MD&A, "In terms of future buybacks, we have no plans to dip below $260 million in cash and cash equivalents." Funny, because the company had $257 million in cash as of the end of Q3. Additionally, up until recently Netflix was aggressively trying to telegraph to the public that its stock was undervalued having issued $200 million in debt to, among other things, buy back stock. To quote management: "During the quarter, we continued to use excess cash for share repurchases. In total we spent $58.6 million to purchase 530 thousand shares at an average cost of $110." The bolded statement may also be a further indication of future intent: the CFO would be rather naive to not take advantage of a 50% move higher literally in days, on his investment in his own shares.
What about further debt issuance? The recently (November 2009) issued $200 million in unsecured debt (at 8.5%!) has a carve out for a $300 million credit facility, but the company was already in a rush to repay its previous $100 million credit facility (the purpose of the note issuance) so presumably the banks were giving the company a bit of a hard time about collateral that could be bought in any subway in New York at one tenth the price. And with pledgeable assets essentially consisting of $260 million in DVD library content, good luck getting anything close to a 50% LTV on that, especially from a bank which may have "some" MBS exposure.
How about more unsecured debt? The Limitation on Incurrence of Indebtedness has a 3.5x consolidated leverage top. While the denominator is based on EBITDA, we have a feeling that with $110 million in LTM non-GAAP FCF, any new unsecured bondholders will make the max allowable debt ceiling based off of that number, and thus cap new debt at around $100 million. And any new debt issuance at or around 8%, which is not expressly designed for shareholder friendly purposes, will certainly be frowned upon by shareholders.
Netflix spends roughly $40 million on PPE per year and has already hit bandwidth capacity. We estimate the Company would need to roughly double this number to have at least some capacity for the future without running into capacity bottlenecks again. And while this number in itself is not large on the surface, the far bigger nut that NFLX has to crack in conjunction is the suddenly exploding cost associated with its transition to a streaming content provider: a transition which as we pointed out earlier cost $115.1 million in Q3 alone compared to just $66.2 million in Q2 (even as absolute gross profit remained flat sequentially) and $10 million in Q3 2009: what some would call a linear progression. Maintaining this level of streaming content expenditures makes it inevitable that the company will have to resort to some form of financing, especially since its DVD library content acquisition costs have already dropped to a $30 million maintenance level as NFLX seeks to move away from its old business "mail order" model.
In other words, with the company likely needing to finance between $100 and $200 million in funding needs (over what it can fund using debt) just to keep its new business line growing (assuming revenue does keep growing instead of merely adding free subscribers and churn), we are somewhat confident that NFLX will be forced to announce a stock offering in the interim, especially with its stock at such lofty valuations. And after all, with everyone a speculator, who can fault the company at taking a piece of the pie: the CFO has already made a 50% profit on his stock buybacks over the past quarter. In fact, we are confident that the bond offering underwriters of JP Morgan and Morgan Stanley are already hard at work pitching a modest follow on offering to the management team. After all, now that the hedge fund model of banking is no more, investment bankers are once again reminded what it means to pitch deals.