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Analysis: 'Tougher year' ahead as Netflix manages growth, debt amid volatility

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Analysis: 'Tougher year' ahead as Netflix manages growth, debt amid volatility

Shifts in Netflix Inc.'s financial strategies indicate the company is preparing for difficult decisions in 2019 regarding how to best manage its debt load while still funding growth, analysts said.

In the first two weeks of the year, the company hired a new CFO, reclassified certain expenses and announced a price hike on U.S. streaming subscribers. The changes come as Netflix seeks to maintain its dominant position in the streaming market, fuel growth and manage a growing debt load. Although the company upped its debt in 2018 to pay for its geographic and content expansion, analysts said executives appear to be recognizing that more volatile market conditions and rising interest rates make issuing more debt a less tenable strategy in 2019.

Newly appointed CFO Spencer Neumann's experience includes work in private equity as well as at two prominent entertainment firms: video game publisher Activision Blizzard Inc. and Walt Disney Co.'s theme park business. Analysts said Neumann's tenure in private equity likely brings a good understanding of the pros and cons of funding growth through debt, key knowledge for Netflix as it charts a path forward.

"The good news is they are bringing in a guy with private equity experience," said Renny Ponvert, CEO and director of research at Management CV, a research firm focused on analyzing executive teams for institutional investors, in an interview. Debt is typically cheaper than an equity offering, but the downside is it must be repaid. Ponvert said Neumann's experience speaks to someone who should well understand leverage ratios and how to best balance debt and equity offerings.

Ponvert's Management CV believes Neumann should push for an equity offering and then work to sharply reduce its debt.

Netflix ended the third quarter of 2018 with total debt of $8.34 billion, up from $4.89 billion a year earlier. The third-quarter 2018 figure does not include $2 billion in debt that Netflix raised during the fourth quarter of 2018, meaning the company ended the year with more than $10 billion in debt, Ponvert noted.

In July 2018, former Netflix CFO David Wells defended the company's decision to raise debt rather than issuing new shares, noting that the cost of capital was lower for debt. "We see debt as the right choice," he said.

But content consultant David Bloom pointed out that when Netflix started on a debt raising path in 2018, interest rates were still low and Netflix's share price was moving higher. "Now the rates are higher and their shares, along with everyone else's, are down," Bloom said in an interview. "It's an argument that made sense six months ago ... I'm not sure it makes as much sense now."

Netflix's stock gained about 33% in 2018, but it peaked mid-year, after which shares lost 32% in the second half. The momentum has improved in the new year: Netflix shares had gained about 24% year-to-date as of Jan. 14, and the price hike announcement sent shares soaring early on Jan. 15.

Neil Begley, a Moody's senior vice president, also believes the company would be on stronger financial footing if it balanced its past debt offerings with an equity offering going forward.

"Given that they don't generate any free cash flow yet, funding virtually all their expansion and intellectual property growth with debt just seemed unnecessarily risky," Begley said in an interview.

While an equity offering might dilute the share price, Begley said it "is not going to make that much of a difference for a stock that moves the way Netflix does."

In addition to improving Netflix's balance sheet, Bloom suggested Netflix could better monetize its original content through games, parks and other experiences. CFO Neumann's tenure at Activision and Disney could be helpful with this type of strategic effort, Bloom noted.

"There are other opportunities. You just have to figure out what those are," Bloom said, citing possibilities such as Netflix partnering to offer a "Stranger Things" ride or video game.

So far, Netflix has indicated it is squarely focused on global streaming opportunities and original content production. In line with that, the company has reclassified certain global content and marketing expenses previously included under general and administrative expenses as cost of revenues and marketing expenses, respectively. Global streaming delivery personnel expenses previously classified under technology and development were also reclassified under cost of revenues.

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Ponvert said the reclassification will allow analysts to regard these expenses as "variable costs of sales." For instance, for the first nine months of 2018, the company moved $280.9 million global content personnel costs from general and administrative expenses — typically regarded as "fixed costs that will impact margins indefinitely," Ponvert said — to cost of revenues, seen more as the necessary price of doing business. Another $197.8 million of G&A expenses were reclassified as marketing costs. Overall, the company more than halved its G&A expenses for the first nine months of 2018.

"They know Wall Street will be very forgiving about expenses associated with growth," Ponvert said.

Looking ahead, Bloom sees 2019 as "a tougher year" for Netflix as it navigates how to retain its lead in an increasingly competitive streaming marketplace.

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