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Netflix Stock: What Prompted Wells Fargo’s Bearish Stance?

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Netflix’s (NFLX) cash flow situation is back in focus. On Monday, Wells Fargo’s Steven Cahall downgraded the stock to “underperform” from “market perform,” according to an Investor’s Business Daily report. Cahall also cut the price to $265 from $308, which indicates a downside of nearly 16% from the current level. Wells Fargo cited Netflix’s negative cash flow issue as the main reason for its bearish stance.

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Wells Fargo warns about a dismal cash situation

The streaming giant’s exorbitant spending to stay afloat amid fierce competition has been a concern for a long time. However, Cahall thinks that the problem is graver than it appears. According to his estimates, Netflix won’t reach a breakeven point on the free cash flow until 2024. Even after that, Cahall thinks that the cash returns would be “modest.” According to Investor’s Business Daily, he estimated the company’s cumulative cash outflow at $9.3 billion from 2019 to 2025.

The analyst is confident that Netflix will meet analysts’ expectations for subscriber additions. However, the cost to gain new subscribers would be high. Market Watch cited more of Cahall’s analysis. He said, “Netflix still losing around $2/sub/month (cash) despite >158 million subs.” To sum up his study, Cahall said, “…If content is king, then cash is queen,” noted Investor’s Business Daily.

Initially, Netflix stock fell due to news about the downgrade. However, the stock rebounded later. On Monday, the stock closed 1.6% higher at $315.55.

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Netflix faces a prolonged period of negative cash 

Since Apple TV+ (AAPL) and Disney+ (DIS) stepped into the video streaming world, the competitive pressure has intensified. With more players joining in 2020, the situation will continue to intensify. Netflix has increased its content spending to $15 billion for 2019 to produce more exclusive content and strengthen its foothold.

The company relies on debt to fund its position, which puts pressure on its cash flows. Since September 2014, Netflix has consistently reported negative cash flows. As of September 30, Netflix had $12.43 billion in debt. The company also raised an additional $2.2 billion through junk bond sales in October. Netflix has piling debt obligations. In October, Variety noted, “The latest proposed debt offering would be the eighth time in the last five years that Netflix is raising $1 billion or more through debt.”

In the third-quarter earnings letter to shareholders, Netflix indicated its commitment to narrow the free-cash-flow gap. The company wants to achieve this by expanding its revenue base, improving operating margins, and funding content expenditure internally. The company said, “As a result, we’re expecting free cash flow to improve in 2020 versus 2019, and we expect to continue to improve annually beyond 2020.” Netflix also expects a negative free cash flow of $3.5 billion in 2019. To learn more, read How Netflix Plans to Improve Its Free Cash Flow.

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Analysts have mixed views on Netflix

However, not all of the analysts are bearish about Netflix’s negative cash situation. Cowen’s John Blackledge expects the company to post positive free cash flow up to $305 million in 2021, according to an article from The Hollywood Reporter. The article also cited Michael Morris from Guggenheim Securities. He said, “Netflix will reduce its cash shortfall to $1.88 billion in 2021 before turning slightly free cash flow positive in 2022 with $300 million before a big free cash flow jump in 2023 to $2.92 billion.”

These analysts differ from Cahall. According to the analysts, Netflix will be able to post positive cash flows in the next two years. They think that increased spending will help the company pull more subscribers due to its top-notch and original content, especially in overseas markets. The company might also fend-off competition by creating high barriers to entry. Pivotal Research Group’s Jeff Wlodarczak said, “Netflix has a massive head start on potential competitors, has created substantial barriers to entry and ultimately we think they win the global OTT race and generate material profitability.”

More debt could be risky in an uncertain economy

The streaming space is getting very competitive. Netflix will likely continue to increase its content spending. More spending could pressure its cash flows and make the business model appear unsustainable. However, we need to watch for a while before reaching a conclusion. The streaming war has just started. We’ll have to see if Netflix manages to expand its revenue base.

If the company continues in this situation indefinitely, it’s a concern. If Netflix’s cash burn continues to outpace its profit, investors won’t be able to accommodate it for long. Economic uncertainty could make junk bond markets inaccessible for the company. Last year, there weren’t any high yield US bonds available from November 30 to January 10, according to a CNN report in January. We’ll have to see if Netflix meets its target and improves its cash situation by 2022.

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