As most readers probably are aware, Netflix (NFLX) gives consumers the opportunity to watch DVDs, movies and TV-series through DVD-by-mail or online through streaming.
But Netflix needs to acquire the content before consumers can stream it, and therefore it has a few agreements with suppliers of movie/TV-series content. But the way Netflix pays for its content is slightly tricky from an accounting perspective, and over the last few years, it has definitely confused an analyst or two. But I believe it is necessary to understand the accounting, if one wants to predict future earnings of Netflix.
In this article I will show why analysts likely underestimate future subscription costs due to a simplified understanding of Netflix's cost structure.
How amortization expenses works
When Netflix announces a license agreement with a content provider; they will typically pay for the content over an x-year period. The value of the agreement will initially show up in the balance sheets under current content library or non-current content library, and as you can see in the below graph, the value of the content assets have increased a lot over the last 2 years.
As followers of Netflix are aware, Netflix previously had an extremely attractive deal with Starz, which meant that the book value of the content library was very low. However, over the last 2 years, Netflix has agreed to more expensive deals, which has increased the book value.
But the interesting part of Netflix's accounting, is that the license agreements do not show up in the income-statement directly. Instead, Netflix amortizes the content over the length of the agreement. So if Netflix agrees to purchase content for $600 million over a 3-year period the book value of the assets will increase by $600 million. Over the next year Netflix will amortize $200 million, which shows up as increased subscriptions costs in the income-statement. So the costs are spread out over the length of the agreement.
As you can see in the below diagram, amortization costs were the biggest component of total operational costs of Netflix in Q3 2012, and thus it is the most important to analyze.
Future amortization expenses
In order to predict future amortization costs, we need to estimate two variables:
- The average length of license agreements.
- The future book value of the content library.
In the below graph you can see that the average length of a license agreement has increased since Q1 2010, as the amortization percentage has dropped from 53% to 34% in the most recent quarter. A quarterly percentage of 34% means that the average length is (1/(0.34*4) 0.73 years. Looking forward, I expect this length to continue over the next year.
It also seems realistic to assume a continuing increase in "additions to streaming content" due to the international expansion. To give my assumption further support, I have included a comment from CEO Reed Hastings from the most recent earnings call.
Hopefully, content spend will grow substantially as we continue to make our service better, and that's built into our plan, but we don't believe that we're overcommitted.
Therefore I assume a growth rate of 7.5% at a quarterly basis (over its 4-quarter moving average).
You can see the effect of my estimations in the below graph. Given the above assumptions, amortization expenses will increase to $600 million on a quarterly basis in Q3 2013.
Why earnings will decline
Through my due diligence, I have estimated the future growth rate and operational profitability of each segment (International, DVD, domestic stream). During the process, I have discovered one very interesting, but somewhat unnoticed, margin. The margin is calculated as "(Revenue - subscriptions costs + amortization)/Revenue", and in this article I will mention it as "excl. amortization"-margin.
In the below graph you can see the development of the margin, compared to two other margins, calculated as "amortization/revenue" and "(Revenue-subscriptions)/revenue".
Source: Own calculations based off SEC-filings.
If you look at the above graph, you will notice that the "Revenue-subscriptions costs"-margin has decreased throughout the period, which is due to higher amortization expenses. However, if you are really smart, you will also notice that the decrease in margin was partially offset by the improvement of the "excl. amortization-margin", which increased from 60% to 80% over the period.
I believe the increase in the before-mentioned margin is explained by the split-up of the DVD-by-mail segment from the domestic streaming segment, which effectively increased the price which consumers pay. This split-up has been criticized somewhat, and while most of it is justified, the change in business model was necessary as the margin would have been much lower had there been no change.
Looking forward, the biggest problem for Netflix is that there will be no significant further improvements in the "excl. amortization"-margin, as the past improvements were mostly related to the split-up. And I do not see any factors contributing to a significant further margin improvement.
On the other hand, amortization costs will increase due to the international expansion, and therefore we will likely see the "Revenue-subscriptions"-margin continuing to decline.
And it gets worse, the international expansion will increase marketing expenses and "technology and development"-expenses over the next year, and the most profitable segment, the DVD-segment, will continue to lose subscribers according to CEO Reed Hastings.
As you can see in the below graph, I expect that Netflix's operating profit will turn negative over the next twelve months. While analysts are very negative over a five-year period (-12.5% expected growth rate), they are "decently optimistic" regarding the next twelve months, as they expect an operating profit of roughly $100 million.
I think they will most likely be wrong, and I think it's likely that they are underestimating how much subscription costs actually would have increased if there had been no business model change. Therefore they are probably misestimating the effect the increased book value of the content library will have on future amortization expenses.
The way Netflix accounts for its license agreements makes it a bit challenging to estimate the future earnings growth rate. However, given a couple of (not unrealistic) assumptions I was able to show that it will be difficult for Netflix to become profitable over the next twelve months. But even if my assumptions turn out to be wrong, I still doubt that there is any significant upside potential, as Netflix currently trades at a P/E-ratio of 39, and as I will argue in future articles, I also do not think the long-term prospects of the company are particularly impressive.