Netflix (NASDAQ: NFLX) just reported one of its best quarters yet, adding 1.1 million subscribers in the United States and another 4.1 million internationally. Management pointed to its successful original content as the reason for its success.
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That said, management also addressed the fact that it's burning through billions of cash and expecting to produce negative free cash flow between $2 billion and $2.5 billion this year. "We will deploy increased capital in content, particularly in owned originals, and, as we have said before, we expect to be FCF negative for many years," management wrote in the letter to shareholders.
To help investors understand how Netflix can burn through cash and still produce positive net income, the company provided some additional context on its content accounting. Here's how it impacts investors.
Cash payments exceeding expenses
For both its original productions and licensed content, Netflix generally pays more in cash up front than it shows as an expense on its income statement. That's because Netflix amortizes the content expenses over the useful life of the show or film. Netflix says the useful life of a licensed movie or TV show can range anywhere from six months to 10 years.
That said, Netflix uses an accelerated amortization schedule for the vast majority of its content licenses. For its original shows, Netflix amortizes 90% or more of a production's cost within the first four years. Some shows, like Chelsea Handler's talk show, are expensed when they air due to the short relative useful life of the content.
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While amortizing content expenses is common practice for media companies like Netflix or Disney (NYSE: DIS), it can hide the amount of cash the company is paying up front for content. It certainly shows up in the company's cash flow statement, but it doesn't appear in earnings per share -- which often gets more attention.
The push into original productions is killing cash flow -- will earnings follow?
Netflix has been cash flow negative for the last three years, corresponding with its big push into original content. Following the success of early productions like House of Cards and Orange Is the New Black, the company decided to aggressively pursue more original productions. Management's comments indicate it will continue to pursue original productions aggressively, which will put a strain on cash flow.
Netflix has moved to producing new series in-house instead of licensing exclusive first-run streaming rights from production companies. The move gives Netflix more control over the content (never available on DVD) and opportunities to license the intellectual property as it sees fit, but it also costs a lot more up front. What's more, Netflix can incur these cash expenses well before a series makes its way to the streaming service. While such a series' costs won't show up on the income statement until it starts streaming, they show up on the cash flow statement as they occur.
As Netflix moves into more of these original productions, the disparity between its cash burn and its content expense will grow even wider. Investors should pay very close attention as Netflix shifts its focus from licensed originals and second-run shows to in-house productions. All of the money spent on the cash flow statement will eventually make its way to the income statement.
Growing content obligations
Netflix also has various long-term contracts with media companies like Disney to license content in the future. Some of this content has a known price and date when it will come to Netflix. Anything that won't start streaming for another year doesn't show up on the balance sheet. Instead, Netflix outlines those obligations in a separate form, which shows it has $8.7 billion in additional obligations after the next year.
Netflix is keen to point out other media companies, like Disney's ESPN, do the same thing with their long-term sports rights. Indeed, ESPN has some huge content obligations over the next decade. That said, Disney also generates a ton of cash flow to cover those obligations.
What's more concerning is that Netflix can't account for content that it doesn't yet know the price it will pay. For example, Netflix has a deal in place with Disney to stream all of its new feature films. But Disney could produce any number of new films, so the exact amount Netflix will pay is still unknown. Netflix has a similar problem with TV shows where the number of seasons is unknown, but it's already agreed to buy the streaming rights to all seasons.
Those costs don't show up anywhere in Netflix's financial disclosures. The company estimates they will add another $3 billion to $5 billion over the next three years.
The importance of subscriber growth
Netflix's ability to amortize its huge content spending over several years gives the company time to use all that content to attract subscribers. It was extremely successful in the second quarter with that strategy. But Netflix needs to keep adding subscribers at a rapid pace in order for it to show progress on the bottom line when all of those cash expenses finally hit the income statement. Meanwhile, its balance sheet is loading up with debt and content obligations, and it will continue to burn through cash for the foreseeable future.
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