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Netflix Still Smoothing Out Original TV Strategy

Stocks in this article: NFLX

NEW YORK ( TheStreet) -- Netflix (NFLX) is still fine-tuning its strategy to produce original series, even after shows created by the Reed Hastings-run company were nominated for 14 Emmy Awards earlier this month.

Netflix said in a second-quarter earnings release it is still judging how to recognize costs the 30 million member streaming service incurs to make original shows such as House of Cards, Hemlock Grove, Orange is the New Black and new seasons of Arrested Development. Meanwhile, Netflix disclosed the company is amortizing about $150 million in spending on such original series to date.

"In terms of relative size, of the approximately $3 billion in content library net book value we are amortizing, currently around 5% is for Originals," Netflix said in a letter to shareholders.

As the company gains confidence in how to project the earnings impact of its original series, Netflix said Monday it is open to changing how the company expenses upfront cash costs of its shows.

Currently, Netflix capitalizes spending on original series, and then amortizes those costs on a straight-line basis over the shorter of four-years or the show's license period. The company, however, said it continues to consider whether viewing trends could cause it to amortize those costs at a faster rate in the future.

"We are in the early stages of Originals and continue to monitor whether the viewing pattern is enough higher in the first few months to have us amortize at a faster initial rate, and then to continue on a straight-line basis for the remainder of the amortization period," Netflix said in the letter.

Netflix's disclosure of the amount of original content it is currently amortizing and the life of its content assets gives investors added clarity as the online entertainment company tries to make original shows a force for subscriber growth and bargaining power with studios. The company's recognition that amortization practices may change, however, indicates Netflix is still hammering out its strategy.

How Netflix recognizes costs of original series is a point of uncertainty for shareholders, and has created a divergence between the company's reported profits and its cash flow.

While Netflix spends heavily up front to make its original series -- about $50 million a season -- very little of that money is expensed to the company's bottom line. Instead, Netflix treats its original programming as a capitalized asset that will be amortized over multiple quarters.

Because of the accounting, Netflix's recent earnings reflect very little of the cost of its spending, however its cash flow statement shows the full amount of the money going out the door for originals.

Given a lack of detail on how much Netflix had spent on original programming and how it would amortize content expense, there was some uncertainty heading into second quarter earnings on whether original programming could drag on profitability.

Netflix has reported negative free cash flow even as profits have risen sharply in recent quarters, however, the company reported $13 million in second quarter free cash flow. Those positive cash flows were attributed a reduction in content spending and strong international growth, and helped to reverse a trend of three quarters of negative FCF.

The company, however, warned profits and cash flow could again diverge. "Our investments in content, including Originals, will continue to weigh on FCF relative to net income and thus our FCF trends," the company said.

Netflix also said it will be expanding original programming to include feature-length documentaries and stand-up comedy specials. "Netflix has become a big destination for fans of these much loved and often under-distributed genres," the company said.

Overall, Netflix second-quarter earnings may raise some investor concerns about the company's near-record high valuation. However, they also give further evidence of strong domestic and international growth that could give the company the scale to report meaningful profit growth in coming quarters.

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