S&P Cuts Netflix (NFLX) to 'B+';Outlook Negative

Standard & Poor's Ratings Services today lowered its corporate credit rating on Los Gatos, Calif.-based online video service provider Netflix Inc.(Nasdaq: NFLX) to 'B+' from 'BB-'. The outlook is negative.

At the same time, we lowered our issue-level rating on the company's existing senior unsecured notes to 'B+' from 'BB-'. The '3' recovery rating remains unchanged, indicating our expectation for meaningful recovery (at about the middle of the 50%-70% range) of principal for the noteholders in the event of a payment default.

We also assigned our 'B+' issue-level and '3' recovery ratings to Netflix's proposed $1 billion senior unsecured notes offering. The '3' recovery rating indicates our expectation for meaningful recovery (at about the middle of the 50%-70% range) of principal for the noteholders in the event of a payment default.

The downgrade and negative outlook reflects our expectation that Netflix will incur significant discretionary cash flow deficits over the next several years and that debt leverage will be high during that time. The proposed financing represents a significant departure from Netflix's existing debt leverage, which had supported the 'BB-' rating. Under the proposed financing plan, Netflix's debt leverage will increase to about 5x by the end of 2015 (up from 1.9x as of year-end 2014), and the company will likely incur significant discretionary cash flow deficits through 2017 due to step-up investments in original programming and international expansion. The proceeds from the proposed transaction will likely provide sufficient liquidity for the next 24 months. However, it is possible that Netflix could seek additional financing in 2016 or 2017.

We view Netflix's business risk profile as "fair," reflecting the company's leading position in the increasingly competitive and rapidly evolving online video service and its large subscriber base. However, Netflix remains dependent on movie and TV studios for content, and we expect the company to increase its investments in original programming for which success is unpredictable. There are also risks associated with the company launching its service in new international markets, as well as technology and content risks associated with delivering video movies and streaming content to homes.

We expect Netflix to continue to enter new markets in 2015 and 2016, and that it will possibly complete its global rollout by 2017. The company announced that it will enter Australia and New Zealand in 2015, with other markets to come. Netflix will also need to enter into additional content commitments to serve existing and new markets. The company's streaming content commitment was $9.5 billion as of Dec. 31, 2014, up from $7.3 billion a year earlier. We expect that streaming content commitments will continue to increase and that Netflix's pursuit of more original programming with global rights will increase its cash flow deficits.

Additionally, the competitive environment for online video services is in flux. DISH, CBS Corp., and several other companies have announced potentially competing over-the-top video services. This is in addition to existing competitors such as Amazon Prime and Hulu. Although we view new entrants as providing a complementary service to Netflix's, based on the type of content and service available, it is possible their services could change over time and become direct competition to the company.

We revised our assessment of Netflix's financial risk to "highly leverage" from "modest," based on our expectation for significant cash flow deficits and high debt leverage over the next several years. We expect that Netflix's debt leverage will increase to about 5x by year-2015 from 1.9x a year earlier. The increase in debt leverage will result from a combination of higher debt balance and start-up costs associated with new market entries. Given our expectation for Netflix to invest very aggressively in its growth, we no longer net cash out of our cash flow/leverage measurements. Entering new markets requires upfront investments and it can take several years to reach breakeven EBITDA. Depending on the level of investments in original programming, it is possible that Netflix could seek additional debt funding in 2016 and cause debt leverage to increase. Therefore, debt leverage could remain elevated before decreasing somewhat by the end of 2016 or early 2017, as international operation losses subside.

The combination of a "fair" business risk profile and a "highly leveraged" financial risk assessment results in an initial rating outcome ("anchor") of 'b'. We applied a positive analytical modifier for comparable rating analysis, based on our view that Netflix's business profile is at the higher end of our "fair" assessment relative to its peers. This reflects Netflix's market-leading position in many of its markets and its sizable and growing international presence. Netflix has achieved critical mass in several markets, and it is by far the market leader in the important U.S. market.

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