You Need to Understand This Weird Netflix Fact

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To help you get ready, I'd like to explain a controversial accounting practice you'll run across when researching Netflix (Nasdaq: NFLX  ) .

Just the basic facts
Netflix is the king of movie rentals. Its DVDs-by-mail service brushed off challenges from Blockbuster and Wal-Mart (NYSE: WMT  ) , and then the company applied the lessons learned to the digital arena. The DVD operation remains a serious cash cow, but management is content to let Coinstar's (Nasdaq: CSTR  ) Redbox service absorb that business over the long term.

Digital media streams are a very low-cost distribution method. Once Netflix pays up for the rights to stream a particular film or TV series, it costs nearly nothing to stream that content to your computer, video game console, or Blu-ray player. Compare and contrast this to paying DVD postage both ways, and the efficiency of this model should be obvious.

Can you show me where it hurts?
The accounting treatment of Netflix's media contracts makes many investors nervous. Quarterly SEC filings contain a section for "commitments and contingencies," where Netflix currently lists $5 billion in upcoming license payments, and this massive item doesn't show up on the balance sheet.

Critics and skeptics often point to these obligations as a Sword of Damocles, hanging over the company's head, and sure to inflict mortal wounds when it falls down. Two billion dollars is due within the next year, and Netflix doesn't have that kind of cash on hand.

This arrangement is often presented as a reason why larger companies with deeper coffers should buy Netflix. The global expansion program would surely falter if Netflix was suddenly hit by a $2 billion bill it couldn't pay. Apple (Nasdaq: AAPL  ) and Google (Nasdaq: GOOG  ) both have serious ambitions in the digital media space, and plenty of cash to burn. Buying Netflix outright is well within their means, and certainly easier than building their own streaming movie services out of their iTunes or YouTube assets.

With a sugar daddy like that, the Netflix train could just roll around the world without an earthly care for financial disasters. In fact, some would argue that this is the only way Netflix could survive long enough to actually cash in that huge bet it's making on international services.

Right?

Comfortably numb?
But then you're forgetting that these amounts do move onto the balance sheet and income statement over time. The 12-month overhang was $1.7 billion at the end of December, and Netflix recorded $1.2 billion as costs of streaming operations in the next two quarters.

A minuscule portion of that bill goes to the costs of running the show, and some is earmarked for marketing efforts. But the bulk of it is paid to content providers.

This puts a dent in the controversial commitments balance, and provides rocket fuel for the company's global subscriber growth. The off-balance-sheet balances never seem to go down, but that's just because Netflix signs new content deals faster than the old ones expire.

Management can't just slap these planned license payments onto the balance sheet, because the terms of these contracts don't always nail down precise release dates or payment schedules. This compromise keeps investors as informed as possible while also satisfying Uncle Sam's accountants and tax collectors.

This unusual liability may look scary at first glance, but it's actually just a forecast of the company's ordinary costs of doing business. If anything, it's a nugget of transparent financial reporting that we should thank the management team for presenting. That's a good thing.

As a Netflix investor myself, I don't lose any sleep over this detail. Neither should you.

Where do I go from here?
The best way to really understand a complex business like Netflix is to dive into its SEC filings. The company's Investor Relations site provides a handy list of quarterly and annual reports. I recommend starting with the latest available issue, and working your way backwards.

We've also created a premium report on Netflix as a shortcut for investors who don't have the time to absorb lengthy SEC reports. The report costs less than a single month of Netflix service, and even comes with a full year of updated analysis. Get started right now.

Better yet, if you'd like to continue using the Fool as a source to improve your knowledge of the financial world, jump over to our InvestBetterDay.com page.

Fool contributor Anders Bylund owns shares of Google and Netflix, and has created a bull call spread on top of that position, but holds no other position in any of the companies mentioned. Check out Anders' holdings and bio, or follow him on Twitter and Google+.

The Motley Fool owns shares of Apple and Netflix. Motley Fool newsletter services have recommended buying shares of Apple, Netflix, Google, and Coinstar. Motley Fool newsletter services have recommended creating a bear put ladder position in Netflix. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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