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Netflix- Volatility is Thy Name



May 09, 2014 – Comments (0) | RELATED TICKERS: NFLX

Board: Value Hounds

Author: MonsterFluff

[See Post for Tables]

Netflix is one of the most volatile stocks I cover. There are a few reasons for that:

•The market is interested in a discrete and limited set of metrics and the company lives and dies by their numbers every quarter

•The accounting is slightly different than most retail businesses and it’s difficult to fully appreciate all the nuances of what their numbers (other than subscriber adds, revenue growth and contribution to margin) are saying every quarter

•The share price is exquisitely sensitive to news and positive developments for competition and/or negatives that impact Netflix’s profitability and move the stock out of all proportion to the facts.

By looking at Netflix from a few different perspectives it’s possible to get an idea of where the business is rather than relying on opinions formed through hype, hope, talking heads, bad SeekingAlpha articles and the usual too-well covered suspects –subscriber growth, contribution to margin and revenue.

Numbers are our friend

There is much more to Netflix than the news and the press releases-- margins, earnings and cash flow can tell us a lot about Netflix’s ongoing transition from DVDs to streaming. The breadth and difficulty of the makeover of Netflix can't be adequately appreciated on the surface--it's been brutal. It’s as if Netflix went into a completely different business after almost shutting down DVDs. There was very little that could be taken from the DVD model leveraged and transposed into the streaming business. They essentially started from zero with nothing but the iconic red envelope left over from Netflix the King of DVDs.

The biggest challenges were profitability and margins. What was a monster cash producing wide margin business devolved into a money-losing cash poor shadow of itself.


Netflix has improved their margins after a long unprofitable transition to streaming from the highly profitable DVD business. It’s been a couple of years coming. The most recent share-killing news is the setback margins suffer as costs of revenue will increase as cable companies charge Netflix more for the right to faster streaming speeds delivered to their customers. Comcast and most recently Verizon are getting extra cash for giving Netflix a faster conduit for content.

Netflix has reached a deal to pay Verizon to connect, the second such agreement aimed at improving the quality of the video streaming service.

Comcast signed a similar deal in February that included Netflix paying for the privilege of connecting networks. Such arrangements, known as "peering," improve data-intensive services like streaming video but are typically done without any money ever changing hands.

"We have reached an interconnect arrangement with Verizon that we hope will improve performance for our joint customers over the coming months," a Netflix spokesperson told Mashable.

Netflix said that the deal is a paid peering arrangement and that customers should see improvements over the course of several months. A Verizon spokesperson also confirmed the deal but declined to discuss the terms.

There have been no terms disclosed but as the quarters go by the cost of revenue should increase and gross margins decrease unless subscription adds with the new rate increases outpace the extra cost. Otherwise Netflix will be forced to backtrack on its profitability.

Netflix is going to raise prices $1-$2 helping to offset margin loss to some extent. The $1-$2 will only be collected from new subs so the “extra” revenue will trickle in while the higher transport charges will be more of flood. We don’t know how big that flood will be yet.

GAAP margins

There are two sets of numbers we can follow -— GAAP and non-GAAP. GAAP margins allow Netflix to use amortization as a proxy for cost of revenue. Non-GAAP revenues and costs are useful for seeing how Netflix is doing by segment and where it eventually falls out on the cash flow statement.

Netflix now reports streaming, DVD revenue and cost of sales separately. However, they stop short of giving real operating margins and instead report a contribution to profits for DVD and streaming. It’s good because we can see marketing costs for each, but completely useless when you’re trying to find out if streaming is actually making any money because tech and administrative costs count on your way to the bottom line.

Netflix doesn't break these out separately for streaming and DVD but we can make reasonable assumptions. The good news is that combined streaming is now profitable all the way down to net (including paying part of the tax bill) on a GAAP basis.

It’s a fair amount of numbers, but they do paint a cohesive picture of Netflix if we take some time to look at them.

DVD subscriber revenue as a percentage of total revenue is down by 8% year-over-year and is now only 16% of the business as combined streaming climbs to 84% of revenue.

DVDs are a higher margin business than streaming and as streaming has closed in on 100% of Netflix’s revenue, margins have had a rocky ride down and are just now starting to improve. The transformation has taken Netflix into negative margins and earnings on a GAAP basis. Through all of this Netflix managed to be one of the most volatile stocks in the SA active investment list as investors looked for any news supporting unlimited growth to send shares up and rare misses to drop the price to multi-year levels. Netflix is never boring.

The recovery has been slow and in Q1 2014, streaming margins finally edged into positive territory with 1% net margins on a GAAP basis. The combined DVD and streaming margins are now more widely positive as DVDs still make a substantial contribution to profitability even as subscribers continue to decline. As streaming loses less money, combined margins have been able to advance even though DVDs are becoming a smaller percentage of revenue. As DVDs dwindle their positive impact lessens and Netflix will have to rely more heavily on a more profitable streaming business.

By GAAP accounting chances are good margins will slowly climb if ISPs don’t take too big a bite out of revenue. Netflix has proven there is scalability of the content costs across an increasing base of consumers and that has showed up as we scan down the income statement and see higher margins and earnings growth. Investors like the earnings growth—they are less concerned with margins.

Growth in paid subscribers has decelerated both domestically and internationally with international growth slowing more dramatically from an 18 month high of 2.4-fold to 87%. It’s easier to realize outsized growth over a small base, but as the base gets bigger, percentage increases begin to drop and then plateau. Domestic has done well to stay in the mid-to-low 20% range for as long as it has. That is an extraordinary feat—adding consistently to a fast-growing base. Cracks may start to appear as Netflix works on its next 30 million domestic subscribers in the back half of its projected total subscriber numbers. Percentage growth in subscriptions and domestic net adds are slowing already.

Looking at net additions we see volatile international numbers the past 5 quarters with a high at 109% --sub adds more than doubled. In the recent Q it dropped off to 72%.

Hastings sees domestic adding 5 to 6 million per year with a top end between 60-90 million subscribers. Netflix is about half way there at the low end. Growth domestically is slowing and that may continue as they try to reach 60 million.

Rich, about three years ago we identified the model that we think, in the fullness of time, we can be 2 to 3 times larger than domestic HBO, linear HBO, which would be 60 to 90 million subscribers in the US. And that model anticipated that, as we got to 40, we'd get better; as we got to 50, we'd get better. So, I would say all of those improvements in the model that we think of are built in to our 60 to 90 million member projection for the domestic market; and so, we'd stand by that.

Every year that we add another 5 or 6 million members makes us feel a little bit more confident of getting into that range, which is great. And then with that, we're able to add more content and continue to make the service better.

You can see that Netflix’s growth in subscribers was much higher back when the subscriber base was under 20 million.

Raising rates

In response to content cost pressures (ISPs and content owners pricing production) Netflix will be charging more for subscriptions. The increase will be $1-$2 and impact new subscribers so for at least a year of two, Netflix will only be collecting extra revenue from net adds to subscriptions. If the increase starts Q1 2015, revenue increase will build slowly but as the yearly 10 million new subscribers anniversary paying an extra $12 per year, the potential addition from just those is $120 million per year. We may see higher revenue growth, but if it’s sucked into content, along with Comcast and Verizon expense, margins may actually shrink. A single high-quality original series can eat up a $100 million alone.

Netflix doesn’t intend for the rate increase to be much help in cash accumulation, but will be spending it on content, marketing and content delivery. That suggests that costs are not going to moderate but will increase and the increase in revenue won’t be falling to the bottom line ie cash flow and EPS.

Doug Anmuth - JPMorgan – Analyst

And, David, how would you think about how you would reinvest the dollars from the price increase, into additional content, or allowing that to fall more down to the bottom line?

David Wells - Netflix, Inc. – CFO

Well, Doug, we've said before that mostly it's going to be towards content. It's about improving our service. If you think about generous grandfathering, that's going to bleed in over time in terms of the average subscription price. It will take a while; I think it will be gradual.

One reason for a price increase is to offset rising content costs and keep margins on an even keel and even if we don’t see expansion, I think Netflix is trying to stave off backsliding into negative streaming margins GAAP-style.

The increase revenue is targeted for content, marketing and cost of delivering the content. Eventually Netflix may ease spending and let the extra dollars percolate down to the bottom line and increase profitability. Although EPS have been growing fast the past few quarters, Netflix is expecting that to slow due to rising costs and are proactively attempting to at least offset increased content cost with price increases and keep the financials from degrading. The plan relies heavily on doubling domestic subscriber numbers.

Rich, about three years ago we identified the model that we think, in the fullness of time, we can be 2 to 3 times larger than domestic HBO, linear HBO, which would be 60 to 90 million subscribers in the US. And that model anticipated that, as we got to 40, we'd get better; as we got to 50, we'd get better. So, I would say all of those improvements in the model that we think of are built in to our 60 to 90 million member projection for the domestic market; and so, we'd stand by that.

Every year that we add another 5 or 6 million members makes us feel a little bit more confident of getting into that range, which is great. And then with that, we're able to add more content and continue to make the service better.

Non-GAAP numbers for streaming

Netflix uses amortization of content as a proxy for the cash cost of content. Since this is a less commonly used model for accounting for cost of sales, it seems like finding the “real” cost of sales is a useful number to evaluate how profitable the segments are.

Netflix has had some difficulty matching the use of particular content to the amortization schedule. This was the case with House of Cards. The viewing peaked early and declined rapidly indicating the shelf life was quite a bit shorter than the amortization schedule. They had to speed up amortization; cost was increased per period and the life shortened.

The following is combined streaming adjusted as if Netflix was paying for their programming as it’s reflected on the cash flow statement. The costs are about 14% lower than the cost of revenue GAAP style on the income statement.

Streaming margins remain negative but have improved year-over-year but not sequentially over the past three quarters.

Just how much is the GAAP accounting undercounting what it actually costs to provide streaming content every quarter?

“So what” you say. In the end all that matters is that Netflix has positive earnings to show at the bottom of the income statement and positive cash flow from operations. By GAAP numbers, earnings are improving and cash flow from operations (CFFO) is positive.

The non-GAAP numbers tell us that if Netflix was paying for content in the period, streaming would still be a losing segment and the amortization schedule is not accurately reflecting the use/cost per period. The recalculation of House of Cards amortization suggests the life of some of the content is shorter than Netflix schedules, leaving them accounting for too little over too many quarters.

Manipulating amortization allows Netflix some control over reported earnings –- lower amortization equals higher gross. This is not an indictment, but an observation of how a company can benefit when amortization is a proxy for costs of the product. It’s worth tracking even if it’s non-GAAP.

Net margins decreased in 2014 with an increase in taxes. All taxes were assigned to DVDs as streaming had negative Operating income and EBIT.

DVDs are a different story. The GAAP costs and non-GAAP are very close quarter after quarter indicating the amortization of the life of a DVD is more closely matched to reported costs.

Here’s why so what

While understated amortized costs are making the bottom line on the income statement look better and better, the impact of using amortization to approximate cash costs will be felt on the cash flow statement. The record $4.4 billion in revenue in 2013 wasn’t sufficient to get cash flow anywhere near the levels that made Netflix a star back in the days of DVDs. It isn’t clear yet that streaming will ever have enough subscribers to make Netflix the cash flow machine it was in 2007 given the huge cash costs of content.

DVD investment was a far smaller percentage of revenue than digital is and its amortization actually closely approximates the cost making the income statement and the cash flow statement more closely aligned. At present, streaming’s big gains in contribution to margin aren’t translating into awe-inspiring cash flow because the non-GAAP costs are widely divergent from the GAAP costs.

So far that hasn’t been center stage important to investors but it will be noticed when growth tails off and the slower growing less momentum friendly revenue numbers need to start producing cash flow to keep investors happy. At present Netflix needs to keep adding subs fast and show improving GAAP numbers. They are only half way to domestic targets, GAAP accounting shows combined streaming moving into positive territory with 1% net margins for the first time, price increases appear to be palatable and there has been outrage from subscribers. There’s a lot to like about Netflix.

While various accounts on the cash flow statement can affect CFFO, the biggest change over they years has been additions to streaming content library. Even after sending part of that to the balance sheet as increased liabilities and adding back amortization, in 2013 it decreased CFFO by $254 million on the cash flow statement. Part of that cost was not reflected in GAAP net income and it was accounted for as cash flow with negative effects. The big additions to streaming content will continue to cap CFFO and free cash flow far more than acquisition of DVDs did.

Free cash flow is negative but did improve in 2013. It’s far below 2011 highs when Netflix was at the height of its powers with record breaking growth and some of its highest margins. Can it get back to where it was with the streaming business? Jury’s still out at least for me. It doesn’t look like costs will be as successfully leveraged over the subscriber base as was possible in 2010-2011 (highest margins in company history).

There will come a time when streaming costs moderate and subscriber revenue continues its fast growth – a sweet spot that almost guarantees higher share prices and more volatility. The subscription price increase will help. In a decade or less as subscription growth stalls, revenue growth will move in tandem and Netflix will do a Microsoft or an Apple and transition from super-growth to mature. Cash flow will become important and cash will be used for share repurchases and dividends to keep investors on board. In the meantime there is till time to make money on the famous Netflix volatility.


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