Netflix keeps raiding the TV biz for big-name creative stars. And it’s tucking the bulk of the eight-figure annual salary commitments and all of the production costs for those pacts into a separate area of its ledger, rather than accounting for them as current operating costs.
Yesterday, the streaming giant announced a pact with Kenya Barris, creator of “Black-ish,” worth $100 million over three years, Variety reported. That’s after Netflix landed Shonda Rhimes (whose hits for ABC include “Grey’s Anatomy” and “Scandal”) in a pact reported to be worth $150 million over five years and signed Ryan Murphy (“American Horror Story,” “Pose,” “9-1-1”) in a five-year deal for up to $300 million.
Those high-priced deals mostly end up in an area of Netflix’s financial reports that it calls “Commitments and Contingencies.” That includes “non-cancelable commitments under creative talent and employment agreements,” according to Netflix regulatory filings, as well as expected payments for licensed content and other production-related commitments.
The salary components of the overall deals are expensed on a straight-line basis (if no projects are in production). Then, when a specific project that’s part of the deal goes into production, Netflix capitalizes a portion of the expense during the production period into the new content/title asset, which is amortized after launch on the service like other titles.
What that means: Netflix doesn’t actually record any of the content under those deals as expenses or liabilities until individual titles become available on the service. Only when a TV show or movie starts streaming to customers does it add a “content liability” to its consolidated balance sheets, according to the company’s SEC filings. So, for example, the costs for the slate of eight shows from Rhimes’ Shondaland is developing for Netflix (and whatever upside Rhimes is due under the contract) aren’t even on the books at this point.
That lets Netflix defer a big portion of the expenses for what it has promised to pay talent, production companies and licensors for years into the future. As of June 30, 2018, the company had a massive $18.4 billion in “Commitments and Contingencies,” up 17% from $15.7 billion from a year earlier. And of that $18.4 billion, $10.3 billion is not reflected on the balance sheet.
A significant piece of that is for licensed content, which still generates an estimated 80% of Netflix’s total viewing time. But according to chief content officer Ted Sarandos, around 85% of Netflix’s new content spending is on originals, as he ballparked at an investment conference in May. That could encompass the recent deals cut with Rhimes, Barris, Murphy, Kohan et al. — which, it should be noted, while they are big-money deals individually amount to a fraction of Netflix’s total content spending.
To be sure, Netflix didn’t invent this off-book accounting method. Traditional media companies also report “commitments and contingencies” — the difference is, Netflix’s future payment obligations are an order of magnitude greater than most mediacos. For example, Viacom reported about $2.1 billion in long-term commitments as of Sept. 30, 2017 (including $354 million for talent contracts), roughly 16% of annual revenue for fiscal 2017. Netflix’s obligations at the end of 2017 were a whopping 151% of annual revenue, meaning its model is predicated on signing up tens of millions more customers (or raising prices) in the years ahead to meet those payment commitments. It’s a calculated bet by Netflix, but a relatively risky one.
Actually, Netflix’s commitments-to-revenue ratio looks closer to ESPN/ABC — which had $45 billion in sports-programming rights commitments as of Sept. 30, 2017, per Disney’s 10-K. Disney and ESPN Media Networks’ sports content deals were 1.9 times annual revenue, vs. Netflix’s content deals at 1.5X revenue for last year. (Disney’s risk here: that cord-cutting could substantially shrink ESPN’s subscriber base in the years ahead and cut into TV revenue; the ESPN+ subscription-streaming service is designed to offset that.)
Some critics of Netflix’s method of accounting for its enormous long-term content obligations say it obscures the extent to which it has mortgaged its future. But Netflix says it handles the accounting in this way because there are a number of unknown variables for many of its agreements. For example, some of its deals include the obligation to license rights for an unknown number of future titles (e.g., the number of seasons to be produced is unknown). That indicates its eventual content bills will be even higher: The company says its “unknown obligations are expected to be significant.” While Netflix could reduce the content-payment obligations line item by inking one-year deals, the company believes it’s a better business decision to secure content and big-name TV creators for multiple years.
To fund its current payment obligations, Netflix has leaned heavily on debt. Over the past five years, Netflix has raised $8.42 billion in financing through debt (including, most recently, $1.9 billion in April). The high-cash-burn, debt-fueled strategy has been led by chief financial officer David Wells, who plans to leave the company after eight years as CFO as soon as Netflix finds a replacement.
Netflix maintains that it isn’t over-leveraged. It pointed out to investors in its most recent earnings report that its current gross debt represents around 5% of its enterprise value. At the end of Q2, the company had $3.9 billion in cash and also an untapped $500 million line of credit.
And Netflix says it’s probably going to amass more debt. As it told investors in the Q2 2018 letter: “While interest rates have risen and the federal tax rate is now lower (reducing the tax shield on interest costs), we judge that our after-tax cost of debt continues to be lower than our cost of equity, so we anticipate that we’ll continue to finance our capital needs in the high-yield market.”
Given the buy-now-pay-later approach currently in play at Netflix, the streamer certainly could be lining up more megadeals with top-flight Hollywood talent in the coming months.
But it can’t realistically keep issuing IOUs forever. At some point, the company will have to pony up what it has promised — to bondholders and content producers alike — and it will need to have the cash coming in the door to pay the bills.