1 Trend That Should Worry Netflix, Inc. Investors

By Markets Fool.com

Netflix has surprised almost everyone in recent years with its ability to attract new subscribers and boost revenue.For the fourth quarter, the video streamer and DVD mailer expects to add another 4 million total subscribers between its U.S. and international operations.

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However, Netflix has not fared nearly as well in one financial metric. Since the second quarter of 2009, Netflix's free cash flow has declined significantly. What is behind this trend, and what can investors expect going forward?

International expansion
Netflix started expanding beyond U.S. borders in the second half of 2010. It began with Canada, then headed south to Mexico, the Caribbean, and Central and South America in 2011. Altogether, the company has now launched in more than 40 countries.

Of course, the early days of entering a new market often produce negative cash flow. There are content and marketing expenses, but no subscriber base to support them. That's why Netflix breaks out its domestic streaming operations from its international business, to give investors an idea of where its international business is heading. Perhaps the company will break its earnings results down by launch-datecohorts at some point in the future.

While the accelerating international expansion has certainly increased operating expenses, the amount spent on capital projects has been relatively stable. Since Netflix runs on Amazon.com's cloud platform, it is easily scalable, and Netflix doesn't have to spend extra on capital expenditures to expand internationally.

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Therefore, the impact of international expansion on free cash flow comes largely from the cost of content -- which makes up the largest expense for Netflix.

The cost of content continues to climb
Netflix's international business is nearing breakeven for operating profit, yet it remains far from spitting out cash flow. The company can amortize the cost of content over the length of time its content licenses last. As a result, the cost of content on its income statement can be lower than what Netflix is actually spending.

Netflix's content spending has climbed significantly in recent years. While some of that increase comes from the company's international expansion, the cost of content in the U.S. has caused Netflix to raise its budget.

Netflix moved away from bundled licensing deals with U.S. networks in the first quarter of 2013 in order to save money by curating its library. At the time, CEO Reed Hastings said the company would continue to spend the same amount on U.S. content (but on fewer titles).

As of the end of the third quarter, Netflix's content obligations stood at $8.9 billion. That was up from $1.3 billion at the end of 2010, when the company had 20 million subscribers producing $2.2 billion in revenue.

The amount of content obligations due by Sept. 30, 2015, is almost $3.6 billion. Meanwhile, Netflix's 53 million-plus subscribers have produced about $5.2 billion in revenueover the past 12 months. That leaves approximately $1.2 billion of cash flow for Netflix to spend on operating expenses and capital expenditures. That amount was bigger in 2010, when Netflix had just $531 million in near-term content obligations ($1.7 billion).

Why pay attention to free cash flow over net income?
The way Netflix accounts for its content costs, as mentioned, is by amortizing the cost of content over the length of the contract. This gives investors a better picture of how much the content actually costs for the period, but it doesn't show how much Netflix actually paid to content owners.

The cash flow statement offers a better picture of where Netflix's cash is going as content costs rise, and it shows that much of its content contracts are front-loaded. That's why we have seen a divergence between free cash flow and net income. Over the last couple years, Netflix has increased net income while free cash flow moved sideways.

This is a trend for Netflix investors to monitor as the company buys up even more content rights in order to compete with other streaming services. Both international and domestic subscriber growth needs to outpace growth in content obligations in order to reverse the trend.

Netflix is beholden to content creators for the bulk of its library, and the fiercely competitive streaming market allows those creators to ask for more money and favorable terms. The result might be an endless cycle of ever-higher front-loaded contracts, which will keep cash flow depressed even as subscriber revenue grows.

The article 1 Trend That Should Worry Netflix, Inc. Investors originally appeared on Fool.com.

Adam Levy owns shares of Amazon.com and Apple. The Motley Fool recommends Amazon.com, Apple, Google (A shares), Google (C shares), and Netflix. The Motley Fool owns shares of Amazon.com, Apple, Google (A shares), Google (C shares), and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.