Netflix's Value is Hidden in Plain Sight

A breakdown of Netflix's Accounting for cap-ex and amortization costs.

“Depreciation is real and its the worst kind of expense. Its reverse float. You lay out the money before you get revenue.” - Warren Buffett (2003 Berkshire Hathaway annual meeting).

Most value investors know of Warren’s complete disregard for the commonly quoted financial figure known as EBITDA (earnings before interest, tax, depreciation, and amortization). His long time friend and investing partner Charlie Munger referred to the figure as “bullshit earnings.” The reason? Because it discounts for real expenses as if they are not actually expenses. The problem is, they most certainly are — particularly the expense known as ‘depreciation.’

Rough Explanation of Depreciation

Take a car manufacturer who spends $100 million on new equipment. That $100 million of cash that used to be on the balance sheet as an asset is still considered an asset, but now it appears in a new line item named “property, plant, and equipment.” The cost of that initial cash outlay is accounted for on the income statement under GAAP accounting as “depreciation.” The entire $100 million is not, however, subtracted from the company’s gross profit in a single year. Instead it is “depreciated” or “capitalized” over its useful life. For even numbers lets say that in 10 years that aforementioned $100 million in manufacturing equipment will be essentially useless to the company. The company (using something called “straight line depreciation”) will subtract $10 million per year for 10 years from the companies revenue as an expense. At the same time, $10 million will also be deducted from that $100 million ‘property, plant, and equipment’ asset. And there we have it: depreciation expense. Of course there is a problem. After the 10 years are up, that company must now spend another $100 million (although usually more) to continue producing its cars! It can’t operate without that equipment and so therefore it absolutely is a real (and recurring) expense and should of course be included in our analysis of profit and loss (earnings).

So what the hell does this have to do with Netflix?

Over holidays I asked my girlfriend if she had seen the show “House of Cards” (she hadn’t). So I fired up the Chromecast and in minutes we were watching season 1 of House of Cards and loving it. As we sat there I remembered watching that season when it first came out well over 10 years ago (season 1 came out in 2013). So, as a loyal Netflix shareholder I started wondering how that might be accounted for today on the companies financial statements, and that curiosity led me to the conclusion I decided to share with you all today….it’s not…

Yep, House of Cards season 1 is well over the 10 year maximum length a media company is able to amortize its content. But let me back up for a second…

What the hell is amortization?

Amortization functions about the same way as depreciation, except that it applies to things you can’t physically touch. For example you may depreciate tangible assets like a building, a tractor, office equipment, or a couch, but you would amortize an intangible asset like a patent, a trademark, software, and of course a movie or a TV show copyright. Netflix is a streamer and so there isn’t a ton of property, plant, or equipment depreciation to worry about (compared to a steel-maker, a manufacturer, an airline, a telecom, ect). Instead they have one big thing they spend a ton of money on each year: content.

Content Spend:

Every year Netflix earns revenue primarily from subscription payments and Ad- dollars. Against that revenue we subtract out the “cost of revenues” which includes the non-cash amortization of the content library (usually depreciation/amortization is an operating expense but in this case it is included in “cost of revenues.”) The table below is from the annual report for the fiscal year 2024.

It should be noted that cost of revenues includes items other than amortization. These other costs would be things like residuals paid in cash to talent, content delivery costs (i.e costs of cloud infrastructure to actually run the streaming service on AWS), personnel costs related to IT and customer service, and really just any other cost associated with actually delivering your content to you on your TV. But of this large 21 Billion dollar expense, most of the cost is the amortization of cash laid out at an earlier date to actually create the content library. See the “amortization of content assets” line item highlighted in the cash flow table below:

Thats 15.3 billion dollars of non-cash amortization of content.

Some Key Figures for Netflix for Context (as of today):

Market-cap: $467 billion

Cash on hand: $8.3 billion

Total debt: $17.4 billion

Net Income: $9.27 billion

Free Cash Flow: $7.45 billion

Amortization costs for 2024: 15.3 Billion.

At a glance Netflix looks expensive.

Whether you’re looking at cash flow or net-income, Netflix’s stock does not look cheap. Its TTM P/E Ratio is at 51 and its forward P/E is 44. Even its free cash flow yield is low (2.4%). But theres a bit more to this story, and it has to do with the way amortization is accounted for in Netflix’s annual reports.

Amortization expense is real

I don’t want to give the impression I believe amortization isn’t real. But I think there are some distinctions to make between the cost of amortization and depreciation. If I own a car factory and I need to replace my $100 million of equipment every 10 years to keep producing my products, I have a truly recurring expense. But Netflix doesn’t have to re-make House of Cards season 1 every 10 years for its users to keep watching it. With that in mind lets review how the accounting for amortization works for Netflix. It should be noted that i’m referring to content produced in-house by Netflix (about half of its content library), and not its licensed content.

How does it work?

For the example below we will use ‘straight line amortization’ (a simplified concept similar to straight line depreciation), but afterwards I will explain why that method isn’t actually used for content. Ok, lets walk through the steps one by one with some very hypothetical numbers:

First: $100 million of cash sits on Netflix’s balance sheet as a “current asset”.

Second: It spends that $100 million to produce “Movie X".”

Third: “Movie X” is now sitting on its balance sheet as a $100 million non-current asset under “content assets.”

Fourth: “Movie X” gets released on Netflix

Fifth: In year 1 of its release “Movie X” costs $10 million in amortization expense (in other words $10 million is subtracted from Netflix’s revenue). At the same time “Movie X” is now only a $90 million dollar asset on the balance sheet.

Sixth: In year 2 of its release “Movie X” costs another $10 million and is only worth $80 million on the balance sheet.

Seventh: This cycle repeats for 10 years in total until “Movie X” no longer costs the company anything in amortization, and is also worth nothing on the balance sheet.

Poof…

Here is where it gets even more interesting!

I mentioned earlier that Netflix doesn’t actually use “straight line depreciation” type accounting for its content amortization. The simple reason being that most of the viewing of that content takes place in the first few years. More realistically about 90% of the amortization of something like “House of Cards season 1” took place within the first 4 years after its release on Netflix. That also means that it was hardly worth anything on the balance sheet after 2017, and worth literally nothing after 10 years (which is the maximum allowed time for a company to amortize its content).

There’s hidden value in plain sight.

As I sat with my girlfriend watching House of Cards I was in some sense consuming an asset worth 0 dollars on Netflix’s financial statements. The same could be said for any content produced over 10 years ago. You would also be correct in concluding that everything produced over only 4 years ago is barely visible on either the income statement or the balance sheet.

Of course Netflix needs to keep spending on content.

Lets not go crazy and suggest that Netflix can suddenly stop producing new content and maintain its revenues. Obviously, management is focused on continuing to create value to its customers and raising prices accordingly. Netflix will almost certainly spend more on content in 2030 than it did in 2024. But the fact remains that your favorite shows will still be there for you to rewatch and show others for decades to come.

The takeaway

Netflix isn’t some cheap stock, and i’m not some genius that discovered a hidden goldmine. But how many shows have you re-watched years after their release? Or recommended to friends who missed them? How many video games can be developed out of IP developed in-house by Netflix? Imagine a “Squid Games” theme park or a “Love Island” party-game. That IP will be valued as essentially worthless in a few years, but its far from worthless. The content library of Netflix is a snowball that grows every year. Sequels are made. Merchandise is sold. And you can always go back and rewatch your favorites. That is worth a hell of a lot in my mind, but according to GAAP accounting it may as well be an old tractor that has rusted into dust.

Closing thoughts

I purchased shares in Netflix at half the price they sell for today. I wouldn’t buy more at this price and expect to clobber the market. That said, this deeper understanding of amortization accounting helps me think more like an owner. I don’t feel I want to sell such an incredible company just yet. After all, how can you put a price tag on showing your girlfriend House of Cards for the first time.