Shares of online movie rental cum streaming video services company Netflix (NFLX) have remained volatile since our previous analysis of the financial statements through Q4 2010. Following that Feb. 21 story, NFLX shares declined about 12.5% into the March lows and are up more than 20% since.
As noted in that review, our dual cash-flow and accrual model differs considerably from more traditional methodologies, such as discounted cash-flow and other fundamental analysis screens. Rather than try to extrapolate future value, our objective is to estimate a reasonable present fair-value based on the story being told in a company’s financial statements. However, NFLX is a stock which has acted independently of fundamentals, cash-flow and earnings quality. Following the Q1 2011 earnings, our data continues to indicate a weakening trend in cash-flow and declining earnings quality.
Balance Sheet: Evidence of weak earnings quality can be seen in the stunted levels of “pure” operating cash-flows and a predominance of non-cash assets supporting earnings. This is represented in the dual cash-flow ratio:
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Earnings surged in Q1, yet the dual cash figure declined. Inventory build (i.e. library content), and accounts payable trends in recent quarters appear to support the dual cash figure to some extent, as each are growing faster than sales.
Cash-flow concerns as a component of earnings can also be seen in the relationship between operating cash-flow and balance sheet cash-flow (BSCF). In the case of NFLX, widening spreads in BSCF indicates weaker earnings quality, which is visible in the chart below.
The gradual rise of accruals also lends support to our view that non-cash maneuvers continue to play an important role in NFLX’s reported earnings. At first glance, the accrual trend appears very subtle, but it has been steadily moving in a bearish direction since Q2 of last year.
Capital Productivity and Revenue Metrics: Investors will also want to keep an eye on margin risk going forward. We note an increase in SGA and the above-mentioned payables as a percentage of sales, offset by modest improvements in cost of sales. As for capital productivity, the cost of inventory and receivables (per $1 of sales) in the latest period grew faster than average of all periods reviewed. This was offset by significantly lower costs of P, P & E.
Fair Value: Based on our analysis for the eight quarters through March 31, current estimated fair value for NFLX shares are $188.94. At $272, we believe NFLX is overvalued by 44%. Our full report for NFLX can be viewed here (pdf).
Admittedly, this stock has defied our analysis and spoiled many a short-seller's plans. But until signs of improvement in both cash-flow and earnings quality become more apparent, we expect this stock to remain extremely volatile through summer.
The company will report Q2 earnings on July 18. In a June 2 post by theflyonthewall.com, Netflix June-September put option-implied volatility is well below the 26-week average, indicating decreasing near-term price movement.
Sitting just off its 52-week highs, this stock can be shorted to cover in the mid 230 area. A retracement to the March lows is not out of the question either, and if you like the Netflix story for the long-term but don’t yet own the stock, a little patience might be rewarding.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.