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Author: howardroark Big red star, 1000 posts Top Favorite Fools Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 21525  
Subject: Re: Netflix accounting questions Date: 11/2/2011 1:41 AM
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I just can't seem to get a grip on actual costs and how that will affect profits and free cash flow and that is largely due to the squirrely account change.

I don't think Netflix is doing anything squirrely, and I'll repeat bcs' recommendation to go through the Netflix presentation on this issue right on the front page of their IR site. Almost everything you think you see here is off base. For example:

-Netflix is not doing anything unusual. Your search for comparisons is either in the wrong place or incomplete. You should be looking at Networks, not cable companies. For a simple one, look at AMC. They call the relevant entry, "program rights." The conglomerates like Time Warner also use ASC 920. What you cite for Amazon doesn't tell you what you think it tells you -- it merely locates the amortization expense on the P&L.

-$1.3b is not what Netflix paid in cash for streaming content for the first 9 months. It is the amount of commitments (future payment obligations) they added to their balance sheet. This is very close to an irrelevant number, since the rules governing whether they must add a new deal as an asset and liability or merely list it as an obligation in their Commitments footnote are not very meaningful. Think: unhelpful lines between operating and capital leases.

-A better estimate of what they actually paid for total streaming content for the first nine months starts with the $1.34b of new liabilities accrued less the $817m actual increase in liabilities = ~$523m. But this isn't the whole story because as mentioned above Netflix also makes cash payments on deals that never hit the balance sheet. This isn't always as easy to find but thanks to Netflix's unusually investor-friendly disclosure (yes), you can use their 10-Q to figure out that total cash paid for streaming content in the first 9 months was ~$762m, meaning that another ~$239m was actually paid for streaming content that never hit the balance sheet. But note this additional $239m cash payment (or something very close to it) is already recognized as a cost of subscription on the P&L over and above the amortization identified in the cash flow statement. As you can see from this (plus the library amortization YTD of $418m), its streaming cash costs appear to only outstrip its P&L costs by about $100m YTD. However, even more disclosure tells you that total content cash costs including DVDs only exceeded expenses by $49.6m YTD. Since there only seems to be about a $12m net inflow from the DVD business, they spent about $60m-$100m more in cash for streaming payment than they recognized as expenses in 2011. The disparity form the $100m estimate could be from any number of minor timing issues in the DVD or streaming business. In any case, the expense and the cash costs were fairly similar -- probably about $660m in streaming expenses and $760m in streaming cash payments, or something a bit tighter.

-The $650m does not represent expected cash streaming costs from existing deals over the next 12 months -- that's a massive understatement. Again, because much of their streaming business doesn't qualify for B/S treatment, you have to check the footnote. They have $741 million due in less than one year that is not anywhere on the balance sheet in addition to the $654m of current A/P that is. Plus, there may be some payments from existing deals that doesn't even qualify for footnote treatment (not to mention new deals).

-bcs is exactly right that comparing this expected cash use to operating cash flow doesn't make sense. For one, it is double counting. Netflix commits to buying content over time. It makes payments over time. The actual payments do not exactly match the expense recognition, but they come very close. Compare a straight line deferred rent expense recognition for a retailer with their actual cash rent payments. You don't challenge an accounting presentation merely because rent due over the next 12 months exceeds operating cash flow, because you know operating cash flow already deducts an accounting estimate of the rent cash cost. Not to mention that comparing a future obligation to a past inflow ignores matching.

-It isn't clear exactly how the CW deal will be accounted for, but you seem to assume they will pay for it up front and amortize it over ten years. That is almost certainly wrong. Most of their deals have payment terms that extend over the entire license term. But what if they did do a deal like this where the payment was $1 billion up front? If it was an on balance sheet deal, they would create a content asset but no liability. The cash cost of the $1b would show up as a hit on the OCF statement because "additions to streaming" would go up by $1 billion while the streaming content liability would not change at all. $1b - 0 = $1b. If it was off balance sheet, the $1b would have to show up as a huge bulge in prepaid content (in this extreme cash they might actually stick it in capex and create a long term prepaid content asset). Nothing would be hidden. So far this is not what's been happening.

-All of this says nothing about whether Netflix is signing deals that will be economic or whether its expense recognition will, with hindsight, match the related benefit (subscription revenue). They are mostly just amortizing streaming costs over the life of the deal, and it's hard to imagine a much better (or allowed) way to do it. But that doesn't mean it will work out. They are making large commitments. What if everyone wakes up next year and sees the CW for the suckfest that it is? Then they should expense the whole thing while the ink is still dry. What if all of the benefit from a deal for a particular title comes in year 1, when everyone who wants to or will want to watch it signs up (or stays signed up) and then cancels (or would have stayed on anyway and doesn't use it)? Then they should have expensed it in one year. But accounting can never answer questions like this. Netflix is absolutely taking on significant risk by committing to future cash payments it hopes will produce sufficient subscription revenue. You could definitely argue that accounting rules should do a better job sticking this stuff on the balance sheet (again like operating leases), but that doesn't screw up Netflix's current P&L or statement of cash flows.
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