In the past week, we have received numerous inquiries and requests on Netflix (NFLX). It’s not a stock we follow closely, but the deluge of interest and near equal split between bull and bear sentiment made us curious enough to see what our model would reveal.
Please note that Merriam Report dual cash flow and accrual model examines the financial statements much differently than more traditional discount cash-flow screens or non-GAAP calculations.
NFLX has a unique capital structure which makes valuation as challenging as it is diverse. It’s no wonder analyst consensus estimates are spread over a 200 point swath. Also, the business model has been accelerating its transition from a "physical" content distribution schema to a digital delivery platform.
Our analysis contains no macro or segmented revenue metrics. You can find lots of that around and most of it fairly detailed. We focus on the relationships within a company’s reported numbers as told in the financial statements.
What does Merriam Report analysis reveal about NFLX?
Income Statement and Balance Sheet
Mid-single digit revenue growth in recent quarters look to be over shadowed by surging pre-paid and partner shared expenses in Q2 &Q3 2010, offset by a sharp decline in these expenses in the latest period. Q4 collection cycles appear to have taken 50% longer compared to the average of all seven periods reviewed.
For the sake of this discussion, we are using “library content” in the context of inventory. Not in the sense of inventory as being two-steps from cash, but because it is an income producing asset with a stated value as a specific point in time.
You can see that the library “storeroom” has swelled in recent quarters as a % of sales, ending Q4 at 30% of revenues, twice the average for all periods reviewed.
Accounts payable too exhibit a surge in the previous two periods and well in excess of their corresponding sales growth in similar quarters.
The dual cash-flow trend suggests a modest improvement during Q4, but overall direction is flat. The premise being, if NFLX was generating rising levels of OCF, we would expect to see dual cash ratios improving also.
click to enlarge images
Another representation of deteriorating operating cash can be seen in the OCF vs. BSCF chart below. While it does appear OCF levels are improving slightly, non-cash balance sheet components of NFLX’s earnings base have been rising at a faster rate since Q1 2010.
Notice how the accrual trend (below) has stabilized in recent quarters after experiencing wide fluctuations in the latter part of 2009 and early 2010. Generally, moderating accrual patterns indicate less reliance on balance sheet maneuvering to support earnings. In this case, we also notice accruals mimicking the trend line (dotted line) during the past several periods.
However, given the extreme contrasts seen in the balance sheet asset changes noted earlier, we would expect to see some lumpiness in the accruals. This is not the case and it tells us that things might be a little too quiet.
By default, this sends us back to the statement of cash flow for clues. The first big numbers that catch our eye are steady increases in depreciation and amortization (below). It’s obviously not capacity related (i.e.. P/P/E) by the company’s own admission. Yet, on a sequential basis, these figures are rising faster than their participation to revenues.
You will also note the build up in accrued expenses and payables (which are also indicated in the dual cash-flow trends). Ironically, payables and accrued expenses in Q4 were more than retained earnings (below).
However, further down the operating cash ledger are several sets of numbers that also growl as you get closer: “Unearned Premiums”, “Current Liabilities”, Changes in Working Capital” and “Adjustments”.
Management says that in comparing FCF to net income, the major recurring sources of “free” cash-flow are stock option expenses, gift subscriptions and the use is prepaid content. Similarly, they discuss accepting streaming content deals where they have paid earlier than the expense was recognized.
We know that deferred revenues have a seasonality component and a blend of bundled and unique service pricing structures. You can expect NFLX to tweak these price structures as they try to place themselves squarely in the crossroads of consumers, content producers and aggregators. Management uses the terms “back-loaded and “front-loaded” to describe the difficulties in forecasting the outcomes.
Yet, NFLX management does not elaborate much detail in Q4’s 8-K or in the non-GAAP material provided. In the forward-looking statements, the company also says that detailed discussion of the 8-K information could differ materially from information included in their 10-K.
Summary
Although our NFLX analysis does not imply or suggest any obfuscation in the reported numbers, it does raise numerous questions as to the massaging of its numbers from starting line net income all the way to EPS.
In particular, it would be advantageous of management to give investors more meat to chew on. The company is on record that it plans to cease providing gross subscriber additions, acquisition costs and churn beginning in 2012. Investors will need more than net additions, revenue and operating income to get this fuzzy film in focus.
Investment Thesis
Our data suggests shares are significantly overpriced, but the model does assign a B+ grade to earnings quality. Estimated fair-value is $150.42.
The analysis could make a reasonable case to be short NFLX, but this market seems keen to keep the tire biters at bay...cash-flow be damned! Yet, we wouldn’t be jumping in long either. Why? The contrasts between GAAP and non-GAAP (at this point), look to be wider than the gap between granny’s teeth.
You can view our full report here.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
