All investors know that they must conduct a rigorous analysis on a company's cash flow statement before making any serious investment decision. The statement of cash flow in the financial report is usually a much better gauge of the financial position of a company than the standard EPS. I believe that Netflix (NASDAQ:NFLX) is playing suspicious accounting games with its cash flow statement. And it's very important for investors to be aware of that.
Netflix and its content library
Netflix reported its quarterly earnings after the trading session on July 22nd. The company beat analysts' forecasts with $29 million in profit, or 49 cents per share, and up from $6 million a year earlier. Analysts on average expected $0.40, according to Thomson Reuters. Revenue for the quarter was $1.07 billion, up 20% from $889 million a year earlier.
In a letter to shareholders, Reed Hastings, the company's CEO, stated -"Our Product Innovation teams greatly enhanced the features and delivery of our service during the quarter, as well as improved discovery and merchandising of our content library."
It's no coincidence that Hastings emphasizes the importance of the content library to the company. It's the company's main asset and the source of the lion's share of profits. It's the most essential part of Netflix's business.
The tricky part
Part of Netflix's business is to purchase DVDs in bulk and then rent them out to its end users. The proper way to account for this massive purchase is to record it as an asset on the balance sheet, and record the cash expense under "cash flow from operating activities," because this purchase naturally falls under the company's normal, ongoing business operations.
Netflix, though, does not think that way. While the company recorded its library as an asset on the its balance sheet, it refrained from recording the expenses accrued by it as an operating cash expenditure and rather decided to record it as an investing action to be included in the cash flow from investing activities.
I believe that this accounting decision does not correspond with the proper discretion that management is obligated to exercise. Investing activities refer to expenditures on such things as plant and equipment, and not on the purchase of standard inventory that is later sold or rented to consumers.
The incentive behind Netflix's move
Cash flow from operating activities is the most closely watched part of the statement of cash flow, whereas the Investing section ("under the line") is usually ignored by most investors and analysts alike. By extracting normal operating cash outflows from the operating section, the net cash position misleadingly appears much more impressive than it really is.
Netflix reported quarterly net cash flow from operating activities just shy of $34 million. Had Netflix properly accounted for the cash outflow of $14 million (for the purchase of its DVD library), the result would have been cash flow of only $20 million instead of the reported $34 million, a decrease of more than 40%.
Anyone else using this accounting gimmick?
It's important to check whether other companies are using the same trick. Coinstar, now officially renamed Outerwall (NASDAQ:OUTR), seems to perfectly understand that expenses for the purchase of a DVD library should be recorded in the operating section. In its most recent quarterly report, Outerwall stated its content library as an asset worth $155 million, and reported the expenses under 'cash flow from operating activities', just as they should be recorded.
Even the great Amazon (NASDAQ:AMZN) doesn't employ Netflix's trick. It records changes in its inventory in the operating section and never in its investing section. In its most recent quarterly report, Amazon recorded an expense in the amount of $535 million related to inventory under its 'cash flow from operations' segment.
Nevertheless, I found at least one company that records its leased goods in a similar manner to that of Netflix. Avis Budget Group (NASDAQ:CAR), one of the world's leading car rental companies, regularly invests in vehicles which it later rents out. That's the main income source of Avis. In its 2012 annual report, Avis records its vehicles as an asset, while at the same time classifies the cash outflow for these cars as "investing activities" and not as "operating activities." This cash expense jumped from $8.6 billion in 2011 to a whopping $11 billion in 2012. This means that after all, Netflix isn't the only company out there that's using this accounting trick.
I believe that Netflix's accounting practice greatly hurts the quality of its reported cash earnings. Personally, I don't like to hold shares in a company that's suspected of using dubious accounting tricks. Sooner rather than later, accounting games tend to catch up with the company that employs them. Unfortunately, it's the unsuspecting shareholders that get hit first.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.