How does NFLX manage to show positive net income yet burn hundreds of millions of dollars each quarter? It’s the magic of GAAP accounting. I did a detailed analysis for my Short Seller’s Journal subscribers back in 2017. Each quarter NFLX has to spend $100’s of millions on content. Most companies like NFLX capitalize this cost and amortize 90% of the cost of this content over the first two years. Amortizing the cost of content purchased is then expensed each quarter as part of cost of revenues. Companies can play with the rate of amortization to lower the cost of revenues and thereby increase GAAP operating and net income.
In the analysis I did for my subscribers, I demonstrated this accounting Ponzi mechanism:
The ratio of cash spent on content in relation to the amount recognized as a depreciation expense can be used to determine if NFLX is “stretching out” the amount depreciation recognized on its GAAP income statements in relation to the amount that it is spending on content. In general, this ratio should remain relatively constant over time.
For 2014, 2015 and 2016, this ratio was 1.42, 1.69 and 1.80 respectively. When this ratio increases, it means that NFLX is spending cash on content at a rate that is greater than the rate at which NFLX is amortizing this cash cost into its GAAP expenses. If NFLX were using a uniform method of calculating media content depreciation, this number should remain fairly constant across time. However, as content spending increases and GAAP depreciation declines relative to the amount spent, this ratio increases dramatically – as it has over the last three years. A rising ratio reflects the fact that NFLX has lowered the rate of depreciation taken in the first year relative to previous years. It does this to “manage” expenses lower in order to “manage” income higher.
In the first nine months of 2018, this ratio was 1.70, which explains largely why NFLX’s rate of GAAP “earnings” growth is declining. To pay for its massive cash flow burn rate, NFLX has to continually issue more debt and stock.
NFLX’s 2019 Q3 income statement contained the usual GAAP games in order to show gross, operating and net income. But as I’ve detailed in the past, NFLX’s treatment of the amortization of the cost of buying content is highly questionable if not outright fraudulent. While the GAAP net income reported provides terrific headline material, the truth shows up in the statement of cash flows. Through the first nine months of 2019, NFLX’s operations burned nearly $1.5 billion in cash. On top of that, NFLX spent another $145 million on content acquisition. Keep in mind that NFLX’s North American subscriber growth has hit quick-sand.
But not only is NFLX’s business model a literal cash incinerator, the Company robotically issues debt. Through the first nine months of 2019, NFLX issued $2.24 billion in debt, which was $343 million more than the same period in 2018. But NFLX wasn’t finished issuing debt this year. Seven days after reporting Q3 numbers, NFLX issued another $2 billion in bonds. This brings its total debt issuance in 2019 to $4.24 billion. NFLX now has a total of $14.4 billion in debt. But we’re not finished. On top of this, the Company has $19.1 billion in streaming content obligations, $16.9 billion of which is due over the next three years. This makes a total $31.3 billion in debt and debt-like commitments.
On top of all of this, NFLX now faces stiff competition from well-funded companies which have started to roll-out their own content streaming operations at lower price points. In some cases, NFLX will no longer have access to desirable content. As an example, Disney rolled out its Disney+ streaming service on November 12th, signing up more than 10 million users by opening day. Verizon offers a free one-year subscription to Disney+ to wireless customers on unlimited plans. Disney’s service is $6.99/month. Apple rolled out its AppleTV streaming at $4.99/month. NBC Universal debuts streaming in early 2020 and is considering offering it for free. AT&T/Warner will soon launch a streaming service that will be similar to Netflix from a cost standpoint but will be built around HBO. Additionally, more and more homes seem to be using cable more regularly these days. Due to the selection of programs available on cable, people seem to be finding ways to make their cable bill more affordable so that they can enjoy the various programs and movies that are available (read this source here to save on cable bills). Cable is still a popular way of watching tv shows despite these streaming services, so it’s clear that Netflix has a lot of competition.
I believe part of the reason NFLX’s stock has run up like it has is due to the release of “The Irishman,” a highly acclaimed movie it produced that is directed by Martin Scorcese and features Robert DeNiro, Al Pacino and Joe Pesce, among other marquee actors. But the movie cost $160 million to produce, an amount NFLX will never recoup.
The movie debuted this past week in a limited number of theaters. Several major theater chains refused to show it because NFLX demanded a 3-week window of exclusivity before sticking it on its streaming platform. Three weeks is the minimum amount of time a movie must spend in public theaters to qualify for the Oscars. Movie production companies rely on huge box office revenues plus revenue sharing deals on concessions to cover the production cost of blockbuster movies. After raking it in from the theaters, they look to milk huge fees from content syndication agreements. NFLX cut short its ability to pocket huge box office revenues and will not benefit from the ability to sell the rights to “The Irishman.”
NFLX sacrificed a large portion of box office revenues with the idea that it could use “The Irishman” as “bait” to catch new subscribers. However, people who don’t already subscribe to NFLX will likely either see it while it’s at the theaters or sign up for the free month to watch it and then cancel, which is what I’m going to do.
NFLX’s business model will lead to an epic fail. Eventually Netflix’s stock is dead meat. While Netflix has a viable streaming business, it simply has too much debt. It will never be able to service its debt load, especially in conjunction with the its content payment obligations.
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The commentary above is an excerpt from the Short Seller’s Journal. Each weekly issue contains macro economic analysis, market analysis, and short ideas. I To learn more about this short-sell focused newsletter, click here: Short Seller’s Journal info