The Stock that's Getting Worse as the Economy Gets Better...

Well, things are starting to look up. Vaccines are being distributed, lockdowns are being lifted—unless, of course, you live in Australia. But businesses are opening up, and the economy is starting to recover.

However, for one very well-known company, this is really hurting their results. I think if management had their way, they'd want everybody back in lockdown ASAP. So in this video, we're going to be running through why this business is now struggling and whether investors should be concerned. So let's get started.

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So, the company that seems to get worse as the economy gets better—the business I'm referring to is Netflix. Check this out: before the lockdown, Netflix was adding, you know, 9.6 million subscribers per quarter—2.7, 6.8 million, 8.8 million. Then, boom! Lockdown hits; everyone is stuck at home with not a lot to do, and Netflix adds 15.77 million subscribers, then 10 million subscribers, then a little blip—yes, 2.2 million—but then back to 8.5 million subscribers.

And look at their free cash flow, too. During this time, again, in the lead-up to the lockdown, all negative—negative 400 million, negative 500 million. Then a whopping negative 1.67 billion. I mean, this was looking grim. But then lockdown hits, and look at this turnaround—positive cash flow! Hooray! 162 million, 900 million, 1.1 billion.

It does look as though they sacrificed Q4 a little, maybe for some accounting purposes. But then again, 700 million in Q1 2021. So, I think the management team wouldn’t know what to feel. I mean, people around the world getting infected, the economy falling to pieces—but it's great for their business.

However, why I decided to make this video now is that just last week, Netflix released their Q2 2021 earnings, and now they're seeing the opposite. As a huge number of people globally get vaccinated, you know, get back into the workshop or back into the office, all of a sudden, Netflix becomes a little less relevant to their day-to-day lives.

And their Q2 results perfectly reflect this. For subscriber additions in Q1, they were already on their way back down to earth with 3.98 million subscriber additions. But now, in Q2, just 1.54 million. Q2 2020, a year ago, they added 10 million subscribers. Now just 1.54 million. And that trend carries over to their cash flows, too.

Last quarter, Netflix still managed to produce 692 million in free cash flow. However, this quarter: straight back to the negatives—negative 175 million. So it does seem as though the party is over for Netflix. To be fair, their management team did say this would happen. They said all throughout 2020 that the amazing increase in subscriber additions was down to a lot of fence sitters that decided to buy the subscription because it was an opportune time to do so, and that would have a negative impact on future growth, as all of those fence sitters have already signed up.

However, the thing that worries me more isn’t so much—it's not so much the subscriptions, but it's the free cash flow. As investors, we always focus on free cash flow. This is the money that the business really makes for the owners after the operating expenses have been paid and the capital expenditures have been made.

When it comes to free cash flow, the management team can do stock buybacks with the money. They can pay a dividend, they can pay off some debt, they can add it to the cash pile for next year. There's a lot they can do with it, but really, it is the shareholders' money, and usually, no matter how it's allocated, it benefits the shareholders.

So we love to see free cash flow really strong as investors. But what concerns me right now about Netflix is if you look back at the past few years’ results, it looks as though Netflix needs a once in a lifetime global lockdown, where people are literally locked in front of their televisions just for their business to be cash flow positive.

If people are stuck at home in lockdown and can't go out with their friends, can't go into the office, can't go to the gym, then yes, Netflix can make money. But as soon as the lockdown eases, life starts getting back to normal, and their business model is in the red once again. For me, that's my major concern.

And management have said they're getting close to a stable break-even free cash flow business model. However, I'm just not sure I believe it. So that's my main concern: the free cash flow.

And the reason why consistent negative free cash flow is a concern is because of the debt that they're in. Because Netflix's business model burns money to keep it going, they need to borrow more money than when it burns through that money. They'll borrow more money again, but of course that money needs to be repaid at some point.

Now, Netflix has worked their way along to 15 billion of long-term debt. Now, I want to put it out there that I'm certainly no doomsday predictor for Netflix. In fact, I think in the long run, chances are they'll be totally fine. But this debt does need to be repaid. And granted, debt is very cheap right now—it's fairly easy to pay off. Plus, Netflix has 7 billion dollars of cash in the bank.

But what I'm saying is that if the company has a substantial amount of debt but can't produce consistent positive free cash flow, that should raise some red flags in your brain. Because what if something unexpected causes a bump in the road for Netflix? What if they can't access fresh new debt? What if investors don't want to give them more money? What if their free cash flow suddenly sinks even deeper into the red and then a big debt repayment comes due?

Again, I do want to reiterate that I'm certainly not predicting doomsday for Netflix. In this current environment and in their current financial position, they'll probably be fine. But as a long-term investor, this is definitely something that should jump out at you when you read through the financial statements.

And the reason it should jump out at you is because this is something that may put you in a scenario where you would violate Warren Buffett's rule number one of investing, which is: don't lose money. As a long-term value investor, yes, of course, we're trying to make money. But before we get to thinking about that, we do a series of checks on the business to make sure it's extremely unlikely that our investment will be wiped out.

We make sure we're capable of understanding the business. We check to ensure the company has a competitive advantage, and importantly, we look at the debts of the business—what they owe to others. You know, any issue with those three things can sink an investment. So we ensure we're across that.

Then we start looking to things like growth of revenues, growth of the cash flows, and the return on investor capital—the valuation, those things that will propel the company forward and make us money.

Another example of this was the airlines over the past few years. You know, running an airline is obviously really expensive. I mean, these companies have a lot of debt, but in the years prior to 2020, instead of using the golden years to secure their financial position, you know, they used a lot of that free cash flow to buy back their own stock.

You know, as a long-term investor that should have raised a bit of a flag in your mind because of that first rule: you know, don’t lose money. At the time, you’re probably thinking, “Well, hang on, what happens if the airlines hit a bump in the road?” You know, all this money spent on buybacks could have gone into debt reduction to de-risk the business.

Now, of course, you can't predict a global shutdown of air travel, and you know, obviously hindsight is a beautiful thing. But chances are you still would have questioned whether the buybacks were the smartest thing to do because of Warren Buffett's first rule of investing.

Actually, on the subject of buybacks—just to add a little more fuel on the fire—Netflix actually did a 500 million buyback this quarter as well, which, you know, I thought was pretty funny. Probably not where I would have put the money, considering the debt.

And also, let’s not forget the competition, right? The competition that's currently undercutting Netflix right now. But, you know, hey, they did it.

But anyway, I'm getting a little bit sidetracked. That's really all that I wanted to discuss in this video. You know, Netflix, I love your product; I watch you all the time, but the fact that you need a global lockdown to be cash flow positive to me means I'll probably be on the sidelines for a little while longer.

But honestly, I'm no Netflix short seller or anything. I really do hope that Netflix succeeds because as a consumer, I want Netflix to battle with Disney Plus, to battle with Prime Video. Because at the end of the day, if there's competition in the space, it just means there's better content for us to watch.

So I certainly hope they succeed. But overall, guys, that will do us for this video. That is what I wanted to highlight—very interesting, very interesting. And it's something that you can keep tabs on, you know, quarter after quarter. Watch how Netflix responds, you know, as lockdowns eased, as life resumes back to normal. Watch that free cash flow! Does it stay negative, or does management actually have a really solid plan to get to a sustained positive free cash flow point? I'd be really interested to see how it plays out.

But anyway, guys, that will do us for this video. If you found it useful, or if you enjoyed it, leave a like on the video. It really helps me out, helps out the video in the YouTube search and the YouTube algorithm. Subscribe to the channel if you are new around here—maybe you haven't seen one of my videos before. We talk a lot about the stock market on the channel, so feel free to subscribe.

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But that will do us for this video, guys. Thank you very much for watching, and I'll see you all in the next video.

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