The Netflix Delusion

(Usual disclaimer applies: this is not financial advice. I do not own any Netflix. Nor am I short Netflix at pixel time (though the thought has crossed my mind). Netflix is actually a super dangerous stock to short at this juncture as it appears to trade purely on momentum as of 3/7/18)

Netflix happens to be a stock market darling.

Netflix’s earnings numbers also happen to be garbage.

To those readers who own NFLX in any real size, I have a simple question for you: how does NFLX generate half a billion dollars of GAAP earnings while simultaneously burning $1.79bn of operating cash?

Source: Morningstar
Source: Morningstar

As I’m sure the NFLX bulls know, it has to do with the way NFLX accounts for the cost of content. NFLX spends real cash today to produce and license streaming content. However, on its income statement it amortizes that cost over a longer time period to (allegedly) better reflect the economics of that content. While the cash flow statement shows $1 of spend on content going out the door today, the income statement spreads that same $1 over about four years.

Who determines the amortization schedule? Why, management, of course.

Here is the relevant disclosure:

Source: NFLX 10K

The table is a little hard to read so here is the text of the note again (emphasis mine):

On average, over 90% of a licensed or produced streaming content asset is expected to be amortized within four years after its month of first availability.

As of December 31, 2017, over 30% of the $14.7 billion unamortized cost is expected to be amortized within one year and 29%, 78% and over 80% of the $1.4 billion unamortized cost of the produced content that has been released is expected to be amortized within one year, three years and four years, respectively.

As it turns out, the NFLX of today is a massively capital intensive business. This wasn’t always the case. Back when NFLX distributed other people’s content it cash flowed quite nicely.

As a general rule I am suspicious of businesses that show growing GAAP income alongside large, negative operating cash flows (in NFLX’s case the cash burn actually gets larger over time–it is moving in the wrong direction). In these cases management’s judgement is driving the income statement. We have a special name for this in analyst land: “low earnings quality.”

So. Does the income statement or cash flow statement better reflect the economics of this business? This is hardly a trivial issue when you are buying a $138bn market cap company on 200x EV/EBIT. After all, it does you no good to add millions of subscribers if you have to burn up all your cash flow to retain them over time. Meanwhile you are funding that cash burn by taking on billions of dollars of debt:

Source: Morningstar (columns are annual figures in USD’000 from 12/31/08 – 12/31/17)

The Red Queen’s comment to Alice is instructive here:

“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

As a CFA Institute publication on earnings quality notes:

The benefit of accruals for smoothing irrelevant volatility comes at a cost. Accrual accounting opens the door to opportunistic short-run income smoothing that can lead to future restatements and write-downs (e.g., Enron). Earnings quality can be improved when accruals smooth out value-irrelevant changes in cash flows, but earnings quality is reduced when accruals are used to hide value-relevant changes in cash flows. Distinguishing between these two types of accrual adjustments is critical to financial analysis. As we discuss in Chapter 3, an astute analyst cannot focus on earnings alone. To assess earnings quality, the analyst must evaluate the company’s cash flow statement and balance sheet in conjunction with the income statement.

Hence I have this niggling contrarian idea about NFLX. My niggling contrarian idea about NFLX is that the business valued at 200x EV/EBIT is an accounting illusion, and what NFLX will really be in the long run is a massive incinerator of cash. A massively levered incinerator of cash. In extremis: a potential zero.

This is not without precedent. The movie business, for example, is notorious for creative accounting.

Now maybe NFLX is cut from a different cloth than the bankrupt movie studios of yore. Maybe it has developed super sophisticated ways of allocating production capital so as only to back projects with a high probability of success and very long cash flow streams. Management sure doesn’t account for content that way in the financials. But hey, maybe they are just that rare conservative management team of a highly touted momentum stock.

Anyway, here is a fun chart via recode:

Source: recode

Has it occurred to anyone buying (or hawking) NFLX stock on 200x EV/EBIT that if you spend like FOX and Time Warner on content, maybe your stock should be priced similarly? (e.g. FOXA: 14x EV/EBIT BUT WITH $3.4BN OF FREE CASH FLOW)

I am not writing this up as a research note or an investment recommendation. This is simply an exercise in healthy skepticism.

What, you don’t believe me?

Ok. Fine.

This is simply an exercise in cynicism.

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