Netflix's Contract Obligations Mountain

Feb.15.12 | About: Netflix, Inc. (NFLX)

Recently, Netflix (NASDAQ:NFLX) released its annual 10-K filing, and some of the details may be shocking to some. We all know that 2012 is going to be a transitional year for the company. It just launched its service in the UK and Ireland, it is going to bleed DVD customers, and will focus on a streaming business model going forward. Netflix said that it will lose money in 2012, which puts international expansion and stock buybacks aside for the indefinite future.

Before I get into the contractual obligations, I'll make a point on their legal issues, which have recently arisen. Netflix announced it settled a $9 million lawsuit late in 2011, which then caused the company to revise earnings per share down by 7 cents. That's a huge drop. This lawsuit, according to them, wasn't accounted for because they didn't think it was a viable lawsuit. However, they think current shareholder lawsuits against them may be viable, but they can't determine a financial estimate of such claims. This company is a mess.

The big number everyone was looking for in the 10-K was Netflix's contractual obligations, primarily their content obligations. Here is how the breakdown occurs for Netflix's obligations.

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But the staggering number isn't just the nearly $5 billion of obligations they have due in the future, it's the rate at which they have been increasing. Look at the following table.

Contractual Obligations 12/31/09 12/31/10 9/30/11 12/31/11
8.5% Senior Notes $336,472 $319,000 $310,500 $302,000
Convertible Notes $0 $0 $0 $200,000
Operating Lease Obligations $40,347 $53,038 $58,005 $59,925
Lease Financing Obligations $12,399 $23,573 $20,311 $19,267
Streaming Content Obligations $0 $1,299,176 $3,458,863 $3,907,198
Other Purchase Obligations* $388,056 $157,957 $269,003 $262,469
Total $777,274 $1,852,744 $4,116,682 $4,750,859
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*Prior to 2009, content obligations were counted in the "other" box.

Netflix's contractual obligations increased by about $635 million in the fourth quarter, and nearly $2.9 billion in 2011. That's a lot. Almost a billion of those obligations are due in the next year.

Now let's look at some key Netflix financial numbers.

Key Financial Data 12/31/09 12/31/10 12/31/11
Cash & Investments $320,242 $350,387 $797,811
Contracts, < 1 year $270,121 $651,301 $986,122
Current Assets $411,013 $640,967 $1,830,857
Total Assets $679,734 $982,067 $3,069,196
Current Liabilities $226,369 $388,579 $1,225,055
Total Liabilities $480,951 $691,903 $2,426,386
Total Revenues $1,670,269 $2,162,625 $3,204,577
Click to enlarge

Netflix's revenues have nearly doubled in the past two years, but the company has also greatly expanded its balance sheet. Oh, and don't forget, when looking at that cash and investments pile, they raised $400 million in the fourth quarter. Take that out of the equation, and they didn't really improve their cash position.

But the troublesome sign is in their financial ratios.

Financial Ratios 12/31/09 12/31/10 12/31/11
Current Ratio 1.82 1.65 1.49
Working Capital $184,644 $252,388 $605,802
Debt Ratio 70.76% 70.45% 79.06%
Return on Assets 17.89% 19.36% 11.16%
Cash+Inv to CL 141.47% 90.17% 65.12%
Revenues to CO 214.89% 116.73% 67.45%
Click to enlarge

Again, when looking at the working capital number, remember the $400 million capital raise. Without it, working capital for the year declined. Despite the numbers getting worse, Netflix's debt ratio might actually improve in 2012, but only because $200 million of that capital raise was convertible debt, which has a chance of being converted. That would lower their liabilities, shifting dollars into the equity basket, which would cosmetically improve the debt ratio. It's all smoke and mirrors.

The current ratio number is troubling. It appears that it will only get worse. The return on assets number is really bad, and we know that it will be negative in 2012. But the bottom two ratios are the worst. The ratio of cash and investments to current liabilities has gone from 1.4 to 0.65 in just two years. Given that Netflix told us cash flow from operations will probably be negative in 2012, and they have another $1 billion of contractual obligations, how much lower is this number going to go? I'll give you a clue, it's not pretty. Also, the ratio of revenues (that year's) to contractual obligations (end of year), has gone from 2.15 to 0.67. That's another huge decline.

At the rate Netflix is going, they could have $7 to $8 billion of contractual obligations by the end of 2012 and possibly $10 billion by the end of 2013. How exactly are they going to pay for these?

Now let's look at the competitive angle. In almost every news article, financial document, earnings release, etc., Netflix says it is the world's leading internet subscription service, or something like that. Amazon, even in their latest conference call, shook off questions about the competition, including efforts from Amazon (NASDAQ:AMZN) and others.

Netflix is the content leader. That is good, and that is bad. Because they are the leader, everyone can take shots at them. Just look at the way Netflix dismissed Amazon's Love Films subsidiary in their conference call.

Historically Love Films has been predominantly focused on DVD. Streaming is really something that they're only in the early stage of. Whereas we have been focused on streaming for five years now. And so if you look at the services, we're better, faster and easier to use in the UK. So we expect there will likely continue to be successful in the DVD by mail and the hybrid segment of the market. Which, for us domestically, is about 40%. If you just look at how they're offering the service today, they came out with a strong streaming only offering around the time of our launch, and yet it is still very difficult to find on their website.

If they came out with a strong launch, why are you dismissing them so easily? Yes, Netflix has been focused on streaming for years, but not internationally, and they just launched a month ago in the UK and Ireland. It's not like they've been in that market for five years. Technically, they have less experience in the market, since Love Films has been operating there for some time.

Back to the "good and bad" statement I made about being the leader. Netflix is getting more and more competition. BskyB is trying to launch a streaming service in the UK, that would hurt. But the biggest news was in the US, where Coinstar (NASDAQ:CSTR) and Verizon (NYSE:VZ) announced a streaming partnership. Coinstar already is doing well, because their RedBox DVD business is thriving currently thanks to Netflix deciding to kill off their DVD unit. Coinstar has a solid footing in this market, and Verizon adds a large partner with significant financial flexibility. Don't forget either, Amazon's Prime service competes with Netflix in some respect, and let's not forget the one big competitor Netflix always says is their main competition, Time Warner's (TWC) HBO Go.

As I said earlier, Netflix is in a transitional period. They are killing their profitable DVD business and going to a lower margin streaming business (although they claim streaming is much more comparable to DVD than it really is). They have billions piling up in future obligations, and it doesn't appear that they have the money currently to pay for them.

Netflix's financials are overshadowed by the $400 million capital raise in the fourth quarter. Netflix said in its Q4 investor letter that they didn't need the money, and won't use it, but wanted a safety net. In their 10-K they said they may use some cash, and may even need more going forward. One thing is clear. They really have no idea. The same company that bought its own stock above $200 sold it at $70. Netflix's stock will crash again at some point. The big question is when.

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