Here’s an unpopular opinion: Netflix really isn’t that great of a product – like, at all. I’ve always felt that their movie catalog was downright awful, filled to the brim with low-budget features that close to zero people have ever heard of. Their television and original series content definitely offers a better selection, but they’ve never been able to convince me to pony up cash on a monthly basis. Alas, the numbers don’t lie – Netflix continues to beat street estimates for new user growth quarter over quarter. So when they announce they’re issuing a bunch of high yield debt to finance new licensing acquisitions and original content production on the back of parabolic customer growth, it shouldn’t surprise anyone. But I’m a cynical numbers guy, so I’m here to poke some holes in everyone’s favorite stock (and one of my least favorite products).
The content industry is very fond of off-balance sheet transactions, and Netflix is no different. The transactions materialize in the form of commitments to purchase content from production houses (Disney, Warner Bros., NBCUniversal, etc.) in the future for a few billion dollars. This ensures that Netflix is able to provide newer content for its audience as tastes change. The weird thing here is how these transactions are accounted for. Netflix amortizes these costs, through COGS adjustments, across the shorter of (i) what they deem to be the length of time viewers will continue to stream that particular show/movie or (ii) ten years, starting on the date that the content becomes available for streaming. As of 12/31/2017, Netflix had amassed $17.7B in content acquisition liabilities, of which $10.2B never makes an appearance in their financial statements as the content isn’t yet available for streaming on the platform.
Once you adjust for the off-balance sheet obligations, Netflix’s total liabilities jump from $15.4B to $25.6B at YE 2017 and $27.5B after this latest bond offering. Normally this wouldn’t be worrisome as your assets and liabilities rise in tandem – or so you thought, until you find this gem they buried in the footnotes of their 10-K:
“…content assets, both licensed and produced, are reviewed in aggregate at the operating segment level when an event or change in circumstances indicates a change in the expected usefulness of the content or that the net realizable value or fair value may be less than amortized cost. To date, the Company has not identified any such event or changes in circumstances. If such changes are identified in the future, these aggregated content assets will be stated at the lower of unamortized cost, net realizable value or fair value. In addition, unamortized costs for assets that have been, or are expected to be, abandoned are written off.”
Ah, yes – there’s always the risk that all of those content assets acquired in the off-balance sheet transactions may not really be worth the acquisition cost, in which case there will be sizable charge-offs that will directly impair their free cash flow (which is already running huge losses as they follow the Amazon business model). As the company continues to grow its customer base, it will need to go to market and increase the size of their content acquisitions, which will inevitably lead to a few charge-offs as their content portfolio expands. This isn’t really an issue from a microeconomic standpoint. It has the ability to become a macroeconomic issue though, if content providers decide they want a bigger slice of the Netflix pie and start jacking up rates for licensing, even as Netflix begins to experience some standalone charge-offs. Any rate increases will continue to hit Netflix right in their cash flow statement. This is the point at which they’d need to pass those costs onto consumers, but who is to say they’ll continue to pay up? Netflix has the benefit of being structured like a low-cost gym membership, where customers forget about (or don’t mind) the cheap, recurring charge hitting their account each month. Were those costs to rise, customers may be a little more sensitive as to what they really gain from their membership, and whether or not it’s worth it.
I’m not saying any of this poses a going concern risk for Netflix, either. I do, however, think it does pose downside risk for equity investors, especially if you’re buying at these levels. Institutional investors are well aware of the off-balance sheet transactions and their cash impact, they just haven’t cared because customer growth has acted as a buffer. If there are any hiccups in customer growth or worse, retention, then lookout below as content cost and cash flow profile move up the ladder of importance in valuing the company.
P.S. – If they knock The Irishman out of the park I will disavow everything I just wrote. Can’t lose with Scorsese directing that cast.