Netflix's Capital Structure

All companies will have a capital structure, each different from the next. A capital structure is the combination of sources of capital that a company uses and the different costs, rewards and risks associated with each source of capital. For example, debt finance has lower levels of risk, therefore it is cheaper to obtain, whereas, equity finance has higher levels of risk and therefore is more expensive due to high returns being demanded by shareholders.

When it comes to the financing of a company, the most common question will probably be; What is the optimal capital structure? Though, it is very difficult for companies to decide what the optimal capital structure is, due to a high number of differing opinions. One way in which a company is able to find an optimal capital structure is through the use of their Weighted Average Cost of Capital (WACC), as during this calculation it is clear to see that when a larger amount of debt finance is used, a companies WACC will be lower due to it being cheaper than equity. However, when it comes to increasing the level of gearing within a company, there is a chance that the lenders will start to worry about the companies’ ability to make repayments, otherwise known as risk of ‘financial distress’.

One example of a company that has done exactly this is streaming service Netflix, with their debt more than tripling from $3.5bn at the end of 2014 to $11.97bn at the end of 2017. When it comes to the use of debt finance Netflix likes to use bonds to fund their investment into creating original content for their 137.1 million subscribers. In October 2017 they chose to receive a 10.5-year bond of $1.6bn with a yield of 4.785% following a higher than projected growth of subscribers. More recently than this, in October 2018, Netflix made the decision to take out another 10.5-year junk bond of $2 billion, issued in both dollars and euros, with the U.S. share of the bond having a yield of 6.375% and the European share having a yield of around 4.625%.

In other words, a ‘Junk Bond’ is a high-yield bond, which in comparison to investment-grade bonds such as municipal bonds, treasury bonds and corporate bonds, has a low credit rating and offers a larger pay-out. The reasoning behind this is that they are considered to be riskier due to a higher default risk (the likelihood of companies being incapable of making their debt payments). Nevertheless, it is a possibility that Netflix will be able to benefit from bond appreciation if the issuer of the bond is able to improve their credit standing. However, although Netflix would be able to benefit from this, there is the chance that if there is a sudden drop in the bond issuers credit rating there will be an adverse effect on the value of said bond.

In my opinion, even though the choice to use more debt than equity does lower Netflix’s cost of capital, tripling their debt and in turn tripling their risk through the use of this form of bond leads to the question of; Is this a sustainable way of financing their company in the long term? One major element that can come into this decision of whether or not to use debt finance in the long term is, the future economic condition and what will happen if it was to take a hit e.g. a financial crisis/recession. If in the future if there was to be another financial crisis like the one in 2007-2008, Netflix may face difficulties in terms of their debt finance as most junk bonds come with a much larger risk that they will end up being worthless during financial crisis. Also, with Netflix being issued a higher debt load it therefore means that as a result of this their interest expenses will become higher, which then means that they will have to make improvements on their cash flow in order to cover their higher expenses.

Overall, I think that due to the year on year increase of Netflix subscribers, that in the current economic conditions their current levels of debt aren’t something to be worried about, however, constantly using high levels of debt to finance their growth may not be as feasible in the future if there was to be a sudden drop in paying customers, for example, if there was a financial crisis, consumers may be less likely to have a subscription to Netflix as it is considered as a luxury and not a necessity.