Investors flocked to Netflix’s latest bond offering after the company demonstrated strong subscriber growth to back up its cash-burning strategy—but with its cost of capital rising, any change in that trend will quickly impact the company’s access to the bond market, said six buysiders and one sellsider following the deal.

The USD 2bn Baa3/BB- dual-currency 10.5-year offering is oversubscribed, and is set to price today. Lead bank Morgan Stanley this morning widened talk for the USD 800m tranche to 6.375%, back in line with initial whispers, but still just wide of talk in the 6.25% area. The USD 1.26bn-equivalent euro tranche also widened to 4.625% from 4.5%, in line with initial whispers.

Despite the pricing fluctuation amidst today’s market volatility, the notes are still set to have the highest coupon on Netflix’s balance sheet—followed by 5.875% on the USD 800m 2025s it issued in February 2015 and the USD 1.9bn senior unsecured notes due 2028 it priced in April this year, and 5.75% on the USD 400m 2024 notes it sold in 2014.

The pricing reflects the company’s increasing leverage and raises the bar for the level of growth creditors will expect to see in order to continue funding the company’s heavy cash burn as it seeks to consolidate and vertically integrate its position in the TV and film industry, said buysiders.

“They’re on a subscriber treadmill, and they keep increasing the speed of the treadmill,” said one. “So far, they‘ve been able to keep up or ahead of how fast the treadmill’s going. But when the economy turns or at least when the market turns and that subscriber growth isn’t going anywhere, they won’t be able to tap the high yield market.”

The company’s yields have risen since it priced its last deal in April—partly thanks to rising rates but also after underwhelming subscriber growth for the second quarter. Those 5.875% notes traded today at 98 to yield 6.144%, according to MarketAxess.

Pro forma the new deal, Netflix is 5x levered based on USD 10.4bn of total debt and about USD 2bn in LTM adjusted EBITDA as of 30 September, according to deal documents. Pro forma cash is roughly USD 5.1bn, leading to net leverage of 2.7x. Liquidity includes an undrawn USD 500m revolver.

House of cash burn

The company expect to burn around USD 3bn for 2018 and 2019, as it continues to invest in acquisitions and new content, sources said—with most adding that they were happy to fund that spending, as it helps Netflix build sticky subscriptions while lowering its production costs in the long term.

“They’re trying to build a moat around the business model,” said one buysider. “They can become free cash flow positive whenever they want to, but original content would be the lifeblood of the company by then.”

Netflix reported that subscriptions grew by 7 million in 3Q, much higher than its projected 5 million target. The results counteracted 2Q’s miss, where subscription growth of 5.2 million was lower than the company’s 6.2 million forecast. Netflix now has 137 million subscribers in total.

CFO David Wells said on the 3Q earnings call that the company expects to see “material improvements” in its cash flow profile in 2020—although he cautioned that break-even cash flow was still some way off.

“We still think it’s going to be a few years towards breakeven because we’re optimizing again for long-term cash flow and long-term profitability, and we think that’s the right thing,” he said.

The good place

As Netflix’s debt load continues to grow, creditors are increasingly turning their attention to the possible timing of its transition to a less capital-intensive model and the impact that could have on subscriptions.

“Eventually they have to make money,” said one of the buysiders. “You can’t just keep ploughing your negative free cash flow into content. The question is going to be when they turn down the content spigot, what happens to their [subscriber] churn.”

Price elasticity is a key question the company will have to address over the coming quarters as this shift comes into focus.

“If they raise prices 20%, will they have much churn? No. If they do 50%, will they have churn? If they do it overnight, yes, but if they ease into it, then they could do it. That’s what future profitability will depend on,” the buysider said.

Investors said that new streaming competitors such as AT&T/Time Warner, Disney, Wal-Mart and YouTube don’t pose an immediate threat to Netflix—so long as Netflix continues to grow subscriptions in the near term.

Competitors have to contend with Netflix’s international market reach and increasing library of content, six of the sources said. That said, one of the main hurdles Netflix must clear is HBO and Disney pulling content from Netflix in support of their own streaming services, said three of those sources.

“The model’s good for now, but there are hiccups down the road,” one of the buysiders said.

Fuller house

The next step in Netflix’s vertical integration is acquiring its own production studio, which could prove to be a defensive move for the company down the line, sources said. The company announced earlier this month that it plans to purchase its first studio complex in Albuquerque, New Mexico, according to a press release.

The weak covenant protections in the company’s bonds would likely allow them to make use of a key asset like a production studio if the company found itself in financial distress, said one of the sources.

“They could build up and then spin off the production arm if there comes up a point when they need to,” the buysider said. “They could get a good valuation for that, and that would bring into effect the bond covenants, which aren’t the best.”

Netflix’s stock traded today at USD 320 for a USD 139bn market cap, roughly in line with where it was at the time of the April bond deal but up significantly on the year.

Netflix and Morgan Stanley declined to comment.

2018 Debtwire