Investors have to give credit where it's due - Netflix, Inc. (NASDAQ:NFLX) has continued to add streaming subscribers at a steady pace. The online-video company ended last quarter with 38.0 million paying members, up 2.4 million from 35.6 million subs NFLX had just a quarter earlier; the growth of streaming-only subscribers more than offset the loss in the DVD-rental ranks. NFLX also cranked up its bottom line, from $0.13 per share ($7.67 million) in the third quarter a year earlier to $0.52 per share ($31.82 million) in Q3 of this year. Almost needless to say, the market loved the news, even though CEO Reed Hastings successfully convinced the market that Netflix shares were overpriced, sending the stock lower. As has been the case for several quarters now, however, NFLX owners and observers are missing a much bigger problem buried elsewhere in the books.
This isn't going to be the first time "off balance sheet liabilities", "cash flow statement", and "Netflix" have been used together to paint a less-than-enthusiastic picture of the digital entertainment company. But, when the problem is getting bigger at a faster pace than the company's revenue is growing, the point has to be made again.
First and foremost (and mostly for perspective), the Netflix top line for Q3 grew from $905.1 million a year ago to $1.106 billion last quarter. That's a 22.1% increase, driving more than a 300% increase in the company's bottom line. Granted, the year-ago comparison was a woefully-low bar to hurdle, but even compared to Q2-2013's top line of $1.069 billion and bottom line of $29.471 million, it's clear progress.
There's more to life than the income statement, however. Indeed, the income statement (aside from the revenue line) may be the easiest place to lose or bury key details. The cash flow statement is increasingly troubling for Netflix.
As of last quarter, NFLX amortized $553.4 million worth of content, up from the $510.2 million in the quarter before last (which was up from $485.7 million in Q1). Point being, the proverbial "hit" being taken for all the new content contracts Netflix Inc. has been taking on lately. Though the amortized amount doesn't show up on a GAAP operating income statement, neither does the purchase cost of all the shows and movies Netflix buys the streaming rights to. And make no mistake - the company is spending more and more money on the content front. Last quarter (on the same cash flow statement) Netflix reported $878.3 million worth of new content-library additions, up from only $594.45 million in Q2. Eventually that big spend on new content will have to be amortized, which will take a tool on the company's free cash flow... sort of a non-GAAP bottom line. Thing is, GAAP rules can be so squirrelly now, the free cash flow figure means much, much more for a business like Netflix's than the income statement does.
So what? The so what is, last quarter, Netflix only booked $7.0 million worth of free cash flow, versus $12.9 million in Q2.
One quarter does not make or break a trend, but this has been and is the issue that could make or break NFLX in the foreseeable future. And, we know with a huge addition (much more so than usual) to the content library last quarter, Netflix Inc. is going to be amortizing a lot more in the near future than it has been lately. Cash flow margins are already paper thin, and if the sales tip any further in the wrong direction - which is likely - the company could slip back into negative free cash flow land again... which in this case could be much more destructive to the stock than any red flags on the income statement.
The really scary part is that we may not even know the full extent of future liabilities that don't even show up on the balance sheet or cash flow statement (but will soon). The off balance sheet liability total has been inching up for several quarters now. We won't have that data until we can see the fine print of the SEC filings, but as of the end of Q2, the company had $6.4 billion in obligations that don't appear on the balance sheet, up from $5.6 billion at the end of last year. A hefty $5.3 billion comes due within the next three years, and that's going to impact the cash flow statement even more adversely than the hit taken last quarter.
It's buried in the details ... on the accounting statements most investors rarely look at, and rarely need to. But, when it's a quirky, difficult-to-define business like Netflix, the market needs to redefine things that matter.
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