In many ways, Netflix is a great business. It has demonstrated considerable strategic flexibility to evolve and iterate its business model multiple times in a single decade. In 2006, it was operating solely as a US DVD movie rental business, with 5 million customers and annual revenue just under $1bn. In the quarter just ended (3Q16) it clocked an incredible 87 million video-streaming customers, and it is on track to exceed $8bn in revenue for 2016.
But Figure 1 below, which breaks down Netflix’s business at a per-subscriber scale, indicates that the company is facing a big challenge. It is not that its revenue per user has declined – one would expect that as it builds scale. It is not even that its profitability has declined over the years to the point where it is barely profitable. Its big challenge is that it burns so much cash as a business. More importantly, its cash burn is getting worse, not better, as it grows in scale, judging by the rapidly sinking line below showing free cash flow per subscriber. (Free cash flow is defined as operating cash flow minus capex.) The company’s rapidly accelerating cash spend is due to the rapid increase in spending on original content such as the House of Cards and Narcos series: Netflix estimates it will spend $5bn on original content in 2016, a figure that is set to increase to $6bn in 2017.
The business doesn’t seem to be able to sustain content spend on such a grand scale. For example, in 2011 Netflix generated $0.81 and $0.67 per customer per month of net profit and free cash flow, respectively. By contrast, in the first nine months of 2016, monthly net profit per customer had declined to $0.16, while free cash flow had declined to -$1.33 – amounting to a cash burn of more than $1bn for the first nine months of 2016 alone. Hence Netflix now borrows just to fund its operations, with the latest debt injection – of $1bn – coming just in October 2016.
We think a major factor behind the big gap between the (small, but positive) net profit and (negative) free cash flow is Netflix’s aggressive accounting. In particular, Netflix expenses its streaming content assets (i.e. capitalized costs it incurs to license or produce content) in such a way that it recognizes too small a proportion of these expenses right now, and pushes more of these expenses into the future, as a result flattering its current earnings. Examples of its aggressive accounting include:
Long streaming content expensing periods. Streaming content assets are amortized (i.e. expensed) over periods of up to five years, which we think is too long a period. By comparison, Netflix expenses DVD rental assets – still visual content, just in different packaging – over one year (new releases) and three years (back catalog). By stretching amortization periods, Netflix reduces current expenses by pushing more of the capitalized content costs to the future, as a result flattering current earnings.
Slow streaming content expensing. Netflix discloses that “most” streaming content assets are expensed on a straight-line basis, which means expenses are evenly spread over the amortization period, which could be up to five years. By comparison, all of Netflix’s DVD rental assets are amortized on an accelerated basis, with higher expenses in the early periods and lower expenses in later periods. We think accelerated expensing more accurately matches viewing patterns, since new shows are most popular in the initial months after release. Again, this policy has the effect of flattering current earnings by pushing more of the costs to the future.
Aggressive accounting aside, can Netflix effectively get over this cash burn problem? Of course it can. It can raise prices, reduce content spend, license some of its original content to third parties, or use a combination of the three. The challenge with these approaches is that they would almost certainly hurt the 20%+ subscriber growth that its investors have come to expect in order to justify its stratospheric valuation: Currently, the company is valued at over $52bn, about 325 times its annual earnings. By comparison, the overall US stock market is presently valued at approximately 25 times the listed companies’ earnings.
So, Netflix has little choice but to continue to squeeze whatever subscriber growth is left out of the “big bang” global expansion it launched in early 2016, continue to aggressively spend on original content to support this expansion, and hope that investors continue to both fund its cash burn and ignore aggressive content accounting. But for how long?
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