Content Obligations Increase Netflix's Leverage

May. 2.11 | About: Netflix, Inc. (NFLX)

Most discussions around Netflix, Inc. (NASDAQ:NFLX) focus around its impressive historical growth, its valuation, or more recently, an ongoing debate around the merits and costs of streaming content. Leverage, however, is not often part of the discussion for Netflix. Given the recent financial challenges, many companies have been strengthening their balance sheets in order to be able to withstand market challenges. Leverage determines a company's exposure to overall performance and its ability to handle business downturns. For this article, leverage is defined as a simple ratio of total assets to equity.

NFLX's Balance Sheet Leverage Doubles
The following table shows NFLX's leverage has doubled over the past couple years when comparing just balance sheet measures:

NFLX Leverage ($ Millions)
Period Total Assets Equity Leverage
Q1 2011 1,090 276 3.95
Q4 2010 982 290 3.38
Q3 2010 770 192 4.01
Q2 2010 694 177 3.93
Q1 2010 648 147 4.42
Q4 2009 680 199 3.41
Q3 2009 490 232 2.11
Q2 2009 590 324 1.82
Q1 2009 627 346 1.81
Q4 2007 683 430 1.59
Q4 2005 365 226 1.61
Q4 2002 131 89 1.46
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Source: NFLX SEC Filings

This increase in leverage has been quite recent. The Q1 2009 result is similar to all the previous figures. However, leverage is not necessarily a bad effect, despite recent events. The critical question is what is the appropriate amount of leverage for a company like Netflix. Despite creation of enormous shareholder value, book equity is lower this quarter than the previous quarter as well as substantially lower than in 2007.

Perhaps more interesting is that book equity dropped from $430 million in Q4 2007 to just $147 million in Q1 2010. This drop is in spite of an additional $231 million in net income over that time frame that would have been added to equity. So the total decline in book equity was about $514 million. This result is primarily driven by Netflix share buy back programs. Netflix also uses equity as a significant form of compensation for its employees and captures additional paid in capital that increases book equity as shares are issued when employees exercise options. The following table shows the amounts of cash used in share buy back programs in comparison to some other key metrics:

Select Metrics and Share Repurchase ($ millions)
Period Net income Operating Cash Flow (OCF) Share Repurchase (SR Ratio of SR/OCF
Q1 2011 60 116 109 93.4%
2010 161 276 210 76.1%
2009 116 325 324 99.8%
2008 83 284 200 70.4%
2007 67 277 100 36.0%
2006 49 248 - 0.0%
Totals 535 1,527 943 61.7%
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Source: NFLX SEC Filings

This table clearly shows why book equity has fallen so much as mentioned above. In 2009 and 2008, share repurchases totaled $524 million. While in hindsight, this looks like a brilliant move given where the stock is today, in reality it shifts resources away from reinvesting in the business. As noted in the right hand column, share repurchases are now totaling 70+ % of operating cash flow, which leaves little left. It should be noted that Netflix raised $200 million in 2009 through a debt issuance. These share repurchases also create additional demand for the stock, which drives its price higher.

The second observation is that Netflix's tremendous growth is clearly shown by the increase in net income. When the Q1 2011 result is annualized (x4), the average annual growth rate is 37.4%. However, the contrast to this growth is the more limited growth in operating cash flow which has grown at a more modest rate of 13.4%. This second assumption assumes an annualization of the Q1 2011 result (4x). While the net income growth would be impressive from 2006-2010, the cash flow growth rate drops substantially to just 2.7%, something a little above inflation.

Leverage is increasing because book equity is being drained through share repurchases while assets are perhaps following a normal level of growth. Furthermore, Netflix currently has about $343 million in cash and short term investments, which should at least pay for some more shares. While this level seems quite high relative to total assets, Netflix had $375 million in cash and short term investments at the end of 2007. So leverage is not increasing due to growth in large liquid reserves.

Contractual Content Commitments change the Leverage Picture
The following quote appears in the Netflix 2011 Q1 10-Q filing:

The Company had $1,634.0 million and $1,075.2 million of commitments at March 31, 2011 and December 31, 2010, respectively, related to streaming content license agreements that do not meet content library recognition criteria. The expected timing of payments for these commitments ranges from less than one year to more than 5 years. The license agreements do not meet content library 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.

These commitments represent future cash outlays as well as potential assets that would expand the balance sheet. Searching through 10-Qs shows a rapid increase in these commitments over the past 2-3 years. The following table also shows their impact on leverage:

Adjusted Leverage ($ millions)
Period Balance Sheet Assets Streaming Commitments at 0% Present Value Adjusted Combination (BSA + PVA) Equity Adjusted Leverage Leverage
Q1 2011 1,090 1,634 1,351 2,441 276 8.85 3.95
Q4 2010 982 1,075 889 1,871 290 6.45 3.38
Q3 2010 770 1,181 976 1,747 192 9.10 4.01
Q2 2010 694 229 189 883 177 5.00 3.93
Q1 2010 648 179 148 796 147 5.43 4.42
Q4 2009 680 115 95 775 199 3.89 3.41
Q3 2009 490 102 84 574 232 2.47 2.11
Q2 2009 590 89 73 663 324 2.04 1.82
Q1 2009 627 95 78 705 346 2.04 1.81
Click to enlarge
Source: NFLX SEC Filings. Present Value Adjusted is my calculation of what these Streaming commitments would look like on the balance sheet. The calculation is explained in the following section. The streaming commitments column is data taken directly from various 10-Qs and 10-Ks.


This table shows leverage not doubling, but increasing 4.5x. Furthermore, the peak leverage without content obligations peaked in Q1 2010. Adjusting for content obligations shows the peak in Q3 2010. Also, the difference between the current values and peak values is much smaller for adjusted leverage than for the simpler leverage calculation.

Adjusting Streaming Commitments to be "On Balance Sheet"
Later in the 10-Q, Netflix provides a rough timing schedule showing 1 year obligations of $642.9 million, 1-3 year obligations of $800.6 million, and 3-5 year obligations of $392.6 million for a total of $1,843.9 million. The difference between this figure and the $1,634 million probably reflects content that meets the content library recognition criteria and thus appears on the balance sheet. It should also be noted that the $1.8 billion represents the floor of contractual content obligations as noted in the 10-Q:

For those agreements with variable terms, we do not estimate what the total obligation may be beyond any minimum quantities and/ or pricing as of the reporting date. - NFLX Q1 2011 10-Q

This timing schedule was modified and used to determine the Present Value-adjusted figure used to calculate the leverage of the company. The first step was to allocate the numbers for 1 year, 1-3 year, 3-5 year obligations to an annual schedule. Then these values were adjusted proportionally since their gross value of $1,843.9 million is above $1,634 million. I then applied a discount rate of 8.5% and summed up those values to get the $1,351 million. The same payment distributions and discount rates were applied to the contractual obligations for each of the preceding quarters.

Calculations of Estimated Content Obligations ($ millions)
Period Estimated Contractual Content Obligations Adjusted by 89%* (1) Discount Factor of 8.5% (2) Present Value
Adjusted (= 1 x 2)
Year 1 643 572 92.2% 527
Year 2 400 356 84.9% 303
Year 3 400 356 78.3% 279
Year 4 196 175 72.2% 126
Year 5 196 175 66.5% 116
Totals 1,836 1,634 NA 1,351
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Source: Adapted from material in NFLX Q1 2011 10-Q and author estimates. *89% equals 1,634/1,836. The result of $1,351 million is subject to the assumption that the timings of the obligations is the same for the $1.6 billion as for the $1.8 billion. This approach also assumes that the payments occur at the end of the year, which is probably a conservative assumption.

Conclusion
I've seen quite a few comments praising Netflix as a service and know many subscribers who have no complaints. In looking at investment opportunities, it is critically important to recognize that a great company might not be a great investment. Also, a lousy company might not turn out to be lousy investment either. Rather, the question at hand is based on the price (broadly can be thought of as enterprise value) of the company and whether there is a reasonable amount of upside given the risks that the company faces. Skepticism or concern about a company's valuation is not necessarily a negative view of the company itself.

Netflix shows a substantial increase in its leverage when adjusted for contractual content obligations. These future contractual obligations might strain the company should subscriber growth not continue at an adequate pace. The leverage situation is further exacerbated by Netflix's share repurchase program. There is a risk that this cash might be been needed in the future to meet these obligations. These obligations further increase the risk of financial distress for the company. It remains to be seen whether or not Netflix can grow at a sufficient pace to both meet its obligations while maintaining the same pace of share repurchases.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.