The Real Reason Hollywood Studios Should Beware of Netflix (Opinion)

44 FEA Netflix Arrested Development H
Sam Urdank/20th Century Fox Film Corp./Courtest Everett Collection

Netflix will stream new episodes of "Arrested Development" in 2013.

Media analyst Tony Wible warns of a coming debt crisis given the company's dependence on trade credit to buy content.

Everyone knows Netflix has been an aggressive buyer of Hollywood movies and television shows -- in March, it acquired rights to distribute David Fincher's dramatic series House of Cards, and on Nov. 18, it announced a deal to revive Arrested Development. As of last quarter, it had $3.5 billion in off-balance-sheet obligations for content. However, a closer look at the company's financial statements reveals two things that should be troubling for investors and entertainment companies.

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As I first noted in June, Netflix has been spending more on content but has been slower to recognize these payments as a cost in its financials, which results in a weaker cash position for the company than its income statement would otherwise imply. Second, the company has been funding the majority of its content acquisition with trade credit. Essentially, Netflix only pays about 40 percent of its content bills up front and agrees to pay the remainder in the future.

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Netflix's dependence on trade credit is much clearer when one considers its accounts payable has grown 340 percent year-over-year while its global subscriber base grew 49 percent during the same period. Year to date, the use of trade credit has kept it from paying $816 million for the $1.3 billion worth of content it received.

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In fact, Netflix's reported nine-month free cash flow of $151 million would drop to a loss of $665 million if one netted out the use of trade credit. I believe this disparity, the roughly $1 billion in total trade credit due and the $3.5 billion in off-balance-sheet obligations are the root causes for Netflix's price increase and its recent issuance of debt and equity. Simply put, Netflix no longer can sustain losses as its bills come due.

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We believe Netflix built a steep barrier to entry with its aggressive pricing model. It paid aggressive rates for content while pricing the service at a level that produced cash losses, which would inhibit others from entering the market. Hollywood studios and consumers were happy with the model. Content producers saw Netflix as a new large buyer, and consumers loved the pricing structure. Ironically, the damage Net-flix triggered in the DVD business increased studio dependence on the Netflix checks -- creating a virtuous cycle for Netflix and a vicious cycle for the producers.

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However, the momentum has shifted as consumers have shown a reluctance to pay more for content, which might leave some studios needing to contemplate their Netflix counterparty risk, as Netflix might need to ration its spend in the face of consumer backlash. Worse, we suspect many studios are ignoring the risk or are unaware of the changing dynamics in Netflix's model.

Netflix will continue on, but the business model likely will change. The company might need to raise prices again and/or might be relegated to showing more nonexclusive syndication content. The challenges at Netflix should be a wake-up call for studios, which would be wise to spread their content deals across multiple platforms.

Tony Wible is a media industry analyst who covers Netflix for Janney Montgomery Scott.