Earnings are an accounting measure of the firm’s performance and do not represent real profit. A company cannot use its earnings to buy goods, fund investments, pay employees or pay a dividend.
Cash is necessary in order to do these actions (Petersen & Plenborg, 2012). Free cash flow (FCF) is
the cash left over after a company pays for its operating expenses and capital expenditures. Based on Netflix’s financial statement, the company had a negative FCF during the entire historical period from 2013-2018. Table 6.14 and Figure 4.5 display the development. The negative FCF was 185.25 times higher in 2018 compared to 2013, indicating a very negative development (Netflix, 2019). The company’s management furthermore expects that the FCF will be negative in the coming years as well, mainly due to high investments in original content production (Netflix, 2019). However, as we have seen in the Profitability Analysis and Risk Analysis, the net income has been positive throughout the period. In this section, we will analyze the cash flow statement and examine why Netflix has had, and are still having, such high negative FCF, as well as examining the difference between the stated net income and the negative FCF.
Table 4.7: FCF 2013-2018, in million dollars
Year 2013 2014 2015 2016 2017 2018
Net cash used in OA 97.8 16.5 (749.4) (1474.0) (1785.9) (2680.5) Acquisition of DVD content assets (65.9) (74.8) (78.0) (77.2) (53.7) (38.6) Purchases of property/equip. (54.1) (69.7) (91.2) (107.7) (173.3) (173.9) Change in other assets 5.9 1.3 (1.9) (0.9) (6.7) (126.6) Non-GAAP free cash flow (16.3) (126.7) (920.6) (1659.8) (2019.7) (3019.6)
Source: Own calculations using data retained from Netflix annual reports
There are substantial differences between the net income and the FCF, which can be explained by Netflix’s accounting practices. For both its original content and licensed content, Netflix generally pays more in cash up front than what is showing as an expense in the income statement. This is because Netflix amortizes the content expenses over the useful life of the show or movie. Where the useful life of a show or a movie can range from six months to ten years depending on the type of content, either it being a talk show with a short lifetime or a classical show with a longer lifetime (Netflix, 2018). This accounts for the most substantial costs of revenue and the amortization method therefore profoundly affects the net income.
There are two ways to amortize expenses, either on a straight-line basis which means expenses are evenly spread over the amortization period or on an accelerated basis where there are different weights throughout the amortization period. Until 2016, Netflix disclosed that the majority of the streaming content assets were expensed on a straight-line basis (Netflix, 2016).
However, the viewing patterns of movies and series are most often not evenly distributed throughout the life span of the content, and the straight-line basis, therefore, did not accurately reflect the costs of the content. Hence, in 2016 Netflix changed the amortization by reporting that the vast majority of its content is amortized on an accelerated basis. For original content and other content with more up-front viewing, Netflix amortizes on an accelerated basis, reflecting the fact that the bulk of the content’s
value is exhausted in the first few years (Netflix, 2016).
Netflix first began amortizing some of its original content on an accelerated basis in the third quarter of 2013. The effect of this change was a decrease in operating income and net income of $25 million and
$15.4 million, respectively for the year ended December 31, 2013 (Netflix, 2015). This change shows how much the amortization method impacts the bottom line.
The positive net income is likewise more misleading the latest years as Netflix has moved its focus to producing series in-house instead of licensing exclusive first-run streaming rights from production companies. This change gives Netflix more control and the ability to adjust the content as they want, but it also requires more up-front costs. While such costs will not show up on the income statement until it starts streaming, the costs show up on the cash flow statement as the costs occur. Since Netflix heavily invest in original content, it results in significant expenses that are not included in the income statement before it is available for streaming.
As a result of the amortization method that pushes the expenses into the future, the growth in operating margin is not the best indicator of improving cash flow. In 2018, Netflix’s income statement stated that the firm spent about $10 billion on content, by looking at amortization for domestic and international streaming and DVD segment. However, on the cash flow statement, the company’s actual cash spending on streaming content assets totaled $12 billion. The $2 billion difference is why Netflix is profitable on a GAAP basis but unprofitable on a cash flow basis (Netflix, 2019). The graph below illustrates the growth in the gap between net income and cash flow from operations, showing how much cash the company is using and a more accurate picture of the financial situation. Even though the net income has increased over the years, indicating positive growth, the cash flow from operations has had a much higher decline, which indicates a negative development.
Figure 4.5: Net income vs. Cash Flow from operations vs. Non-GAAP FCF
Source: Own creation using data retained from Netflix annual reports
Netflix also has various long-term contracts to license content in the future. Some of this content has a known price and date when it will be available to Netflix, and anything that will not start streaming for another year does not show up on the balance sheet nor the income statement. Instead, Netflix outlines those obligations in a separate form. Looking at Table 6.1, we can see that Netflix has $19.3 billion in content obligations after 2018. These substantial obligations will profoundly affect the company’s future income statement and balance sheet. However, the growth of the content obligations has dropped the last few years, 9 % in 2018 compared to 22.2 % in 2017 (Netflix, 2019). Other companies like Disney’s ESPN also do the same thing with their long-term sports rights, where ESPN has substantial content obligations over the next decade. However, Disney likewise generates a large amount of cash flow to cover those obligations (Levy, 2017).
Table 4.8: Content obligations Netflix 2013-2018 Year Less than 1 1-3 3-5 > 5 Total Growth
2010 530.9 531.7 236.6 - 1299.2
2011 797.6 2384.4 650.5 74.7 3907.2 200.7%
2012 2299.6 2715.3 540.3 78.5 5633.7 44.2%
2013 2972.3 3266.9 929.6 83.3 7252.1 28.7%
2014 3747.7 4495.1 1164.3 44.05 9451.1 30.3%
2015 4703.2 5249.2 891.9 58.1 10902.2 15.4%
2016 6200.6 6731.3 1386.9 160.6 14479.5 32.8%
2017 7447.0 8210.2 1894 143.5 17694.7 22.2%
2018 8611.4 8841.6 1684.6 148.3 19285.9 9.0%
Source: annual reports
Netflix cannot account for content before the price is recognized. For example, the company has a deal with Disney to stream all of its new feature films. However, Disney could produce any number of new films, so the exact amount Netflix will pay is uncertain. The same problem exists with TV shows where the number of seasons is unknown, but Netflix has already agreed to buy the streaming rights to all seasons (Levy, 2017). Those costs do not show up anywhere in Netflix’s financial disclosures.
It can also be discussed if the amortization method was deliberate from Netflix, which is called aggressive accounting. Because by using the straight-line basis it recognizes too small a proportion of the expenses right away by pushing more of the expenses into the future. This accounting method results in Netflix flattering its current earnings. Further, Netflix might also deliberately stretch the amortization periods in order to reduce current expenses by pushing more of the costs to the future, also resulting in flattering current earnings. This action is possible for Netflix because the individual amortization plans are not disclosed in the annual reports, and, therefore, difficult for externals to control. Furthermore, the separate form with future content obligations might also be a way for Netflix to push the expenses into
the future and thereby resulting in positive net income.
Netflix’s ability to amortize its massive content spending over several years gives the company time to use all the content to attract subscribers, and thereby increase subscription revenue. However, Netflix needs to keep adding subscribers at a rapid pace in order to cover future content costs.
4.3.0.1 Summary Cash Flow analysis
Based on this section we can conclude that the Profitability Analysis and Risk Analysis might not give the most accurate picture of the financial health of the company. The cash flow statement indicates much higher costs, where the costs are pushed into the future by amortizing the expenses, leading to significant negative cash flow. Additionally, the company also have substantial future content obligations which will profoundly affect the company in the future.