Netflix, Inc. (NFLX)
This idea is closed
- Asset Class
- Common Equity
- Expected Timeframe
- 12 months
- North America
- United States
- Price at
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We believe that Netflix, a leading online distributer of video content, is engaged in aggressive accounting that is inflating its true economics in a very material manner.
Specifically, we contend that since the company accelerated its shift in focus — from renting DVDs through the mail to streaming media — its reported profits have been significantly inflated and don't reflect the true profitability of the company.
Equally, while Netflix likes to boast that it generates high levels of cash (which it then uses to buy back stock), it is our contention that, if not for aggressive working capital management, Netflix would have generated very little cash in the last few quarters.
The "complex" accounting of streaming media
In fact, there is a substantial difference in the accounting treatment of the costs of DVDs and the distribution rights for streaming video. With DVDs, it is pretty simple. Netflix buys a certain number of DVDs that it in turn rents to its customers.
These DVDs go on the balance sheet as an asset and are amortised over their useful life. Historically, quarterly capital expenditures, or capex, for DVDs and quarterly amortisation of the DVD library were roughly equal.
This meant that the P&L charge associated with DVD purchases was always closely matched by the cash outlay. In other words, there was never a big discrepancy between P&L and cash flow.
If anything, former CFO Barry McCarthy was conservative in depreciating DVDs; there is tangible evidence that the company tended to err on the side of caution (i.e., fully depreciating DVDs before the end of their useful life).
Proof of this is the fact that in 2009 and 2010, the sales of DVDs generated cash proceeds of $11.2 million and $12.9 million respectively — and also generated positive P&L gains on disposal ($7.6 million and $9.9 million). Given the large P&L gains on disposal, it is quite apparent that the DVDs were almost fully depreciated on the balance sheet.
Things started to change rather radically in 2010 as Netflix stepped up its streaming offering. Now, rather than purchasing the DVDs outright, Netflix obtains content distribution rights from various studios in order to stream TV shows and movies to its customers.
Think of "content" as a fixed asset
In a way, we can think of "content" as a fixed asset that is used to generate revenues. No matter how much it is used, it will always cost the same to the company (unless there are variable elements to the compensation). In the case of Netflix, not all streaming rights make it to the balance sheet under content library.
Some deals, where the license fee is not known or reasonably determinable, it appears on the balance sheet under prepaid content. Still, regardless of whether it appears under content library or prepaid content, whatever the company pays under "acquisition of streaming content" appears on the balance sheet, just under different line items. Netflix then amortises this content over the life of the contract. This, in theory should be easy: if, for example, we have a one-year streaming deal with Paramount for $100 million, we should simply charge to the P&L $25 million in amortisation costs per quarter.
And at the end of the year, we shouldn't have any residual content associated with this contract. However, a lot of deals are not so simple or plain vanilla but have different clauses — which apparently gives Netflix some degree of flexibility in respect to P&L cost recognition.
This becomes apparent if we compare historical content capex (DVD and streaming) with historical content amortisation. As long as the company was only renting DVDs, those two items tracked each other closely. Yet as soon as the company started spending hundreds of millions of dollars on streaming content, a most intriguing phenomenon occurred:
Capex was increasing, the content library on the balance sheet was also increasing, but amortisation of the expenses through the P&L mysteriously didn't — or if it did, certainly not as fast as we'd expect.
The rising "real" cash costs of streaming
Netflix's "real" cash costs of streaming accelerated significantly in 2010 and 2011, as the company signed a number of expensive deals with the studios. However, the "accounting" costs (i.e., those recognised in the P&L) have been consistently understated for each of the past six quarters.
In our view, the reason for this is obvious. Had Netflix expensed the "real" cost of streaming, which is ultimately what it paid the studios, it would have missed its numbers dramatically.
Let's take Q1 2011 as an example. If instead of the reported amortised $113 million of content cost, we use the real cash that Netflix paid to secure the content (i.e., $212 million), the bottom line EPS figure would have looked very different.
If not for its aggressive accounting, Netflix would have reported a net LOSS in Q1 2011. This is not a one-off, the same exact thing happened in Q4. Netflix expensed only $96 million, while its real cash cost was $205 million.
Even in Q4 2010, Netflix would have posted a P&L loss had it matched expenses with cash flow. It didn't. And this is the real crux of the matter.
Why is there a discrepancy between P&L expense and cash flow? We can think of two reasons:
- Netflix is prepaying for content
- Netflix's accounting treatment of content expense is too aggressive
Assuming we give Netflix the benefit of the doubt and assume that it is in fact prepaying for content, this would imply that the company heavily invests in the beginning, but later needs to pay less to the studios.
Returning to our previous example, if Netflix signs a one-year deal worth $100 million, you would expect a P&L charge of $25 million in each of the quarters — but maybe a cash outlay of $50 million in Q1 and $50 million in Q2, followed by a zero cash outlay in Q3 and Q4.
In other words, in Q1 and Q2 you'd be creating higher content on the balance sheet which you'd then amortise over the course of four quarters. This is what the new CFO David Wells claimed during the Q4 2010 and Q1 2011 conference calls.
From the Q4 2010 conference call: "We had a significant increase in the investment in our streaming library…a couple of these were large payments that just were timing at the end of the quarter that should reverse themselves in Q1…".
These did NOT reverse in Q1. In fact, they kept going up.
During the Q1 2011 conference call, the CFO said: "Cash payments for content increased $130 million year over year versus a $110 million year-over-year increase in the expense associated with that content. So to the extent that we talked about close matching of our payment terms with our expense, we are continuing to execute on that. We ran a little bit ahead in Q1."
The CFO is trying to say that whilst in the past there was a slight mismatch, this is no longer the case. We have a few problems with this:
We cannot understand what the CFO is talking about when he says that the year-over-year increase in expenses was $110 million. Whilst cash expenses for securing DVD and streaming content did indeed increase by roughly $130 million year over year, as the CFO said ($127 million to be specific), the yearover- year increase in amortisation of content library was just $50 million for the quarter — and not $110 million as stated by the CFO. In fact, the entire amortisation cost for the quarter was just $113 million (compared to $60 million last year). What was the CFO talking about? It's difficult to tell since Netflix has inexplicably banned live questions during conference calls since its Q4 2010 call, but he is definitely saying something which is factually incorrect.
If it's just a timing mismatch, we would expect a reversal of this — as, in the first two quarters, the company is building up a "credit" with the studios which gets "used" in the second two quarters. At the end of the deal, the surplus or, in this case, the deficit has to be zero by definition. This is NOT what has been happening at Netflix since Q4 2010. The alleged deficit has been constantly increasing. We have seen no reversal whatsoever. Even in Q1 2011, where during the January call the CFO said we should expect a reversal, we have seen the deficit increase by another $99 million!
If we are to believe the CFO that cash flow and P&L mismatch is all down to prepayment, we would expect accounts payable (AP) on the balance sheet to go down significantly — and it would also negatively affect working capital changes in the cash flow statement.
From the Netflix 10K… "For the titles recognized in content library, the license fees due but not paid are classified on the consolidated balance sheets as ‘Accounts payable' for the amounts due within one year and as ‘Other non-current liabilities' for the amounts due beyond one year."
In other words, if Netflix prepays studios, these liabilities should go down. If, on the other hand, Netflix "consumes" streaming content without paying for it, these liabilities go up. CFO David Wells seemed a little bit disingenuous during the April conference call on this point by saying that "we signed a bunch of new content deals that we discussed in the investor letter and to the extent that those deals were within a year, with identified titles, it drove the AP up".
The point here is that these deals were signed but not paid for. This is why AP went up. Accelerating AP is a sign of a company that is stretching suppliers — the studios in this case —not of a company that is prepaying.
- Finally, and in some ways most interesting, the CEO himself tells us that we should expect a close matching of expenses and cash costs. In a reply to Whitney Tilson, CEO Reed Hastings wrote, "On a long term basis, FCF should track net income reasonably closely, as it has in the past, with stock options as an offset against small buildups in PPE and prepaid content".
Finally, from the company's January 2011 conference call…
"Almost all of our deals, Daniel, right now match cash with expense and you see that in our cash flow for Q4. So, it's really just a question of each of the two sides' relative cost of capital and most of the studios and content owners [we] deal with have lower cost of capital than we do, so, it's not that hard an issue".
Translation: Yes, Daniel, you are right that in theory cash expenses and P&L amortised content costs should match. However, since studios have lower cost of capital than we do, we clearly prefer to pay them later and this drives up AP. In other words, Netflix clearly does not prepay the studios, if anything, it delays payments to them!
It looks clear to us that Netflix does not prepay the studios. If anything, it "consumes" more content than it pays for and it pays for more content than it expenses on the P&L. As a result, the real economic profitability of Netflix seems grossly overstated.
And while we are not trying to fabricate conspiracy theories here, we would like to highlight two interesting points:
Just as the company started inflating earnings dramatically via aggressive accounting as explained above, its long-loyal CFO, Barry McCarthy, suddenly left the company. Reasons given were mainly associated with Barry's ambition to become a CEO and run his own company. It is interesting that at the time he left the company, he had no company to run and only a few months later decided to change his mind again and go to work for a VC company. One wonders whether there is nothing more to his sudden departure and whether it may have to do with Netflix's aggressive accounting.
Just as investors started asking the company delicate questions about accounting and cash generation, CEO Reed Hastings decided to stop live questions during conference calls so that he and his new CFO could choose which questions to answer during quarterly calls.
Nobody is accusing Netflix of fraud or manipulating accounts. We are suggesting that its accounting is very aggressive and significantly inflates profits. More specifically, that the company didn't make a dollar in profits in the last two quarters.
We believe that at some point in 2011 Netflix will have to start adjusting its accounting and possibly reverse some of the accounting gains generated thus far. This will lead to material selloff of the stock.
Sell side analysts ignore the discrepancy between cash earnings and accounting earnings. Sell side analysts ignore the fact that cash flow from operations are generated from working capital and not from actual underlying profitability. Sell side analysts don’t question management in respect to growth in accounts payable well beyond what would be expected simply because the company is growing. Sell side analysts are perfectly happy being fed the tale of “content prepayment” when actual figures suggest that none of this is happening. Sell side analysts seem to back-solve content costs to yield target EPS figure because there is very little transparency in content costs. Rather, they should start from content costs to get to estimated EPS.
|Shares outstanding - diluted||52.5|
|Cash + short-term investments||342.0|
|2011 PEG Ratio||0.0x|
|P / BV||N/A||N/A|
|Net debt / EBITDA LTM||0.0|
|Total debt / EBITDA LTM||0.0|
|Cash / share||6.51|
|Market cap / Debt||58.1|
Note: This is a SAMPLE idea. This strategic short on Netflix stock was originally submitted to the SumZero community on June 30, 2011. It is no longer an active recommendation within SumZero.
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