How Healthy Is The Balance Sheet At Netflix?

| About: Netflix, Inc. (NFLX)

There are a number of things to take into consideration before investing in a stock. Such considerations include profitability, future growth prospects, dividends, and valuation.

Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheet of Netflix (NASDAQ:NFLX), in order to get an idea as to how well this company is doing.

I will go through the balance sheet, reviewing the most important items, in order to assess the financial of Netflix. The information that I am using for this article comes from the company's website here.

Note that this article is not a comprehensive review as to whether Netflix should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.

Also keep in mind that Netflix is undergoing a lot of changes as it expands both domestically and internationally, so the company's financial condition could change a lot from where it is now. This article simply provides a snapshot of the company's current financial state.

This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.

Background

Netflix is the world's largest internet subscription service for movies and TV shows. Subscribers in the U.S. can also have DVDs and Blu-ray discs delivered to their homes. The company has over 40 million streaming subscribers, with 31 million in the U.S. The company currently has 7.1 million DVD subscriptions. They offer subscription plans that don't have due dates, late fees, shipping fees, or pay-per-view fees.

The company receives its content from studios and other content providers through streaming license agreements, DVD direct purchases, and DVD revenue-sharing agreements.

In 2012, the company generated $3.6B in revenue, with 92% of it coming from subscribers in the U.S.

Cash and Cash Equivalents

The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, pay down debt, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.

As of Sept. 30, 2013, Netflix had $1.14B in cash and short-term investments. Instead of using this cash to pay dividends or buy back stock, Netflix will use it to acquire and license content, as well as pay for content delivery expenses, along with marketing and payroll expenses. This is important for the company as it continues to expand outside of the U.S.

Netflix is currently expecting negative operating cash flows in the near future due to investments in licensing streaming content both domestically and internationally. Year to date in 2013, the company reported a free cash flow deficit of $21.5M. During 2012, they had a deficit of $58.2M. However, this figure has turned positive over the last two quarters, with a total free cash flow of $20M.

Current Ratio

Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of its operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.

If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.

The current ratio of Netflix is 1.47, which is very good.

Return on Assets

The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:

Return on Assets = (Net Income) / (Total Assets).

For Netflix, the return on assets would be $71.9M in core earnings over the last 12 months, divided by $4.9B in total assets. This gives a return on assets for the trailing twelve months of 1.47%, which is nothing to write home about in absolute terms. I also calculated the company's returns on assets over fiscal years 2012, 2011 and 2010 for comparative purposes. This can be seen in the table below.

Symbol

ttm

2012

2011

2010

NFLX

1.47%

0.04%

7.56%

16.3%

Click to enlarge

Table 1: Returns On Assets At Netflix

The numbers in Table 1 do not look very good for Netflix. The return on assets for 2010 looked pretty good, but they were cut by more than half in 2011, as the company's asset base more than tripled, against earnings that rose by more than 40%. That's not necessarily a bad thing.

However, those returns disappeared completely in 2012, as there was an increase of $746M in content acquisition and licensing expenses due to continued investment in new and existing streaming content. During 2012, there was a 41% decline in DVD sales volumes due to fewer subscriptions. There were losses in the company's international streaming segment due to having to make the aforementioned investments without an established customer base, which their domestic segment has. It should also be mentioned that there were a lot of cancellations due to plans that management made to separate the company's DVD and streaming businesses, which would have led to price increases. Netflix ended up deciding not to follow through with these plans.

Over the last 12 months however, we see that the return on assets may be starting to recover. In fact, the company turned a $32M profit in the most recent quarter, with guidance for the upcoming quarter coming in at $37M. The third quarter of 2013 was their best since the fourth quarter of 2011 in terms of earnings. If this momentum continues as the company expands internationally, the return on assets should rise from here. Time will tell.

Short-Term Debt Versus Long-Term Debt

In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.

This is not a problem at all for Netflix as it doesn't have any short-term borrowings at this time.

Long-Term Debt

Long-term debt is debt that is due more than a year from now. An excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.

Right now, Netflix carries $500M in long-term debt, which is more than the $200M that the company had at the ends of 2012, 2011, and 2010. This debt is in senior unsecured notes, at an interest rate of 5.38%, due in 2022. This debt was issued in February 2013, partly to pay off the $200M of long-term debt that the company had before. That debt carried an interest rate of 8.5% with a maturity of 2017.

In determining how many years worth of earnings it would take to pay off the company's long-term debt, I use the average core earnings of the company over the last three years. In the case of Netflix, that figure would be $137M. The calculation is given below.

Years to pay off long-term debt = long-term debt / 3-yr. average core earnings

For Netflix, it goes like this: $500M / $137M = 3.65 years

This means that Netflix could pay off its long-term debt with an amount that is less than four years worth of company earnings. This is normally a good sign, but given that earnings at Netflix have been in flux over the last few years, along with negative free cash flows, this figure is suspect.

Debt-To-Equity Ratio

The debt-to-equity ratio, as normally calculated, is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Netflix stacks up here.

Debt-To-Equity Ratio = Total Liabilities / Shareholder Equity

For Netflix, the debt-to-equity ratio is calculated by dividing its total liabilities of $3.97B by its shareholder equity of $1.20B. This yields a debt-to-equity ratio of 3.31.

This is pretty high for Netflix. The table below shows how the debt-to-equity ratio has changed over the last few years.

SYMBOL

Q3 2013

2012

2011

2010

NFLX

3.31

4.32

3.78

2.39

Click to enlarge

Table 2: Debt-To-Equity Ratio Of Netflix

The debt-to-equity ratio of Netflix has been pretty high over the last several years. However, some may disagree with this calculation, as the company has only $500M in actual borrowings. Included in my calculation, however, are its other liabilities, such as accounts payable, and the $2.8B in streaming content obligations that are related to streaming content licenses. These content obligations account for 70% of the company's nearly $4B in total liabilities. While these items don't constitute official borrowings, they still represent money for which Netflix is on the hook, so I include them in my calculations.

There are a total of $6.5B in these streaming content obligations. However, $3.7B of this is not on the balance sheet, as that portion does not yet meet the criteria that the company uses in determining asset recognition. Of this $6.5B that the company owes, 86% of it must be paid within the next 3 years.

Return On Equity

Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.

Return On Equity = Net Income / Shareholder Equity

Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks. However, Netflix is not one of these companies.

So, the return on equity for Netflix is as follows:

$0.072B / $1.20B = 6.00%

In the table below, you can see how the return on equity has fared over the past three years.

Symbol

ttm

2012

2011

2010

NFLX

6.00%

2.28%

36.1%

55.6%

Click to enlarge

Table 3: Returns On Equity At Netflix

The returns on equity at Netflix follow the same trend as the company's returns on assets, due to declining earnings against a rising equity position that has more than quadrupled since the end of 2010.

However, if the company can at least replicate the results that it reported in the most recent quarter, over the next 12 months, then the return on equity could move back into double-digit territory. As I mentioned earlier, a lot of this is going to hinge on how well the company does internationally.

Retained Earnings

Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:

Retained Earnings = Net Income - Dividend Payments - Stock Buybacks

On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.

Netflix currently has a retained earnings figure of $504M. Below, you can see how the retained earnings have fared at Netflix at the end of each of the last four fiscal years.

Symbol

2012

2011

2010

2009

NFLX

$440M

$423M

$237M

$199M

Click to enlarge

Table 4: Retained Earnings At Netflix

From the above table, you can see that Netflix has increased its retained earnings by more than 150% between the ends of 2009 and 2012. This is great, especially for a young company like Netflix, as it has generated some money that can be reinvested into its operations.

Conclusion

After reviewing the most recent balance sheet, it can be concluded that there are a couple of things to like about the financial condition of Netflix. For starters, the company has a good current ratio, which shows that Netflix should be able to meet its short-term financial obligations, even in the event of an unexpected disruption to its operations. The company has kept its borrowings under control for the most part, and has refinanced a portion of it at lower rates. Netflix has also shown impressive growth in retained earnings.

My biggest concern is the company's profitability, which has been hampered by what management claims is increased investment in content acquisition and licensing, as the company expands not only domestically, but internationally. Whether this expansion pays off remains to be seen. This has resulted in low returns on assets and equity over the last couple of years, although these figures are showing signs of recovery. We'll need to monitor this in the quarters to come.

I am also concerned about the company's debt-to-equity ratio, which is very high, in large part to the $2.8B in streaming content obligations that the company is currently carrying. Over $5.5B in payments related to such obligations will need to be made over the next 3 years. Profits at Netflix will need to get back on track if the company intends to make good on these obligations.

While this is not a comprehensive review as to whether Netflix should be bought or sold, I don't believe that the company is in great financial condition at this time. However, that is subject to change as the company continues to expand both domestically and internationally. Time will tell.

More information on how I analyze financial statements can be found at my website here. It's a website that I created in order to help people make more intelligent financial decisions.

Thanks for reading, and I look forward to your comments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.