Judge Netflix Content Strategy On Cash Flow, Not GAAP Results

| About: Netflix, Inc. (NFLX)

Summary

Netflix reported improving operating margins.

A large part of improving margins is driven by differences between GAAP amortization charges for content spend and cash costs.

Cash costs for content spending have been rising.

Investors should evaluate Netflix based on cash content costs, not GAAP costs.

Netflix (NASDAQ:NFLX) recently reported earnings. In their press release they touted improving operating margins (emphasis ours): "In Q1, we surpassed $2.5 billion in quarterly streaming revenue and added 5 million members. The opportunity provided to us by the growth of the global internet is gigantic and our plan is to keep investing as we increase membership, revenue and operating margins." Indeed, the company reported operating margins rose from 2.5% in the first quarter of last year to 9.7% this year (2017Q1).

The problem with focusing on GAAP metrics such as operating margin is that it ignores Netflix's growing content spending. Not only is content spending at Netflix increasing due to user growth but the cost of content also is going up. To judge the true financial picture of Netflix investors should focus on cash flow metrics as opposed to GAAP accounting metrics.

Content Amortization Lags New Content Spending

Looking at Netflix's financials we can see that Netflix's amortization charges for content are dwarfed by the company's actual cash spending on content. The picture below shows the quarterly cash charges for content spending in red compared to the accrual accounting amortization charges and change in content liabilities in blue.

Zooming out yearly we can see almost a $4B difference for the past fiscal year.

Even more interesting is that the difference between the accrual accounting measure of content costs and the actual cash content costs has been increasing each year. Back in FY2012 there was only about a $1B discrepancy between the two. Fast forward to FY2016 and that difference has grown to almost $4B.

To some extent this should expected. Netflix is a fast-growing company that is rapidly expanding across the globe. It's going to need to continue to increase its content spend in order to make sure its expanding user base is satisfied. Amortization is naturally going to lag new spending as long as the company keeps up its tremendous user growth.

The question then becomes how much of the increased spend is due to growth and how much is due to escalating content costs? It is here that we find some serious issues. Last year AllFlicks released data showing how many movies and TV titles Netflix had in its library in 2014 and 2016. Using that data we can see an alarming trend.

Netflix's content library has shrunk by 31% but its cost per title has ballooned by 228%! What this means is that its escalating content costs, not an expanding library to serve a growing user base, that's driving content costs.

We can look at it another way too, this time using just data that Netflix discloses in its financial statements. The table below shows the content library costs per streaming user (we used the average number of users for the period) for the past five fiscal years.

From FY2012 to FY2014 we see an encouraging trend. The content cost per user is dropping and Netflix's growth is leading to economies of scale when it comes to content costs. Then in FY2015 and FY2016 content costs begin to jump dramatically. Part of this jump is likely due to an increased focus on producing original content. But part alsois due to escalating licensing costs as other streaming services like Amazon (NASDAQ:AMZN) and Hulu are now competing to license the same content.

However, Netflix has begun to adjust. The company is increasing its focus on producing original content. In the short run this may increase costs but in the long run, if successful, it should allow Netflix to begin seeing economies of scale in content costs.

Summary

Netflix management is smart and can see the writing on the wall and is moving in the right direction with their emphasis on original programming. Investors in Netflix should monitor its cash flow statement, not its income statement, when looking for signs of success in its content strategy. Looking at GAAP operating margin obscures the true picture of what content is actually costing Netflix because its amortization charges severely lag it's actual cash content costs.

Disclosure: I/we 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.

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