Netflix is betting billions on its original shows and movies — but this analyst warns it’s a far riskier gamble than investors realize (NFLX)

One of the central pillars of the bull case for Netflix may be resting on shaky grounds.

Investors and analysts backing the stock have based their optimism, in part, on the company’s growing investment in its “originals” — the shows and movies that are exclusive to Netflix. Although that investment is already costing the company billions of dollars, it should pay off in the long run, because the “originals” will help insulate it from rising costs of licensing other companies’ content, the thinking goes. Over time, Netflix’s content costs should go down — at least as a portion of its revenue — and its profits and cash flow up, according to the bull case.

But that assumption that the company’s “originals” will eventually help it get a handle on its content spending is misguided, said Michael Pachter, a financial analyst and longtime Netflix bear who covers the company for Wedbush. The streaming media giant pays license fees on nearly all of the content on its service, including on the vast majority of its most popular “originals,” he said. It will continue to have to pay license fees on those videos as long as it has them on its service.

Worse, the amounts it pays to license new series in the future — and its overall content spending — will likely continue to rise “in lock step” with its revenue going forward, Pachter said.

“It is exceedingly difficult to project when [Netflix’s] cash burn will stabilize and begin to improve,” Pachter said in a research note earlier this week. He continued: “Our competitors appear to believe that the company will deliver leverage from its content spending as it grow its revenue base. We disagree, given that the vast majority of Netflix’s content (including the bulk of its ‘originals’) is licensed.”

Netflix’s debt is swelling as it bleeds cash

Netflix saw its stock soar earlier this week after reporting better-than-expected subscriber growth. The company’s shares have more than doubled over the last year amid surging revenue, earnings and subscriber numbers.

But the company’s ability to control its content spending costs could become a significant problem. Even as its sales and profits have improved, it’s been burning through cash at an ever-increasing clip, thanks to its investment in original shows and movies. Its free cash flow — which represents the cash provided by or used up in its operations, minus investments in DVDs for its legacy business, property, and equipment, was in the red by $2 billion last year.

With all that cash flowing out the door, Netflix has had to sell debt on the capital markets repeatedly to raise new funds. It now has $6.5 billion in debt, which is nearly double its debt load from a year earlier. And its debt is growing much faster than its revenue. At the end of the first quarter, its debt amounted to more than half of its trailing-twelve months sales, up from about 35% of its trailing-twelve month sales a year earlier.

And even Netflix acknowledges that the situation will likely get worse before it gets better. The company expects its free cash flow to be in the red by $3 to $4 billion this year. And it warned that it expects its free cash flow to remain negative for “several more years” as it continues to invest in original content.

Netflix and its bullish backers expect the big, expensive bets the company is making now on original content will pay off in the long run. Much of that optimism is built on the different economics between owned and licensed content.

Netflix and its backers are betting on its ‘originals’ but there’s a problem

When Netflix launched its streaming service, it licensed basically all of the video that it streamed to its customers. Although it signed some extremely favorable deals at the start, license holders wised up and started charging more for their content in later years, particularly as the streaming service drew more and more subscribers and brought in increasing amounts of revenue. In some cases, Netflix balked at the higher license fees and dropped videos from certain studios from its service. In other cases, it paid up.

“Stranger Things” is one of the relatively few popular original series Netflix owns outright.

With original content, the company potentially has better control over the economics. When a network or video service owns a show or movie outright, it typically pays for it just once. It doesn’t have to pay ongoing license fees to air or stream it. And it doesn’t face potentially higher renewal rights.

But here’s the problem:

Even with its big push into “originals,” Netflix only owns outright about 10% of all the content on its service, according to Pachter’s estimates. Netflix licenses the rest, including popular “original” series such as “Daredevil,” “House of Cards,” “Orange is the New Black,” and “The Unbreakable Kimmy Schmidt,” he noted.

A Netflix representative declined to confirm or deny how much of the company’s content it owns outright.

In terms of economics, Netflix’s originals aren’t all the same

Much of Netflix’s original content falls in a kind of gray zone between these two models, Pachter said. Netflix doesn’t own the shows and movies, so it has to pay ongoing license fees for them. But those fees are typically fixed and generally go down over time, he said.

So, just as an example, Netflix might pay $2 million an episode for the first season of a new show, Pachter said. If it continues the show for a second season, it would typically pay the same $2 million an episode for the second season, but would also be committed to continuing to offer the first season and paying $1 million an episode for that right. If it continued the show for a third season, it would again pay $2 million an episode for the newest season, $1 million an episode for the second season, as the next most recent available, and licensing rights for the first season would drop to about $500,000 an episode, Pachter said.

What Netflix spins is this fiction that it’s going to get to a steady-state of content spending … To which I say, ‘bulls–t.’

Each new season would have similar economics, although older seasons likely wouldn’t fall below $500,000 an episode.

Although such arrangements keep Netflix’s costs for any particular show relatively stable, the licensing fees add up over time. If a show is on the company’s service for several years, Netflix could end up paying more for it than the show cost to produce, Pachter said.

What’s more, while those licensing terms are fixed for particular shows, they don’t stay the same overall. After “Daredevil” became a hit, Netflix almost certainly paid Disney more in per-episode licensing fees for “Jessica Jones,” the next show in the “Daredevil universe,” and likely paid even more for “The Punisher,” Pachter said. As Netflix grows its audience and makes more money from that audience, studios expect the compensation they get for their content to increase.

“What Netflix spins is this fiction that it’s going to get to a steady-state of content spending as they go from 100 million subscribers to 200 million and then 300 million, that the next 200 million is gravy,” Pachter told Business Insider. “To which I say, ‘bulls–t.'”

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