Netflix: Can They Pay Their Off Balance Sheet Liabilities?
I have been
watching Netflix for some time playing both stock and option strategies. I was
a large proponent of the company being "over-valued" when they traded
around $300/share at astronomical multiples.
I even chuckled at the dialogue between Whitney Tilson and Reed Hastings
over Seeking Alpha. Ironically, both the
men were ultimately wrong, and now Whitney is long the stock. The interesting thing is that he compares the
company to Green Mountain Coffee in going long for who knows what reason, but
hey, made for some good reading.
Personally, I made some money on the way down, but lost repeatedly on
long put positions as I thought the market was expecting too much in terms of
growth prior to earnings releases. I
actually had puts at $250 and literally missed the collapse by a week due to
option expiration. Now that the stock
has crashed heavily, experts, such as Whitney, are now signaling its time to
buy as the valuation is much lower and the growth is still in full force. I am going to present one issue in their
accounting that may significantly hurt the company over the next 1-3
years. I found something that I thought was interesting on
pages 35-36 of their 10-K. They disclose
the following chart and descriptions:
Contractual
Obligations
For the purposes of this table, contractual obligations for
purchases of goods or services are defined as agreements that are enforceable and legally binding and that specify
all significant terms, including: fixed or minimum quantities to be purchased;
fixed, minimum or variable price provisions; and the approximate timing of the
transaction. The expected timing of payment of the obligations discussed
above is estimated based on information available to us as of December 31,
2011. Timing of payments and actual amounts paid may be different depending on
the time of receipt of goods or services or changes to agreed-upon amounts for
some obligations. The following table summarizes our contractual obligations at
December 31, 2011:
that include renewal provisions that are solely at the option of
the content provider, we include the commitments associated with the renewal
period to the extent such commitments are fixed or a minimum amount is
specified. For these reasons, the amounts presented in the table may not
provide a reliable indicator of our expected future cash outflows.
We have entered into certain streaming content license agreements
that include an unspecified or a maximum number of titles that we may or may
not receive in the future and/or that include pricing contingent upon certain
variables, such as theatrical exhibition receipts for the title. As of the
reporting date, it is unknown whether we will receive access to these titles or
what the ultimate price per title will be. Accordingly such amounts are not
reflected in the above contractual obligations table. However, such amounts are
expected to be significant and the expected timing of payment for these
commitments could range from less than one year to more than five years."
Note 3:
"For purposes of this table, less than one year does not
include liabilities which are reflected on the Consolidated Balance Sheets as
current liabilities. Content accounts payables for instance includes $905.8
million in streaming content obligations not reflected in the above
table."
The first thing I
did was check the numbers, my eyes may be going bad as I have been reading
extensively, after checking again it was true, nearly $1 billion in 1 year and
over $2.5 billion in 1-3 years. Add in
note 3 above, and this number increases by another $906 million for content
alone. So NFLX will owe $1.9 billion in
this year alone for content! Yes, those numbers are in thousands up above, they
are going to owe nearly $3.5 billion in the next 1-3 years in off balance sheet
liabilities (plus the $.9 billion). To
put this in perspective (% of $1.9 billion owed this year displayed next to
actual number for comparison purposes):
·
Market cap is
around $6 billion (31.7%)
·
Book Assets are
$3 billion (63%)
·
Revenues $3.2
billion (59%)
·
Net income is
$226 million (841%)
·
EBITDA is $428
million (475%)
·
Book Equity is
$642 million (296%)
·
Short Term Investments
are $290 million (655%)
·
Cash balance is
$508 million (374%)
They additionally have these major liabilities:
·
Short Term
Liabilities are $1.23 billion (including the $.9 billion)
·
Debt is $400
billion
·
Other Long Term
Liabilities are $770 million
Note of Off Balance Sheet Liabilities
First, before I get too crazy on the numbers,
I want to discuss why these are Off Balance Sheet Liabilities. Generally, when investors want to check
future operating lease liabilities, they look at this section. This holds for
NFLX as they have $21.7 in operating leases due in one year and $79.2 million
in total. Based on NFLX's cash and
balance sheet, I am not concerned with these being paid off. The major question I have is how the company
can call these "off balance sheet" if it's clear they have a contract
to pay up and can place a minimum value on the portion they estimate and they
have to 100% for sure pay this portion at set agreed upon times? Maybe they
should put this on the balance sheet as "Other Liabilities" and put
in the notes that they may owe more depending and add an offsetting
"prepaid other assets". They
specifically state that they are legally bound to make, at minimum, these
payments. They have the minimum they will owe, the minimum price they will pay,
and the time when they will pay, so why is this not on the balance sheet? They state in their "Streaming
Content" note:
"The Company had $3.91 billion
and $1.12 billion of obligations at December 31, 2011 and December 31, 2010,
respectively, including agreements to
acquire and license streaming content that represent long-term liabilities or
that are not reflected on the Consolidated Balance Sheets because they do not
meet content library asset recognition criteria. The license agreements do not meet content library asset recognition
criteria because either the fee is not known or reasonably determinable for a
specific title or it is known but the title is not yet available for streaming
to subscribers. For those agreements with variable terms, the Company does
not estimate what the total obligation may be beyond any minimum quantities
and/or pricing as of the reporting date. For those agreements that include
renewal provisions that are solely at the option of the content provider, the
Company includes the commitments associated with the renewal period to the
extent such commitments are fixed or a minimum amount is specified."
Notice they give
reason as to why they do not reflect these liabilities in the accounting
statement. They claim because they don't
know the fees or the timing of the fees generated from the assets (not from the
liabilities, which they do), they do not have to reflect the content as an
asset, and thus do not have to reflect a liability! Almost like magic! Amazing, so because they
can't reasonable estimate the value of the asset, the liability also do not
exist, but they all will soon, very soon.
This is a definite loophole in FASB for Netflix as their leverage is
reduced significantly based on balance sheet multiples. Just viewing the statements would show a
relatively healthy, fast growing company, but buried you find this, turning
their Balance Sheet sour in a hurry. They
further state that they are claiming the absolute bare minimum that they will
be required to pay. They then go on and
explain that costs above the stated
amounts could be "significant".
I wonder by significant if they mean $100 million, or $10 billion? Your guess is as good as mine.
Note, someone is
already suing them for these "off balance sheet" liabilities
according to page 63 of their most recent 10-k, and NFLX is already stating
they will "reasonably possible" lose money as a result of the suit,
"based its current knowledge".
However, NFLX cannot estimate the liability once again and thus will not
record anything on the Balance Sheet. The excerpt in the 10-K:
"On January 27, 2012, a purported
shareholder class action suit was filed in the United States District Court for
the Northern District of California against the Company and certain of its
officers and directors. The complaint
alleges that the Company issued materially false and misleading statements
regarding the Company’s business practices and its contracts with content
providers, which lead to artificially inflated stock prices. The complaint
alleges violation of the federal securities laws and seeks unspecified
compensatory damages and other relief. A second suit was filed on January 27,
2012, alleging virtually identical claims. Management
has determined a potential loss is reasonably possible however, based on its
current knowledge, management does not believe that the amount of such possible
loss or a range of potential loss is reasonably estimable."
Most troubling is
that Netflix also agrees with me on their short comings in the future. In the section titled "Liquidity",
they have this excerpt:
"As a result of the significant
increase in subscriber cancellations negatively impacting domestic and
consolidated revenues, coupled with increased investments in our International
streaming segment, and in international content in particular, we expect consolidated net losses and
negative operating cash flows for 2012. Although we currently anticipate
that our available funds will be sufficient to meet our cash needs for the
foreseeable future, we may be required
or choose to obtain additional financing. Our ability to obtain additional
financing will depend on, among other things, our development efforts, business
plans, operating performance, current and projected compliance with our debt
covenants, and the condition of the capital markets at the time we seek
financing. We may not be able to obtain such financing on terms acceptable to
us or at all. If we raise additional funds through the issuance of equity,
equity-linked or debt securities, those securities may have rights, preferences
or privileges senior to the rights of our common stock, and our stockholders may experience dilution."
The scary thing
is that they flat say they will burn more cash, have losses, and explain they
"may be required or choose to obtain additional financing," and
further state at the end, "our stockholders may experience
dilution." Even Netflix management
openly agrees with me that they need to raise money and explain that current
shareholders will be diluted to do so.
They further state beyond this in the next paragraph, " As we expect to have negative operating cash
flows in future periods, we do not expect to make further stock repurchases for
the foreseeable future." They buy shares when the stock is above $200, and
stop when it trades at $100? This is signaling cash flow concerns, most
certainly as why would they buy expensive shares and stop when they become
cheap unless they can no longer afford to buy them. At this point, this does not sound like a
company I would want to own, in fact, this sounds like a company that is
screaming SHORT ME! Negative cash flows,
slowing growth, lofty valuations, margin pressure, competitors with deep
pockets and changing business model all lead me to believe that NFLX will be
under some pressure. The interesting
part is that they mention content last as the reason and specifically mention
international content with no mention of domestic content.
Just to reiterate
my point, I want to show the recent increase in content liabilities due to the
switch of focus from mail DVD to streaming content, NFLX presents on Page 59:
The main purpose
in posting this excerpt is to view the content liabilities from 2010 and
2011. In 2010, they post $185 million,
in 2011, they post $1.6 billion! That's
roughly a 789% gain in one year and as I mentioned above, this number is
continuing to swell. The reason they
have these new content costs where they did not before is due to something
called, "First Doctrine Sale."
Under the mail order model, Netflix would buy the DVD once, that was it, and occur no further
costs. NFLX could then rent the DVD as
many times as they wanted to free of charge.
With streaming, they are no longer protected by this clause as they
never actually buy a physical product.
They now need to sign contracts to stream content. This is changing their business model and
adding significant costs. Also note,
Netflix does now own the pipes where they stream this content, and essentially
is a middle man providing a replicable service.
Further, of the competition entering to compete directly, Apple, Amazon,
and Comcast among others, Netflix controls the low end of the spectrum in terms
of content and hence the massive costs to catch up. If you look at it from the content providers
side, they basically have deep pockets bidding for their goods and will give
rights to the highest bidder, but only lock in short term contracts enabling
them to re-evaluate who has the most money to pay them the next time contracts
are signed. Netflix acknowledges that
they are lengthening their contracts to yearly terms from the shorter contracts
they used to use, but this does little in terms of sustainable competitive
advantage especially given the liquidity concerns they are facing compared to
the deep pockets competing in the bidding process.
I am no
mathematician, but I can do basic addition. Let's look roughly at their cash
situation in 2012 just from what we have viewed in a high level setting. This
is going to be by no means a perfect analysis, but should provide a
"rough" estimate of where liquidity concerns may pop up for
2012. Assuming NFLX owes $1.9 billion in
content this year as described above and they have another $325 million in
short term liabilities (deferred revenue is $150 million, not a true cash
outflow, but will be deducted from CFO as its being added to Net Income so
important). This brings the current
liabilities to roughly $2.25 billion. They
currently have $1.8 billion in short term assets, and a net loss. I do take note that they have a bunch of
other cash adjustments, but for argument sake, these are the large ones. Note that this does not include any further
additions to their content library, which certainly Netflix will want to do to
stay competitive or cash flow from investing.
Just with those numbers, they need to raise at least $425+ million
without an investing from cash flows assumed in the numbers. As you can see, realistically the math does
not work and NFLX will have to raise money.
They probably will not have great access to the debt markets again (they
are already paying 8.5% on notes, a massive credit spread given rates are so
low), so they will more than likely have a large equity offering or pay an
interest rate that is well above what they could under normal conditions. A raise of this magnitude would be worth at
least 5% the company and with Netflix against the wall with the recent
"Qwickster" fiasco and a couple lawsuits, I doubt shareholders will
be pleased and will punish the shares.
Conclusions
Netflix's
shareholders are are going to be in trouble for the short term. They already claim they expect negative CFO
and earnings in 2012. Capital IQ has
NFLX losing ($0.23) / share this year, but recovering to earn $2.60 / share in
2013 and $4.47 / share in 2014. This
places the stock at $110 today trading at a 1.7 forward P/E of 42x and 2.7
forward P/E of 25x, hardly cheap by any metric. I think the upcoming equity raise or massive
leveraging of the balance sheet (this time on the balance sheet) that is most
certainly going to occur will be the catalyst to make this trade a
success.
