Friday, March 30, 2012

Netflix - Can They Pay Their Off Balance Sheet Liabilities?

Caleb Tommasini

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.   

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.  



  2. Thanks for making things clear. This topic gives me headaches for quite sometime already. I am really glad you shared this information.