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Serial high-yield issuer Netflix has already disrupted the movie and TV space, and has now set its sights on the video game industry. Given the possibility of debt-funded acquisitions, could this new adventure delay its full graduation to investment grade?

In 2021, Netflix’s original production Squid Game broke viewing records, and the company dominated the Emmys and Oscars. Perhaps more pertinently for credit investors, the company finally expects to generate positive free cash flow this year.

For years, the streaming giant used the bond market to fuel an epic cash burn, as it poured money into new content creation to attract subscribers. This strategy finally appears to be paying off—so why the shift towards a new market?

The share price offers some clues. Netflix stock is down more than 40% since November, on fears that subscriber growth has hit a wall, and that competition—not just within movies and TV but also video games and other digital media—may lure viewers elsewhere.

As pressure mounts to find a new growth engine, debt investors have begun to wonder whether Netflix could be tempted to make a splashy acquisition in the video game space—and whether such a deal could potentially be funded via the high yield market.

“If something came out tomorrow, it would not surprise me by any stretch of the imagination,” said a high yield portfolio manager familiar with the company. “They've got the balance sheet to do it and they'll have no trouble raising capital at attractive rates.”

Netflix’s years-long debt binge kept leverage high and free cash flow deeply negative, but both of those metrics improved rapidly last year. 

In 2021, Netflix reported negative free cash flow of $158m, down from $1.9bn in 2020 and $3.2bn in 2019. The improvement came even as the company spent more on content: roughly $13.6bn in 2021, up from $10.81bn in 2020 and $9.22bn in 2019, according to S&P.

Leverage has also come down, to 1.4x as of FY21, compared to 1.6x for FY20 and 3.1x for FY19 (click here to see the full financials on 9fin). Total debt was $15.4bn as of FY21, and the company has said it intends to keep its debt load between $10bn and $15bn. 

It should be on track to keep its word, after redeeming $700m of 5.5% senior unsecured notes that came due earlier this month. Its last new bond issue was in 2020, a dual-tranche $500m and €370m unsecured deal (click here to see a list of the company’s debt instruments).

These improving credit metrics highlight the company’s incredible growth trajectory, which was boosted by the pandemic. Adjusted EBITDA was $6.8bn last year, up from $5.1bn in 2020 and $3.1bn in 2019. Liquidity is also plentiful, with $6bn of cash on hand as of FY21.

But as the share price suggests, many are concerned that growth is stalling—and that if Netflix is to maintain earnings momentum, it needs to diversify away from movies and TV. At the very least, that will involve extra spending. It could also mean raising more debt. 

This could potentially complicate Netflix’s rising-star trajectory. Although the company was upgraded to BBB by S&P last October, it is still rated Ba3 (with a positive outlook) by Moody’s. But delaying this graduation to IG might be worth it, said another credit investor familiar with the company.

“The cost of capital for a high double-B versus a low triple-B is pretty de minimis,” the investor said. “If they can make an intelligent acquisition that jumpstarts growth, that would probably be a smart thing to do.”

There has been a wave of dealmaking in video games of late. This year alone, Take-Two Interactive (Grand Theft Auto, NBA 2K) has announced a $12.7bn deal to acquire Zynga (FarmVille, Words with Friends), Microsoft its $68.7bn acquisition of Activision (Call of Duty, World of Warcraft) and Sony a $3.6bn deal for Bungie (Halo, Destiny).  

As consolidation continues, other potential acquisition targets include Electronic Arts, Square Enix and Ubisoft, sources told 9fin. The space includes smaller developers like Kojima Productions, which produced the Metal Gear Solid series, and CD Projekt Red, maker of the Witcher video games that were adapted into a TV series by Netflix.

There are also smaller acquisition targets that Netflix could go after, which would be less likely to imperil its high-grade S&P rating, said Hunter Martin, media and cable analyst at CreditSights. “For Netflix to go down at S&P, it would be a big deal,” he said. 

Last September, Netflix acquired a small mobile gaming company called Night School Studio, with plans to offer its biggest game Oxenfree—playable on most games consoles and smartphones for $5—to subscribers at no extra charge. In the past, Netflix has also used external studios to produce games, such as one based on the hit series Stranger Things. 

Since then, the company has become more vocal about its intentions for bigger deals in the video game space. Gregory Peters, the company’s chief operating and product officer, flagged the potential for such deals during the company’s last earnings call. 

“We're open to licensing, accessing large game IP that people will recognize, and I think you'll see some of that happen over the year to come,” he told investors.

During the same earnings call, executives also said they were making hires in the video game space as the company looks to further monetize its existing intellectual property. Could a video game based on Squid Game be around the corner?

This strategy could help address a common criticism of Netflix by investors: that, outside of Stranger Things, it has proven less adept than competitors at capitalizing on the popularity of original content (Netflix did not respond to a request for comment for this article). 

WarnerMedia has pushed out sequels and prequels based on everything from The Sopranos to The Matrix and Sex And The City. Amazon is spending $1bn on a new Lord of the Rings series after purchasing the TV rights back in 2017. Disney has turned Marvel and Lucasfilm into highly productive franchises, with spin-offs including several popular video games.

And the urgency of looking beyond movies and TV is amplified by competition from other forms of digital media, as newer social media platforms like TikTok and Snapchat and much-vaunted projects like virtual reality and the metaverse threaten to steal precious eyeballs.

On a recent Vox podcast, Netflix CEO Reed Hastings noted the “danger” posed by other forms of digital entertainment. 

“A hundred years ago we might have tried to be the best at the opera, and the novel,” he said. “And then those turned into very small art forms today, because television became so much more compelling. So we have to watch out for those substitution threats.”

Virtual reality is still in its infancy. The metaverse does not yet exist. But it’s not crazy to imagine a future where you could access the latest viral game on a streaming platform, between enjoying Season 8 of Stranger Things and Squid Games the Musical (...maybe). 

Gaming is becoming an enormous business. Platforms like Twitch, where users broadcast video of themselves playing games like Fortnite, have helped the industry literally fill stadiums with paying spectators.  

And yet, it’s telling that Twitch is what first comes to mind when we talk about “streaming” and video games. So far, the concept of cloud gaming (where users can game on-demand without a $500 console) has been less successful, with some notable failures.

But that may be changing, as giants like Amazon come up with new solutions. And technological constraints do not negate the pressure to innovate—Netflix knows this from when it pivoted from mail-order DVDs to streaming video, seeing the potential even before broadband internet was widespread. 

The company appears to have had a similar realization around the potential in video games, said Martin at CreditSights.

“They don't need to do this immediately today, but they need to start making progress in that direction,” he said. “I really think of it as a long game.”

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