(The title isn’t original… I know. Sue me.)
I wrote two prior posts on Netflix ($NFLX) both in August of last year. First about their Off Balance Sheet Liabilities “Enron, Lehman Brothers, and… Netflix?“, followed by their competitive challenges “Netflix, meet Porter“.
Full Disclosure: Similar to $AMZN “The Amazon Dilemma“… although I continue to write negatively about it, I have never shorted $NFLX (personally, as well as for clients). With certain investments, you have to respect John Maynard Keynes’ famous saying “The market can stay irrational longer than you can stay solvent.” The hype, stupidity, extremely high short interest, focus on top line vs bottom line, lack of respect for standard valuation metrics etc. make them extremely difficult shorts.
Back to my first post, Zero Hedge wrote a similar – Off Balance Sheet – post after this quarter’s earning last week. He made the same mistake as I originally did – failing to add a corresponding asset line on the balance sheet when bringing in the off balance sheet liabilities. In other words, while you would add the $3.3B of liabilities to current and long term liabilities, you would also have to add another $3.3B to their Content Library assets.
I totally agree with him though – as I wrote in my original post – that those asset lines, even the way they currently are, makes a little difference to the financial health & liquidity of the company. So adding billions more to it doesn’t mean much. The only “real” assets the company acquires from all these content liabilities are subscribers. At least the company hopes so.
I was inspired to write this follow-up post mainly because of a twitter conversation I had with @KidDynomiteBlog. (You should be able to see the thread here.) I wanted to clarify the “issue” I had/have with the approach $NFLX is taking here by keeping these liabilities off balance sheet.
First, I agree with KidDyno 100% – this has no effect on their income statement or their statement of cash flows. Even the current off balance sheet liabilities when paid show up on those statements, and are the main reason why the company isn’t really profitable. The balance sheet isn’t there to show investors income or cash flows, the balance sheet is important for many reasons, but mostly to see the financial health & liquidity of the company.
Many investors buy a stock like $NFLX and – assuming they are somewhat educated – would like to understand the risks involved. What happens if $NFLX loses subscribers? What type of liabilities – especially fixed – to they have?
In my most recent post – Leverage: Financial vs. Operating – I wrote about Financial Leverage – actual debt – vs. Operating Leverage – leverage attained by having lots of fixed (vs variable) costs. Of course the upside was displayed with $SIRI, and we all know plenty of over-leveraged companies that suffered downside – to the extent of bankruptcy – because of leverage.
$NFLX is leveraged. Big Time.
Looking at their typical “financial leverage” via debt to equity or debt to assets, you can surmise that the company isn’t badly leveraged at all. They have just $700M of long term debt vs. >$12 billion equity value and a stated $4.36B of assets! That seems pretty solid.
However, similar to many retail companies which have long term leases on their stores, and since the company needs those stores to operate and generate revenues, the money that is owed for the leases, is money that will have to be paid, and consequently, when looking at the company’s financial health & liquidity – must be factored in.
Same with Netflix and their content cost. Without content, Netflix will lose their subscribers, they have no business without it. It must be paid, and therefore has to be treated as an obligation/liability.
On their balance sheet, they show that other than the $700M of LT debt, they have another $2.44 Billion in content liabilities, which have to be paid to content providers in order for them to continue to have the rights to stream their content. The balance sheet is also where you realize that $2.97 billion of their $4.36 billion of assets, aren’t your standard assets.
When I look at the Asset side of a balance sheet, I’ll always separate things like Cash/Accounts Receivables/PP&E vs (almost any) intangible assets, especially goodwill. Since most intangible assets are hard to sell and convert into cash or into something tangible, when looking at the financial health of the company, you have to discount those assets considerably. (I almost always give zero value to intangible assets.)
In $NFLX’s case, you have most of their assets in the form of their “content library”. Other than for accounting purposes – where every liability will always have to be matched with a corresponding assets – why is this content an asset? Do they own it? For the most part – No. Can they resell their streaming rights and convert it into cash? It definitely isn’t like cash, receivables, inventory, or a piece of property, so what makes it an asset?
Say $NFLX signs a deal with $CBS for $500M per year for 5 years. The first year’s $500M goes as “content liabilities” and “current content library” (under assets), and the other $2B goes as “Non-current content liabilities” and “Non-current content library” (under assets). So for accounting, similar to buying a company for more than their book value, you have to add a line to balance the purchase, which creates “goodwill”, here too (to an extent) you add these assets.
Are these really assets? They’re definitely not cash. Can/will they convert into cash? Through subscribers, yes. But not definitely. And here’s the key – the amount of subscribes in relation to the amount of library assets that they have – although probably correlated somewhat (where the more/better content they have the more subscribers they’ll retain/acquire) – it is not that important.
In other words, if they owe $2.5B for this library, does that $2.5B of supposed assets mean they’ll be getting that in subscriber money over the next X number of years? Would it make a difference if the library was valued at $1B or $4B? Should they do impairment charges to change the “fair value” of what the library is worth?
My point here is that it’s an intangible assets, and should by no means be valued at face, or anywhere close to it. Due to the content contracts and money owned they have the business, but it isn’t inventories, especially not from a financial health & liquidity prospective.
So returning to their off balance sheet liabilities. By now adding an additional $3.23 billion of liabilities (and assets) to the balance sheet, the real leverage goes through the roof! Real assets vs real liabilities.
From the assets side, it’s mostly irrelevant if these off balance sheet assets are brought back on the balance sheet – it doesn’t matter – because they aren’t really real – I would have discounted them like all intangibles assets either way! It is the subscribers that produce revenues. They are the real assets – did the subscriber numbers change when you added more of those assets (& liabilities) onto the balance sheet? No! These are contracts that the company already had.
The liabilities side though makes a huge difference. Adding them back in adds real liabilities and real leverage to the balance sheet.
I created a simple spreadsheet with a few important columns. Please look at the huge difference. First between the company’s stated balance sheet to the “real” balance sheet. Then look at the company’s TANGIBLE balance sheet. The company has a little over $1B of cash and a total of $1.4B of tangible assets vs. $6.78B of liabilities. Real liabilities.
This doesn’t even include the following paragraph from the 10-Q presented without comment (emphases is mine however ;-))
The Company has entered into certain license agreements that include an unspecified or a maximum number of titles that the Company may or may not receive in the future and/or that include pricing contingent upon certain variables, such as theatrical exhibition receipts for the title. As of the reporting date, it is unknown whether the Company will receive access to these titles or what the ultimate price per title will be. Accordingly, such amounts are not reflected in the commitments described below. However such amounts are expected to be significant and the expected timing of payments could range from less than one year to more than five years.
Back to @KidDynomiteBlog, yes this is why the company isn’t earning money – content costs are through the roof. However from a prospective of leverage / balance sheet / health of company / liquidity etc… How risky is $NFLX? If you look at Column B – what the company wants you to look at – not so bad. Column E however, is just brutal.
I believe this is the reason that over the last few years $NFLX has probably been the single highest beta stock in the S&P500. The company is the epitome of leverage. It isn’t your typical financial leverage, and it isn’t even your typical operating leverage. But if subscribers grow as bulls think, and somehow their content costs stay stable or even decline – cash flow will flow straight to the bottom line, and you’ll have a cash cow. If however (which were the worries last year,) competition causes subscriber growth to stall, then the company is toast. Liabilities are just way too high to compensate.