Netflix (NFLX) is a stock that proves that the market is not efficient. After reporting first quarter earnings on April 22, the shares jumped over 24 percent. So, were the first three months of 2013 really that good to justify the rise? If we examine what had actually happened, we see that the company added about three million new subscribers and beat earnings estimates by an incredible 13 cents! Now the stock is only trading at a conservative 500 times trailing earnings.
It really does not take a genius to realize that Netflix is overvalued. But what most investors fail to understand is that things are much worse than they appear. Netflix did beat GAAP earnings; I think we can all agree on that. But are these real earnings? To the true investor it is cash that matters and this is something Netflix is lacking. During the last few years free cash flow has deteriorated significantly from a high of $183 million in 2011 to a negative $113 million during the last twelve months. This should be a huge red flag! Since Netflix is not cash flow positive anymore, the company has been forced to take on more debt in order to be able to continue purchasing new content.
In this article I will prove that even raising subscription prices and continuing to capture more market-share will not help Netflix over the long run. I will also talk about the company's billions in "off-balance sheet" liabilities that most investors do not even know exist. Finally, I will attempt to show why Netflix is a bubble stock that will eventually burst.
Profitability is an Illusion
It drives me crazy whenever I hear someone say that Netflix is profitable. Anybody who has ever taken a basic accounting course knows that reported net income (as required by GAAP) is not true profit. There are countless examples of companies reporting huge "accounting profits" and end up still going bankrupt. It is free cash flow that matters and this is what I will mostly focus on.
In the table above I have analyzed free cash flow and net income over the last 21 quarters (including the most recent one). The truth is that Netflix simply is not as profitable as it once was. As should be plainly visible, free cash flow peaked in the first quarter of 2011 and has been in decline ever since. In fact, free cash flow has been negative three out of the last four quarters.
Some investors might argue that free cash flow will eventually "revert to the mean," in other words, be similar to what it was in the past. I will now demonstrate using a simple example why this will not happen with Netflix.
I will prove that Netflix simply cannot be profitable over the long run. In order to do this, I only have to show three things: revenue growth, acquisition of streaming content growth (affects free cash flow), and amortization of streaming content growth (affects net income).
Using the numbers given in the table above, we come up with the following growth rates:
- Quarterly Revenue Growth = 4.9 percent
- Quarterly Acquisition of Streaming Content Growth = 20.7 percent
- Quarterly Amortization of Streaming Content Growth = 21.7 percent
Looking at these growth rates, does anybody see something wrong here? The acquisition and amortization of streaming content is growing more than four times as fast as revenue. Simply put, Netflix will never be able to grow its revenue fast enough to make up for this huge discrepancy. I am now certain that Netflix will never regain profitability. Free cash flow, which is already negative, will continue deteriorating. Net income will also continue deteriorating and should be negative in future quarters.
Now since Netflix has (and will continue to have) negative free cash flow, the company is forced to take on more and more debt in order to be able to continue purchasing new content. This is obviously a huge problem, mainly because the company already has a good amount of obligations (both on the balance sheet and off-balance sheet). It is these obligations that will cause the eventual downfall of Netflix.
Financial Health Continues to Deteriorate
At the end of March 2013, Netflix had a little over $1 billion in cash and short-term investments (24 percent of total assets). However, the majority of the company's assets consisted of streaming content - over $3 billion (69 percent of total assets).
Moving on to the liabilities section we see that Netflix had $700 million in long-term debt (20 percent of total liabilities). Content obligations totaled approximately $2.4 billion (69 percent of total liabilities).
While the balance sheet does not look that bad, it is just the "tip of the iceberg." The company has billions in off-balance sheet liabilities that also must be analyzed to get an idea of the company's true financial condition.
As I mentioned above, on the balance sheet we can see that Netflix had about $2.4 billion in content obligations. However, those willing to dig through boring footnotes will realize that Netflix had total content obligations of close to $5.7 billion. This is because $3.2 billion in content obligations are held off-the-balance sheet. According to a footnote in the most recent quarterly report, the obligation that are not reflected on the balance sheet do not yet meet the criteria for asset recognition. This is because the fee is not known or reasonably determinable for a specific title or it is known but the title is not yet available for streaming to members. I expect these content obligations to significantly increase over the next few years as Netflix continues acquiring content.
There is another off-balance sheet liability that must be mentioned. In the footnotes it is just called other purchase obligations. At the end of the most recent quarter, other purchase obligations amounted to approximately $116 million. Since these obligations primarily relate to DVD content acquisition (a shrinking business), I expect them to be insignificant in the years to come. In fact, these obligations have decreased by about 57 percent over the last twelve months alone. I expect this trend to continue in the future.
The final off-balance sheet liability I want to talk about is the company's non-cancelable operating leases. Operating leases should be capitalized and treated as debt and that is what I have done in my analysis. At the end of the most recent quarter, capitalized operating leases totaled approximately $202 million. I expect lease obligations to increase in the future as the company continues expanding.
As should be plainly obvious by now, Netflix is not as financially healthy as most investors tend to believe. The company has billions in hidden liabilities that it simply cannot pay off without taking on more debt (increasing risk) and issuing more stock (causing more dilution). The company will be forced to continue doing this because it is not cash flow positive. Where else will the money come from? It certainly will not fall from the sky!
Valuation is Absurd
So far we have learned that Netflix is burning through tens of million in cash every quarter and its financial condition is deteriorating. Although, we would not know this if we just looked at the recent stock performance. Mr. Market has been kind to Netflix and bid the stock up close to 200 percent during the last twelve months. Now this stock is the most overvalued it has ever been.
What is Netflix worth as a business? The truth is I have no idea. But I do know that it is not worth the $12.2 billion investors are willing to pay as of this writing. In theory, the fair value of a company is the sum of its future cash flows discounted to the present (discounted cash flow). Since I have already proven that it will be close to impossible for Netflix to ever again be cash flow positive, we can throw this theory out the window.
The only way to value Netflix is to look at its liquidation value. I believe the company's book value is a good approximation of this. As of the most recent quarter it was only $813 million, but mostly made up of intangible assets (in other words, the content that the company paid too much for). It is also true that Netflix has over 36 million streaming subscribers, which probably also adds value to the company. However, they do not add as much value as some might think. There simply is no customer loyalty and stickiness - as we saw back in 2011 when a price hike caused the company to lose one million subscribers.
Bet Against This House of Cards
I do not believe in making predictions. I am not trying to predict the exact date when Netflix will crash. My model is quite simple; I identify fragilities and make a bet on the collapse of that fragile unit, in this case Netflix. I believe it is much easier to understand if something is harmed by volatility (making it fragile) than try to forecast harmful events. Considering Netflix's deteriorating profitability, awful financial health and ridiculous valuation, it is definitely a fragile stock. It will only take a small setback to cause a massive crash in the stock price.
Netflix is clearly a bubble stock. The company is burning through cash and its financial health continues to worsen. Moreover, I believe things will continue to get worse since it is virtually impossible for the company to become cash flow positive. This will force the company to take on even more debt and make it more fragile. This is a disaster waiting to happen!