Len Brecken's Netflix Short Case, Part 1: Is the Company's Accounting Just Smoke and Mirrors?

| About: Netflix, Inc. (NFLX)

If the name Len Brecken sounds familiar, it might be because you've seen him on CNBC making (and, in some cases, defending) his short case in Netflix (NASDAQ:NFLX). Brecken has appeared on the network at least three times so far this year.

Brecken has a decade of experience as a sell-side senior technology analyst at Oppenheimer & Company in the 1990s, after which he was the senior technology analyst at Feirstein Capital, a $1B hedge fund located in New York City, through 2001. In 2002, he founded Brecken Capital LLC. He acts as the portfolio manager of the hedge fund, located in New Jersey.

For the record, I find it difficult to get NFLX bulls from the analyst community to do interviews. I will continue to ask them to share their perspective on the stock with the Seeking Alpha audience. As for this interview, I requested it after Brecken and I emailed and compared notes on Netflix for several weeks. While I don't agree with or endorse everything he says, I think his analysis is sound and agree with his general opinion. I appreciate his hard work and straightforward, easy-to-understand presentation.

This interview marks the third in what I hope will be a growing number of interviews I publish on Seeking Alpha. A majority of readers have responded positively to the first and second interviews I conducted. You can view the current interview in two parts. To see part two, please click here.

Rocco Pendola: Before we get to your views on Netflix, what do you think of recent takeover talk?

Len Brecken: I don’t foresee any interest in a takeover of NFLX, which currently sports a $12B market capitalization. For one, the content is non-exclusive except for EPIX, which is only exclusive for non-cable competitors. It thus can be readily replicated for a few billion dollars by any competitor for much less than $12B. With nearly a 47% subscriber churn, negative net worth (including $1.6B on off-balance sheet content obligations) and negligible adjusted (for ballooning accounts payable) operating cash flow, what is worth $12B to buy then? Further, both Hollywood and NFLX’s competitors are realizing the $7.99/month streaming plan makes no economic sense, relative to the obscene content expenses NFLX is racking up. Don’t believe me -- ask them yourself.

RP: When it comes to Netflix's financials, it's really difficult determining where to start. What do you think are the most important issues for investors in this regard?

LB: I’m focused on whether the business model makes sense at all. NFLX’s overall strategy is to overpay for content in an attempt to create an artificial barrier to entry while quickly ramping subscribers. To its credit, it appears to have succeeded somewhat in the near-term, but at what cost? I say "appears" because all it's doing as it shifts its model from a DVD mail order one to a streaming one is replacing upfront DVD mail expenses with deferred content expenses through amortization over multiple years in the streaming model. It’s all an accounting gimmick. Eventually, EPS growth will slow and catch up with the fact that NFLX is not generating cash from operations.

The four things to focus on financially are: 1) Adjusted Operating Cash Flow (taking into account accounts payable, which has been ballooning and thus is subtracted from cash flow); 2) Amortization to Content Acquisition Ratio; 3) Paid Subscriber Momentum (PSM); 4) Off-Balance Sheet Content Obligations.

1. Adjusted Operating Cash Flow: Cash flow does not lie, but accounting can -- this is my primary rule when determining NFLX’s financial success. NFLX has seen declining year over year Adjusted Operating Cash Flow for four quarters in a row, when you adjust those flows by deducting the rapid rise in accounts payable it has seen throughout the past year. Accounts payable in 1Q11 has risen $200M year over year -- 4X more than pre-tax income. As I will explain in a minute, NFLX’s management is hiding this in its earnings, which appear to be growing but are only doing so by deferring amortization expenses.

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2. Amortization to Content Acquisition Ratio: This ratio measures the rate at which NFLX is amortizing or expensing its content relative to its cash outlays for content. The ratio has been dramatically falling year over year, demonstrating that before NFLX began its streaming ramp and was just doing DVD mailing, it was amortizing at a much higher rate in 2009. In fact, it was amortizing nearly 2X more -- thus why EPS is growing while cash flow (as explained above) has been falling. To demonstrate, the chart below tracks the ratio and shows that if the ratio was adjusted back to historical levels, pre-streaming NFLX Adjusted Net Income would be negative the last three quarters and declining year over year thru 2010 and 1Q11.

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3. Paid Subscriber Momentum (PSM): Simply put, this is a measure of how many paid subs NFLX adds in each quarter, excluding the free subs it carried over from the prior quarter. I am focused on this measure domestically because I believe management has seen the first signs of subs slowing here and is thus why it engages in an attempt to refocus investors internationally. Furthermore, why should investors, when looking at the current quarter, care as much about free subs that get converted to paid ones from last quarter when trying to gauge sub momentum? In other words, this attempts to eliminate the free sub game by management as it tries to smooth out sub adds in any given quarter. In any event, as you can see below, the PSM has dramatically slowed and is expected to decline for the first time in 2Q11, even if NFLX hits the top end of its range of subs 24-24.8M.
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4. Off-Balance Sheet Content Obligations: These obligations rose 60% sequentially to $1.6B in 1Q11. I remind investors with $275M in Shareholder Equity if the off B/S Content Obligations were not off B/S and classified as debt or liabilities NFLX would have negative Net Worth. I think that speaks for itself on why it's important to track.

RP: Michael Pachter of Wedbush described Netflix's content acquistion costs vis-a-vis its balance sheet as a "black box." He notes that every penny will make its way to the P&L, however, within the next five years. One number that always sticks with me is the ever-growing costs linked to "streaming content license agreements that do not meet content library recognition criteria." They increased from $1.075 billion at the end of 2010 to $1.634 billion at the end of last quarter. Can you make sense of these amounts -- what are they linked to specifically, when do they make it to the P&L, where do you see them headed, and can Netflix cover them going forward without incurring a loss?

LB: The off-balance sheet content obligations strike at the core of the accounting gimmick by management. In theory, when these obligations come due and get paid in cash, they will be included in the balance sheet as a deduction to cash, added to the streaming content asset and then, over time, they will be amortized over the life of the agreement. It will never get paid, because NFLX simply cannot capture enough subs to ever generate enough pre-tax income to pay for it.

Simplistically, NFLX makes about $120M in pre-tax for every 10M subs it adds, so if they add 10M subs for five years, that makes ($120M+$240M+$360M+$480M+$600M) $1.8B in pre-tax ... so in order to return that investment, it will take over four years and they would have to grow subs to over 70M net (23M+ currently plus 50M more). And to drill home the point, this is pre-tax, mind you, as NFLX pays 35% in tax -- so on a net income basis, it will take even longer.

As a reminder, for every two subs they gain, they lose one tied to churn. Thus, adding 50M net of churn would mean adding nearly 80M gross, iomplying since they already have 23M-plus subs and if they add 80 gross, they would have to fully penetrate the entire US. There are only 80 to 100M broadband subs total in the US! This is an impossibility and management knows it, keeping in mind that by year’s end cable would have replicated their entire program offerings on streaming and thus all of NFLX’s content in addition to other competitors coming like Amazon (NASDAQ:AMZN) and Google (NASDAQ:GOOG).

On a pure cost basis, do the math: At an estimated $1.6B in off-B/S costs as of 1Q11 that have yet to hit the income statement -- at most they are on three-year term -- $1.6B/3 = $533M per year in incremental amortization costs to hit the P&L. $533M/ 54M shares is nearly $10/share additional expenses.

And yet management continues to buy back stock amounting to $100M in 1Q11 at the same time it continues to sell stock? NFLX has declining cash flow, ballooning off-balance sheet obligations, international expansion in Canada stalling and signs that its domestic subs are slowing. Yet it buys back stock? It's almost as absurd as raising $300M in debt at the end of 2009 exclusively to buy back stock while management unloads virtually all its stock through 2011. NFLX has $150M in cash, $300M in debt and negative net worth, no way of paying its off-balance sheet obligations and it buys back stock? I think it’s obvious what is motivating management here.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in NFLX over the next 72 hours.