Why Netflix Is Binging On Junk Bonds

Netflix went back to the junk bond well again on this week with a new $2 billion offering for general corporate purposes, which can include content, production, and development. It’s not the first time the company has gone calling—this issuance raises the company’s total long-term debt to more than $12 billion. It may not be the last, either, although CEO Reed Hastings said in an analyst call on April 16, 2019, “you better get in soon, because there’s not going to be that much more [bond offerings] to go.”

Netflix’s need for money is simple arithmetic. To keep growing its customer base, the company needs a lot of content that people will come for, and that requires plenty of money, especially with the likes of Disney, AT&T, and Apple eying the same markets. The company spent more than $12 billion in cash for content in 2018, according to its financials, and expects to be “cash flow negative for many years,” according to the company. Monetary injections have to come from somewhere and junk bonds have become the solution.

According to data from credit rating agency Moody’s Investors Service, Netflix and the current round of bonds have a Ba3 rating, which is equivalent to a BB- rating from Standard & Poor’s or Fitch. That translates into concern the company is vulnerable to a weakening economy or internal problems, and so must pay buyers higher interest rates. What drags down the rating is the amount of debt Netflix already has as well as the company’s substantial negative cash flow: those two factors lock the company out of the investment-grade bond market.

Junk bond jamboree

Junk bonds have been a fact of investing life since the 1980s when they were pioneered by financier Michael Milken and investment bank Drexel Burnham Lambert, according to Robert Johnson, a professor of finance at Creighton University. “They were mostly for management-led leveraged buy-outs,” Johnson said. The nickname came from the low credit of the companies issuing the bonds.

The first decade of junk bonds and the “greed is good” crowd ended badly. Milken was indicted and spent time in jail for securities violations and Drexel ultimately collapsed. But junk bonds remained because there were times that companies with lower credit ratings needed cash and investors with a taste for risk looked for higher interest rates.

“[T]hey typically become popular with investors when economic times are good, yields tend to be fairly low, and people are reaching for a yield,” Johnson said. “Right now is a great time to issue junk bonds and, in my opinion, a horrible time to invest in junk bonds.” But investors who are hungry to get a better return on their investment frequently eye junk bonds because of the potential reward.

Better for shareholders?

For Netflix, it still makes sense to go the junk bond route. “For the issuer, debt is cheaper,” said Renny Ponvert, CEO of Management CV. “Debt has been basically subsidized by the federal government” because of low interest rates from the Federal Reserve, which affect all other rates.

“And to be blunt, it’s much better for the founder and his management team to issue debt rather than equity,” Ponvert said. “A lot of their incentive will be in the form of stock options and equity grants.” Issuing additional stock to raise money dilutes the earnings per share value “and probably causes the share price to drop,” which isn’t good for those who hold a lot of shares as part of their pay.

Issuing bonds, even if junk, can prove useful in another way. “I think the equity [investors] will get a bump out of how many times over-subscribed it is,” said David Tawil, president of Maglan Capital. The reason is that oversubscription shows that people think the company is worth the risk—that it will stay afloat and pay off. In turn, stock investors can take such moves as a sign that a company is in better shape than a set of numbers may show and push the price up through their buying.

Three times as many orders as there were requests for the current came in as were available. However, the company didn’t see an immediate stock pop from it. By midday on Wednesday, shares were down about 2%.

In the long-run, the move, while necessary today, may prove difficult to sustain. The company has said repeatedly that it would begin lowering losses next year and soon stop taking on new debt, instead attracting new customers and raising prices to increase operating income.

Not all are convinced. “If you look at the free cash flow of the company, these are just hopes and dreams that they’ll have free cash flow in the future,” said Cole Smead, managing director of Smead Capital Management. He thinks they’ll need to continue to tap the bond market going forward. But if interest rates begin to jump or the economy slows, the cost of rolling over the debt gets higher and larger interest payments take a bigger bite out of the already bad cash flow. That could be a recipe for lower share prices and disappointed investors.

In that case investors will have the same option as the rest of us: break out the junk food and start a Netflix binge.