The downgrade reflects the higher risk surrounding the company's shift to a fixed cost streaming business model which requires much higher subscriber levels to reach profitability, combined with an increasingly competitive operating environment. While Netflix's initial Ba2 CFR, assigned in 2009, considered the risk associated with the company's ability to transition from physical DVD rentals to digital streaming, it did not consider the higher risk associated with a shift from a variable cost model to a fully fixed cost structure for the streaming business. Though the company has exceeded our expectations for its transition to a digital model, albeit with some missteps that resulted in an accelerated and harmful decline of its DVD business, and has grown subscribers at a higher than expected rate, it now faces a much higher cost business model that requires a far higher number of subscribers to reach break even. At the same time, streaming content is now becoming much more competitive. In Moody's view, in order to maintain the same level of financial strength and reach a similar level of profitability as Netflix previously had under its DVD business when we initially rated it in 2009, Netflix would need to have at least 35 million domestic streaming subscribers, almost double the level of DVD subscribers it had at its peak. This is even before considering the additional risk associated with the fixed content costs and therefore the greater vulnerability of the streaming business to poor growth or declines in subscriber growth. Though Moody's recognizes that the company may be able to cut back on new content additions and renewals to reduce content costs if subscriber growth slows down from one year to the next. In addition, we believe streaming-only subscribers are less sticky than those that subscribed to the company's now discontinued hybrid offering, which makes it all the more important to maintain a superior product relative to competition, and increasing viewer engagement to drive customer retention.
The downgrade also reflects Moody's concern over growing competition from a broad range of competitors for a streaming subscription video-on-demand (SVOD) product. While the streaming business is more sustainable from the standpoint of changing technology, maintaining product quality and user experience, it lacks the complete content offering, including new film releases that could be viewed via DVD rentals. As content distribution and consumption trends continue to evolve, and the home entertainment market declines further, we believe it is possible that a competitor could emerge with an offering that fills in the void of new releases, which could be of greater value to customers. The company already faces a broad range of competitors, some of which have deep pockets and who may have different objectives for entering the business, and may be willing to undermine Netflix on both price and product offering and suffer a loss to gain subscribers. For example, a pay-TV provider may want to build a competitive offering in order to drive subscriber retention for its larger, profitable pay-TV distribution business, or, the giant retailer Amazon with its Amazon Prime SVOD service may wish to attract subscribers to drive retail sales and tablet sales. However, we believe that as long as Netflix can continue to materially outspend its competitors for content and build a large enough library with increasingly exclusive content, which is supported by its large subscriber base and scale, it may be able to create a moat around its business and remain a leading player. We also believe that with around 80 million broadband households in the US relative to Netflix's 25 million streaming subscribers, we believe there is potential for higher penetration and scope for multiple players to co-exist in the content streaming business.
The company has also embarked on an international expansion strategy in the past two years, and plans to reinvest a majority of its domestic profits into international markets over the intermediate term, resulting in higher leverage and negative free cash flow on a consolidated basis. However, this does not impact the company's credit rating at this juncture, as investment in growth is more favorable to the company's credit standing than an alternative use of the company's cash flows such as engaging in share repurchases which serve no benefit for creditors. Moody's remains more focused on the profitability and sustainability of the core domestic business, as long as Netflix's international investments are not debt-financed and do not rapidly consume cash and impact liquidity.
Another change over the past year has been the company's decision to produce original and exclusive content. While the downgrade of Netflix's ratings considers the possibility of a significant increase in spending on original programming, which may negatively impact ratings giving the riskier proposition of new content production, we currently expect original programming to remain a small portion of its total content budget.
The following is a summary of today's actions:
..Issuer: Netflix, Inc.
.... Corporate Family Rating, Downgraded to Ba3 from Ba2
.... Probability of Default Rating, Downgraded to Ba2 from Ba1
....Senior Unsecured Notes, Downgraded to Ba3 (LGD5-70%) from Ba2 (LGD5-72%)
Netflix's Ba3 Corporate Family Rating reflects the company's position as the largest content streaming subscription service in the U.S., with a sizeable subscriber base and a market leading streaming product offering. It reflects the company's strong balance sheet, with very low gross domestic debt-to-EBITDA leverage of under 1.0x and a significant level of cash and short term investments relative to its debt. The above credit strengths only partially mitigate key business risks, however, including the company's relatively young history, business concentration, and risks associated with low barriers to entry and the potential for disintermediation from competitors in the distribution of content. The company's past predisposition for share repurchases (having repurchased almost $1 billion since 2007), significant subscriber churn and relatively low EBITDA margins compared to traditional media also weigh on its rating.
Although Netflix has successfully developed a digital business model and has quickly evolved into the dominant online content streaming company in the US from a pure physical DVD rental subscription service, its business continues to be in transition with the next few years being crucial to its developing a profitable streaming business that can fully offset the rapidly declining profits from the high margin DVD business. Its Ba3 CFR reflects the execution risk associated with this transition, especially in the context of a broad range of emerging competitors and the evolving digital content distribution models that may hamper the subscriber growth it needs in order to successfully build a profitable streaming business.
The rating reflects our expectation that the company will reinvest a majority of its domestic profits into international expansion. We do not view these investments negatively, as long as it remains measured in its pace of international market launches and does not fund these via debt financing or consuming material amounts of its cash balance. However, combined with its increasing investments in original programming, the company may reduce the cushion that has existed to support new and existing content contractual commitments in the event of slower than expected subscriber growth or subscriber losses. The company's Ba3 rating is limited by its ability to demonstrate enough subscriber growth to meet (a) the content commitments and expenditures to offer a streaming plan that would enable it to maintain a significant lead ahead of competitors and (b) its investments in international markets while maintaining strong liquidity. We believe that it would be possible to do so if the company grows to around 40 million subscribers in the US and is able to maintain at least break even cash flow in international markets, with profitable launched markets funding the launch of new markets.
The stable outlook reflects Moody's forecast that the company will grow domestic streaming subscribers in the range of 4-5 million per year over the next two years, and maintain its pace of additions relative to competitors such that it remains at least double the size of the next largest competitor, while managing content costs so as to increase its streaming margin. The outlook does not contemplate the company's international businesses to contribute to profitability well into the intermediate term.
The company's rating may face downward pressure if it experiences domestic streaming subscriber growth of under 4 million per year, and is unable to maintain domestic margins above 12% (after allocating most of the overhead to domestic) by growing streaming profits to offset declining DVD profits. Ratings may also be downgraded if its domestic leverage is sustained over 2.0x or consolidated leverage is sustained over 5.0x as it launches expands internationally, or its international investments materially impact liquidity or require debt financing.
Ratings may be upgraded if the company can demonstrate a successful transition to a profitable domestic streaming business, with subscriber growth that allows it to reach and sustain 40 million streaming subscribers, manage content spend such that it increases and sustains domestic margins at above 16% as well as maintains a significant lead on its content offering relative to competitors, and if its profitable international markets can fund new market launches such that gross consolidated leverage remains below 2.0x.
Netflix's ratings were assigned by evaluating factors that Moody's considers relevant to the credit profile of the issuer, such as the company's (i) business risk and competitive position compared with others within the industry; (ii) capital structure and financial risk; (iii) projected performance over the near to intermediate term; and (iv) management's track record and tolerance for risk. Moody's compared these attributes against other issuers both within and outside Netflix's core industry and believes Netflix's ratings are comparable to those of other issuers with similar credit risk. Other methodologies used include Loss Given Default for Speculative-Grade Non-Financial Companies in the U.S., Canada and EMEA published in June 2009. Please see the Credit Policy page on www.moodys.com for a copy of these methodologies.
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Neil Begley Senior Vice President Corporate Finance Group Moody'sInvestors Service, Inc.250 Greenwich StreetNew York, NY 10007 U.S.A. JOURNALISTS: 212-553-0376 SUBSCRIBERS: 212-553-1653John Diaz MD - Corporate Finance Corporate Finance Group JOURNALISTS: 212-553-0376 SUBSCRIBERS: 212-553-1653 Releasing Office: Moody's Investors Service, Inc.250 Greenwich StreetNew York, NY 10007 U.S.A. JOURNALISTS: 212-553-0376 SUBSCRIBERS: 212-553-1653(C) 2012 Moody's Investors Service, Inc. and/or its licensors and affiliates (collectively, "MOODY'S"). All rights reserved.
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