The following case is about Netflix, Inc. and its accounting for streaming content. When beginning its streaming service in 2007, Netflix offered only licensed content. This relates to shows produced by other studios and originally aired on TV (e.g., How to Get Away with Murder) or Netflix Originals produced by other studios (e.g., House of Cards). The company pays these studios a license fee, which is capitalized on the balance sheet as content asset and amortized over its useful life (usually four years).

As Netflix grew over the years, it recognized that such licensed content entails higher costs as compared to selfproduced content, which would eliminate any middlemen and retain intellectual ownership. The company thus began to increase its focus on selfproduced series (e.g., Stranger Things). The downside of this strategic shift is that selfproduced series are capital intensive in that there is a large cash outflow during the production phase, but no corresponding income or growth in subscriptions. In its financial statements, Netflix recognizes the content asset, as a show is produced. Amortization begins once the show becomes available and is based on a longer useful life (compared to licensed content). In any case, Netflix revenue is based on subscriptions, i.e. the monthly fee that viewers pay to use the service.

a. Relate Netflix shift to selfproduced content to strategy analysis: (i) How does understanding a companys strategy help in financial statement analysis? (ii) Refer to one specific item in Netflix financial statements and explain how this item will change as a result of the companys revised strategy.

b. Some analysts have criticized that the companys free cash flow generation is worsening. Following a negative free cash flow (to debt and equity) of $2bn in 2017, Netflix expects the metric to be a negative $34bn in 2018. (i) Do you agree that Netflix is only burning cash or do you think that for a company in a growth stage, such as Netflix, other metrics besides free cash flows might be more important? If so, which? (ii) As a counter argument to such criticism, Netflix calculates a ratio of cash spending on content to P&L spending on content, where the numerator is its annual cash spending on content assets and the denominator is the amortization charge recorded in the P&L. This ratio is currently 1.42. Briefly explain the rationale of this ratio, and how you expect it to change following the changed strategy.

c. The largest part of Netflix cost of revenues relates to its amortization of content assets, which in 2017 was about $6.3bn. In line with the companys revised strategy, assume that Netflix had invested a higher amount in longerlived selfproduced content assets. Assume this would have reduced the amortization charge by $0.8bn. (i) Calculate the companys gross profit margin for 2017 as reported and as adjusted based on these revised assumptions. (3 points) (ii) What do you expect to happen with Netflix profitability, as the company moves to More selfproduced content? What else does the successful implementation of this strategy depend on?

d. To finance its shift in strategy, Netflix predominantly relies on increasing its leverage by issuing longterm debt. It argues that financing growth through the debt market is currently more efficient than issuing equity. Briefly describe two benefits of debt as compared to equity that makes it more efficient. Also, what is the impact of a potentially larger asset base as a result of Netflix focus on selfproduced content?

NETFLIX, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data) As of December 31, 2016 2017 2,822,795 $ 4,310,934 536,245 7,669,974 10,371,055 319,404 652,309 19,012,742 $ 1,467,576 266,206 3,726,307 260,202 5,720,291 7,274,501 250,395 341,423 13,586,610 $ Assets Current assets: Cash and cash equivalents Short-term investments Current content assets, net Other current assets Total current assets Non-current content assets, net Property and equipment, net Other non-current assets Total assets Liabilities and Stockholders' Equity Current liabilities: Current content liabilities Accounts payable Accrued expenses Deferred revenue Total current liabilities Non-current content liabilities Long-term debt Other non-current liabilities Total liabilities Commitments and contingencies (Note 5) Stockholders' equity: Preferred stock, $0.001 par value; 10,000,000 shares authorized at December 31, 2017 and 2016; no shares issued and outstanding at December 31, 2017 and 2016 Common stock, 0.001 par value; 4,990,000,000 shares authorized at December 31, 2017 and December 31, 2016, respectively; 433,392,686 and 430,054,212 issued and outstanding at December 31, 2017 and December 31, 2016, respectively Accumulated other comprehensive loss Retained eamings Total stockholders' equity Total liabilities and stockholders' equity 4,173,041 359,555 315,094 618,622 5,466,312 3,329,796 6,499,432 135,246 15,430,786 3,632,711 312,842 197,632 443,472 4,586,657 2,894,654 3,364,311 61,188 10,906,810 1,871,396 (20,557) 1,731,117 3,581,956 19,012,742 $ 1,599,762 (48,565) 1,128,603 2,679,800 13,586,610 $ NETFLIX, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) Year ended December 31, 2017 2016 11,692,713 $ 8,830,669 7,659,666 6,029,901 1,278,022 991,078 1,052,778 852,098 863,568 577,799 838,679 379,793 Revenues Cost of revenues Marketing Technology and development General and administrative Operating income Other income (expense): Interest expense Interest and other income (expense) Income before income taxes Provision for (benefit from) income taxes Net income Eamings per share: Basic Diluted Weighted-average common shares outstanding: Basic Diluted (238,204) (115,154) 485,321 (73,608) 558,929 $ (150,114) 30,828 260,507 73,829 186,678 1.29 $ 0.44 $ 1.25 $ 0.43 431,885 446,814 428,822 438,652 NETFLIX, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data) As of December 31, 2016 2017 2,822,795 $ 4,310,934 536,245 7,669,974 10,371,055 319,404 652,309 19,012,742 $ 1,467,576 266,206 3,726,307 260,202 5,720,291 7,274,501 250,395 341,423 13,586,610 $ Assets Current assets: Cash and cash equivalents Short-term investments Current content assets, net Other current assets Total current assets Non-current content assets, net Property and equipment, net Other non-current assets Total assets Liabilities and Stockholders' Equity Current liabilities: Current content liabilities Accounts payable Accrued expenses Deferred revenue Total current liabilities Non-current content liabilities Long-term debt Other non-current liabilities Total liabilities Commitments and contingencies (Note 5) Stockholders' equity: Preferred stock, $0.001 par value; 10,000,000 shares authorized at December 31, 2017 and 2016; no shares issued and outstanding at December 31, 2017 and 2016 Common stock, 0.001 par value; 4,990,000,000 shares authorized at December 31, 2017 and December 31, 2016, respectively; 433,392,686 and 430,054,212 issued and outstanding at December 31, 2017 and December 31, 2016, respectively Accumulated other comprehensive loss Retained eamings Total stockholders' equity Total liabilities and stockholders' equity 4,173,041 359,555 315,094 618,622 5,466,312 3,329,796 6,499,432 135,246 15,430,786 3,632,711 312,842 197,632 443,472 4,586,657 2,894,654 3,364,311 61,188 10,906,810 1,871,396 (20,557) 1,731,117 3,581,956 19,012,742 $ 1,599,762 (48,565) 1,128,603 2,679,800 13,586,610 $ NETFLIX, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) Year ended December 31, 2017 2016 11,692,713 $ 8,830,669 7,659,666 6,029,901 1,278,022 991,078 1,052,778 852,098 863,568 577,799 838,679 379,793 Revenues Cost of revenues Marketing Technology and development General and administrative Operating income Other income (expense): Interest expense Interest and other income (expense) Income before income taxes Provision for (benefit from) income taxes Net income Eamings per share: Basic Diluted Weighted-average common shares outstanding: Basic Diluted (238,204) (115,154) 485,321 (73,608) 558,929 $ (150,114) 30,828 260,507 73,829 186,678 1.29 $ 0.44 $ 1.25 $ 0.43 431,885 446,814 428,822 438,652