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Author: TMFGebinr Big gold star, 5000 posts Old School Fool Supernova Phoenix 1
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Subject: Re: Netlix cash costs Date: 11/11/2012 12:38 PM
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While we are on the subject of NFLX, any opinions on off balance sheet obligations as debt?

Hi kitkat,

It's a tricky question. You're right that operating leases are routinely counted as "debt" when analyst's adjust the balance sheet. I'm fine with that on the whole.

The question of whether the content obligations that Netflix has are enough like debt isn't quite as clear cut, I think, but I lean toward not capitalizing them, unlike operating leases.

Remember that when Netflix knows the content and its related cost, it goes onto the balance sheet, both as an asset which is amortized and as a liability which is paid off. But until the content is knowable, it's not a fully recognizable asset / liability. This is unlike an operating lease, where one can point to the land / building / improvements as the asset and the value of the lease as the matching liability. GAAP lets these be carried off balance sheet because the company isn't buying them outright. It's more like a renting situation, where ownership remains with the property owner, not the occupant, but that can be viewed as a mortgage equivalent. That doesn't seem, to me, to be the situation for Netflix's content obligations.

The other thing about operating leases is that when they're capitalized, there's usually an interest rate that's assigned and charged to the income statement, because of that mortgage "conversion" that capitalizing performs. I don't think assigning an interest charge to them is the right treatment for the content obligations.

Finally, I don't know how enforceable the contracts are if Netflix goes bankrupt. With debt, the holders are first in line. But for the right to stream somebody else's electrons? Are the contracts written such that the whole is due upon bankruptcy? I don't know, but I'd be surprised if that were the case. (I'm not sure where leases, with or without "due upon termination" clauses, land on the spectrum of claims against the company upon bankruptcy.)


In short, I think the rationale for capitalizing operating leases is because they're more like a mortgage than not. I'm not sure the same argument can be made for Netflix's content obligations. If anything, they're more like inventory that runs through COGS than anything else. And all the expense for all the content obligations (both on and off balance sheet) already run through the income statement as part of COGS.

However, I agree that one cannot ignore the content obligations when looking at the totality of Netflix and its financial statements. I just don't think that capitalizing them, beyond what happens when the content and obligation is knowable, is the right solution.

Cheers,
Jim
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