The Netflix (NFLX) Numbers Still Don't Add Up

On the surface, the buzz that Netflix, Inc. (NASDAQ:NFLX) is causing within the world of digital content is compelling to investors. After all, wherever a crowd gathers, there's money to be made. There's just one small problem with that old axiom though - it doesn't necessarily apply to NFLX.

To give credit where it's due, NFLX posted kick-butt numbers last quarter, turning in a profit of $0.13 per share versus analysts' prediction of a $0.13 loss. The company also cranked it up on the subscriber count too, adding 2 million new subscribers in Q4 in the United States alone (and about 1.8 million international subscribers). It was also the same quarter Netflix announced it had scored exclusive content deals with Disney and Time Warner, to begin in the foreseeable future. By all accounts, it was a big win for Netflix, and a reason to invest. And traders did just that, pushing the stock up more than 40% on the heels of fourth quarter's news when it was all said done.

There's a devil in the details though, and it's getting progressively worse.

While Netflix is building an army of subscribers and a warchest of content, it's also building a mountain of debt. Were subscriber revenue strong enough to pay off - or at least service the debt - that would be ok. The problem is, it's not clear if the math makes long-term fiscal sense.

Just for the record, Netflix will be raising about $400 million in new debt soon. Most of that - $225 million - will be used to refinance existing debt. The rest, however, will be added to the balance sheet as long-term debt, bringing the total up to something around $575 million. That's manageable, particularly when interest rates are low, but for a company that only makes about $7 million in profit per quarter, even small interest payments on $575 million in debt doesn't leave much room for error, nor does it leave much money for shareholders.

That, however, may be the least of Netflix's problems.

Word of a massive $5.6 billion (yes, with a 'b') off-balance sheet liability started to circulate last year, but with the details being fuzzy and only appearing in the fine print of the NFLX quarterly report, the market largely overlooked it. They won't be able to overlook it this year, however, because $2.3 billion of it is coming due within a year. For perspective, Netflix Inc. has about $1.5 billion in cash or near-cash assets, and about $1.4 billion in 'other' current assets. Mathematically speaking, that's enough to handle the liability. But, there's more to the story.

The nature of Netflix's business model is one of using current revenue to pay current liabilities; that $2.9 billion in cash or equivalents is already spoken for. Yes, it will bring in more revenue in the future (hopefully) to help pay those looming liabilities, but it also needs much of that cash to pay future bills.

Said in simpler terms, Netflix may have to start picking and choosing which bills it pays... a tell-tale sign of the end of the liquidity it needs.

Supporters will be quick to note that subscriber growth was tremendous last quarter. And, that's true. As it stands right now, however, subscriber growth still isn't tremendous enough to fully offset the growth in debt and liabilities. Things certainly change, but the company has yet to actually demonstrate it can handle all the debt it's racking up based on its current subscriber growth. Unless the pace of growth improves and/or the debt growth slows, the two could intersect later this year or early next year, resulting in a swing to operational losses.

Yes, the addition of Disney's content (including Star Wars) will help draw more subscribers, but so far - in the bigger picture - revenue growth hasn't outpaced liability and debt growth; the cost of revenue (as a percent of sales) has grown from 65% in late 2011 to 73% now. When your net margins are only in the 1.0% range, that's nothing to dismiss.

Bottom line? Netflix has painted itself into a corner with a lot of content commitments. Sooner or later, that could come back to haunt the company, because subscriber growth isn't consistently strong yet.