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Netflix Revises Operating Expenses, Revealing Higher Streaming Costs Than Previously Reported

Netflix has changed the way it accounts for personnel expenses related to its streaming service — a move showing the company has invested more in its global streaming rollout than previously disclosed.

As detailed in an SEC filing posted Thursday, Netflix is reallocating costs for employees previously recorded in “general and administrative” (G&A) and “technology and development” line items into cost of revenues and marketing, a change that will take effect in its reporting fourth-quarter 2018 results. The company released revised operating expense results going back to 2016 to provide comparable financial info.

Overall, the change doesn’t alter the picture of Netflix’s financial health. The new accounting method has no effect on Netflix’s consolidated operating income, net income or cash flows. Netflix had previously announced the plans to reclassify the operating expense line items in announcing Q3 earnings.

But the accounting change does reveal that Netflix has spent more on building out and operating the subscription-streaming business than it had previously reported, particularly overseas.

Under Netflix’s restated results, for the first nine month of 2018 it spent $534 million more on streaming operations than previously reported (an amount representing about 5% of total operating costs for the period). Of that $534 million, 61% — or $328 million — was a reallocation in the international streaming segment. On the restated 2017 expenses, Netflix reallocated $532 million (around 6% of operating costs) to streaming, of which 62% was for international.

In addition, the change lowered the operating profits for Netflix’s streaming segments, making them look less profitable than they did before.

In the U.S., the streaming contribution margin of 38.9% as Netflix previously reported for the first nine months of 2018 was restated as 35.3%. International streaming contribution margin changed from 16.0% to 10.2% for the first three quarters of 2018; for full-year 2017, it changed from 4.5% as previously reported to -2.0%.

Netflix says the change in operating-expense accounting provides a more accurate reflection of its business, especially as it shifts to “self-produce and create more of its own content rather than license or procure it from third parties.”

According to Netflix, “the nature of the work performed by certain personnel has changed to be more directly related to the development, marketing and delivery of our service.” In addition, according to Netflix’s 8-K filing, the change “will also align external presentation of personnel related expenses with the way that the company’s chief operating decision maker expects to assess profitability and make resource allocation decisions going forward.”

Specifically, Netflix reclassified expenses for staff who support global content and marketing (previously classified under G&A expenses) into “cost of revenues” and “marketing,” respectively. It also shifted expenses for personnel that support global streaming delivery (previously classified in “technology and development”) to “cost of revenues.”

Note that the new operating-expense reporting approach doesn’t address what should be a bigger concern for Netflix investors: the $18.6 billion in “commitments and contingencies” the company reported as of Sept. 30. Of that amount, $10.4 billion isn’t reflected on the balance sheet — essentially a gigantic IOU that lets Netflix defer a big portion of what it has promised to pay talent (including Shonda Rhimes, Ryan Murphy and the Obamas), production companies, studios and other licensors until years into the future. Such off-balance-sheet arrangements aren’t unique to Netflix, but even as the company keeps increasing those long-term commitments it’s leaning heavily on debt to fund current payment obligations. Netflix reported $8.34 billion in long-term debt as of Sept. 30, up from $6.50 billion at the end of 2017.

Meanwhile, in an effort to reduce the “lumpiness” in Netflix’s subscriber forecasts, the company also previously announced that starting with Q4 2018 results it will provide current-quarter guidance only for paid memberships (excluding free trial accounts). The company explained it this way: “Because growth in paid memberships is more steady, our forecast for paid net adds has been historically more accurate than our total net adds forecast.” For example, in Q2 of 2018, Netflix’s forecast for paid net adds was 11% higher than the actual number whereas its total net adds guidance was off by 17% — a miss that precipitated a plunge in the stock price.

The changes in financial reporting were implemented under soon-to-be-departing CFO David Wells. He will leave the company after Netflix poached Activision Blizzard finance chief Spencer Neumann, as announced this week, to succeed Wells.

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