Investors saw a lot to like in Netflix's (NASDAQ:NFLX) recent earnings report, which came out on Monday afternoon. The streaming subscriber base continued to grow at a rapid clip, earnings came in slightly ahead of expectations, and management provided a solid outlook for the fourth quarter.
However, while these were all great pieces of news, the best thing about the third quarter earnings report was something much more subtle. Netflix beat the $26 million midpoint of its net income guidance despite an accounting change that increased content expenses by $27 million. This was a very impressive achievement, and should give investors much more certainty that Netflix's investments in original programming are paying off.
Accounting for Originals
When Netflix introduced its first original programming, the company decided to account for the content costs in the same way that it accounted for the costs of other licensed content. This meant that the total cost was spread evenly over a four-year period (or the total license period, when that was less than four years).
However, from the beginning, this seemed like an odd accounting method, because viewing of Netflix Originals is not likely to be spread evenly over a four-year period! In fact, the company's decision to release full seasons at once enables "binge viewing," so that many viewers watch the full season in the first week of its release.
As a result, Netflix gets a disproportionate benefit in the quarter when a new original series is released. Yet the company was only accounting for a small portion of the costs at that time. (This would be equivalent to a TV network paying as much for a rerun as for the first-run rights to a show.)
This may seem like boring accounting stuff, but it could have been a big problem for Netflix. Under the previous accounting scheme, Netflix could have found itself struggling under $100 million to $200 million of "dead weight" in content costs by 2016, when it would have been paying for dozens of old seasons at the same rate as it has been paying in 2013 for new shows.
A hidden charge
Now that Netflix has more data on viewing patterns, it has finally decided to do the obvious: assign more of the cost of Originals to the first quarter of release than to the rest of the four-year amortization period. Catching up on the costs it hadn't recognized for shows like House of Cards and Hemlock Grove that premiered earlier this year added $27 million to Netflix's third-quarter content expense.
However, the additional expense was not projected in Netflix's original third-quarter guidance. This extra $27 million easily could have caused Netflix to miss its earnings guidance. Yet stronger-than-expected subscriber growth (and minor expense savings elsewhere) allowed Netflix to beat the midpoint of its net income guidance by $6 million. In other words, the Netflix earnings beat was much bigger than it seems on paper.
A word of caution
While Netflix had a great quarter in many respects, the accelerated recognition of original content expense will remain a headwind as Netflix grows its lineup of Originals. Looking at the company's guidance, Netflix is projecting that the domestic streaming contribution margin will fall sequentially from 23.7% to 23.2% next quarter. That would be the first drop in domestic contribution margin since Netflix's dramatic fall from grace in 2011.
The relatively weak margin guidance may just be management conservatism; perhaps Netflix will report another quarter of solid margin growth in January. However, if the forecast proves accurate, it may herald a period of slower earnings growth ahead, due in part to the higher initial accounting cost of original content.
Fool contributor Adam Levine-Weinberg is short shares of Netflix and long December 2013 $275 puts on Netflix. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.