Netflix’s Dirty, Obscure Secret

by James Brumley | April 24, 2013 8:40 am

Congrats to anyone who owned a stake in Netflix (NASDAQ:NFLX[1]) prior to Monday’s close. As for anyone who didn’t have a stake by that point in time, sorry, but you missed the overnight, post-earnings gain of 25%.

It’s tempting to go ahead and pile on anyway, and many investors did exactly that, not wanting to miss out on any further upside should it materialize. For those investors who still are on the fence about stepping in after the surge, however, here’s one small piece of advice:

Stay on the fence for a little while longer.

Numbers Don’t Lie …

On the off chance you haven’t heard already, Netflix earned 31 cents per share in the first quarter of 2013. That’s much better then estimates of 19 cents, and way better than the loss of 8 cents per share a year earlier. Revenue of $1.02 billion was right in line with analyst estimates, and handily beat last year’s Q1 top line of $870 million.

As compelling as the numbers were, they’re not the reason investors went hog-wild. It was the huge jump in the number of subscribers Netflix can boast that sparked the stock’s meteoric rise. All told, the streaming-video company is now 29.2 million domestic members strong — an increase of more than 2 million since the end of Q4 2012. Assuming more of the same is on the way, Netflix is now expecting a similarly impressive improvement for Q2.

It looks as if the company’s original content like House of Cards ended up being a customer draw after all.

… But They Don’t Tell the Whole Story, Either

The recent Netfllix M.O. hasn’t exactly been a veiled one: acquire more high-quality content, confident that future subscriber growth will more than pay for it later.

And on the surface, the model seems to be working. After all, the top line swelled by 8.2% on a quarter-to-quarter basis on about a 7.3% increase in the company’s head-count during Q1. Between the fourth quarter and the first quarter, net income was up 38%. The math, for all intents and purposes, more than makes sense.

Problem: It’s the math that’s not showing up on the common accounting statements that makes NFLX less than compelling.

In simplest terms, all this fresh digital content that Netflix is spending a fortune on to acquire doesn’t show up on the balance sheet when it’s acquired — it shows up when it’s used. These liabilities are finite, however, and clarified in the text portion of the quarterly SEC filing. They’re appropriately called “off balance sheet” liabilities.

Care to guess how much in “off balance sheet” liabilities Netflix has looming as of the end of Q1? A total of $3.3 billion. That’s on top of the $2.7 billion it actually has on the balance sheet as of the end of the quarter (up from the previous quarter’s $2.6 billion).

For perspective, Netflix is a $12.15 billion company with about $1 billion in liquid or near-liquid assets that drove a little more than $1 billion in sales last quarter and only turned $2.7 million of it into a profit. Granted, the business model isn’t necessarily designed to be — or even required to be — a high-margin one, but that’s still cutting it a little close.

Oh, that $2.7 million is but a fraction of the average income of just under $8 million per quarter in 2012, which is just a fraction of the $60 million-plus in quarterly income the company was producing in 2011.

That diminishing income should alarm current shareholders.

It Gets Worse

As alarming as that trend might be, if you want to see a real red flag, take a close look at Netflix’s cash flow statement (where all those content costs are at least amortized) for last quarter.

Click to Enlarge
The company posted $12.1 million worth of negative operating cash flow for Q1 … the second negative cash flow in row. It’s a far cry from the impressively positive cash flow — as in tens of millions of dollars — Netflix had gotten used to through 2011 before its content amortization costs started to swell on soaring content costs.

And what are those content amortization costs? For reference, the company was only booking its streaming content costs at a pace of about $150 million per quarter in 2011 when it still had some great deals with studios and distributors. Last quarter, it amortized $485 million worth of its content costs — the highest-ever figure — and it’s still rising. Indeed, those rising costs are the core of why the NFLX bears are so … well, bearish.

To give credit where it’s due, total new spending on the content library actually fell a little from 2012’s average, sliding from $764 million in the first quarter of 2012 to $591 million this time around. Still, the math behind the cash flow statement doesn’t imply long-term viability even if the income statement looks OK. We know the off-balance sheet liabilities will have to be put on the balance sheet sometime. When they are, they’ll pump up those amortization costs even further.

Bottom Line

The crazy part is, as concerning as the cash flow statement’s details look, the business model is actually viable. It’s just a matter of ROI and expense control relative to subscriber growth — can Netflix grow revenue faster than it grows its content expenses? The numbers might superficially look like the company can, but the cash flow statement tells a different story.

Indeed, unless things change for the better on the cash flow statement, Netflix’s cash-bleed is eventually going to intercept and overtake net income … one way or another. This is the make-or-break question for Netflix shareholders.

For the time being, though, the market is choosing to ignore the obscure details, hoping the expensive gamble now will pay off in the future. It might work, but that’s a risky bet. You just don’t want to be the one left without a chair if or when the music stops.

In other words, buy NFLX at your own risk.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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