Netflix: Adjusted Free Cash Flow Almost Non-Existent

| About: Netflix, Inc. (NFLX)

Over the past few years, more companies are using "free cash flow" and other non-GAAP financial metrics to entice investors into buying stock in the business. With that said, not all cash flows from operations are created equal. Warren Buffett used his "Owner Equity" approach because this metric weeds out many of the fictitious cash flow line items used by companies to fool analysts -- increases in accounts payables, for example, are included as cash flow from operating activities but many times this cash comes from financial engineering and not actual business earnings.

The whole idea behind cash flow analysis is finding out what the true earnings power of a given business is, not just looking at the numbers eschewed by management teams in the 10Q and 10K. We wonder why line items like a rise in payables or an increase in short term debt are allowed to be counted as operating cash flows because many times management teams have easy access to bank loans and lines of credit which can allow them to juice cash flow in the short run to essentially any number they want to hit.

While I am not saying that this behavior is dishonest, I am saying that calling increasing short term debt "cash flow" is incredibly misleading. Wise investors should adjust for changes in working capital by adding net income to Depreciation and Amortization and subtracting cash flow from investing activities to get to a more realistic view of free cash flow.

Netflix (NASDAQ:NFLX) is a great company offering a revolutionary product. With that said, the valuations are getting extreme to say the least with the stock rising into the stratosphere over the past year and more than tripling in the past two years. While we are not bashing the business, we are a little skeptical of those buying the name at today's prices because to us it's similar to buying real estate in South Florida circa 2007 - when everyone is doing it, you should probably avoid such a speculation like the plague.

Turning to Netflix's cash flow statement, we are blown away by management's discussion of "free cash flow" which claims it earned some $75MM last quarter. While that may seem like a lot of money to some readers, let us remind you that Netflix is a company "worth" $15 billion according to the recent closing price of the stock. What's much more scary than the fact that people are willing to pay such a crazy multiple to NFLX's cash flows is that most of this cash flow was used to repurchase stock, which we view as a bad idea given the overvaluation of the stock. We have already established that borrowing money in the form of rising accounts payables or increases in short term debt is not the same as true cash flow from operating activities - we will call this "refinancing" our Florida home in the fall of 2007 to make home improvements around our Miami condo like buying a new grill or putting in a swimming pool. These moves should increase the value of our house, right? Well, not necessarily.

NFLX essentially earned zero free cash flow from operations last quarter when backing out the $115MM increase in short term liabilities the company took on during the quarter - the cash out refinancing money it borrowed to pay for more streaming content in the form of letting accounts payable increase. In other words, over the last quarter, Netflix earned around $116MM in operating cash flows but most of this (at least $77MM in rising payables) is not actually real cash flow. That means Netflix only earned about $39MM in operating cash flow last quarter.

But wait, it gets even more strange. Of that $39MM the company earned, another 22MM of it came from "accrued expenses" and another $15MM came from "deferred revenue." I know it seems pretty crazy, but Netflix didn't actually earn any money last quarter. Now, I know that "streaming" is supposed to be this exciting new revolution and all, but I have to ask myself whether or not the same was said about the Miami Condo market back in 2007. After all, it was a lot easier "flipping" Miami real estate back in 2007 than it was to actually work. The same thing will one day be said of those buying Netflix at today's bloated prices. Just because a company can sell product does not mean it that company is a good investment - clicks and eyeballs didn't do a whole lot for Time Warner (NYSE:TWX) when it bought AOL (NYSE:AOL) and I don't think buying NFLX will do a whole lot for the current herd of speculators who are bidding up this name to new highs, Latin America, Africa, China, or not.

When looking at Netflix's full year financial statements, we can see similar issues. Netflix reported the following data in its 10K:
2010 2009 2008

(in thousands)

Non-GAAP free cash flow reconciliation:

Net cash provided by operating activities

$ 276,401 $ 325,063 $ 284,037

Acquisition of DVD content library

(123,901) (193,044) (162,849)

Purchases of property and equipment

(33,837) (45,932) (43,790)

Acquisition of intangible assets

(505) (200) (1,062)

Proceeds from sale of DVDs

12,919) 11,164 18,368

Other assets

(70) 71 (1)

Non-GAAP free cash flow

$ 131,007 $ 97,122 $ 94,703

But let's see if Netflix is generating its cash flow from earning money or from rising payables, short term debt, and changes in "other assets and liabilities - remember, borrowing money is counted as "operating cash flow" - like when I borrow money to build a pool in my backyard or fix up the man cave using my cash out re-fi money:

Accounts payable

139,983 (1,189) 7,111

Accrued expenses

67,209 13,169 (1,824)

Deferred revenue

27,086 16,970 11,462

Other assets and liabilities

50,332 618 9,137

Net cash provided by operating activities

276,401 325,063 284,037

As we can see, not only was Netflix's 2010 cash flow largely a product of rising accounts payables and accrued expenses (debt) the business is actually losing operating cash flow as it grows its subscriber base. Something is way off here. Why are investors paying $15 billion for a company earning $131MM in "Non-GAAP free cash flow?" Because they aren't investors. They are speculators and eventually they will lose their shirts just like they did in the dot com fiasco and in the Miami Condo boom of 2007. (I recently looked at a house in West Palm Beach, FL, for $175K that sold in 2007 for $700K - a beautiful place, but I sure like it better at today's price than the bubble price of '07, and it's the same concept with NFLX and its "free" cash flow).

Keep in mind I closed my losing put spread trades on this thing at around $210 or so and only very recently re-entered the short side of this using bear call spreads, but once the bubble pops I view this as a spectacular short sale opportunity. This will be viewed like buying 2007-2008 mortgage CDS in a few years if the cash flow situation catches up with this company like I think it could. The Starz deal will likely cost this company some $500MM per year which the business can't really afford, so we actually think Netflix could have to issue stock or possibly face solvency issues after the past few years of levering up the balance sheet and buying back stock at absurd multiples. While earnings are growing, they are clearly "low quality" earnings for the most part - 2009 cash flows looked much better than 2010's and YTD 2011's. Maybe streaming wasn't all that great after all?

Many Hollywood industry executives have gone so far as to say that Netflix is a endangered species once the Starz business is renegotiated. All in all, I see this chart and recognize boom-bust for what it is. The shorts are right, but they have lost money so far. In the end, the cash flow will determine what this business is worth, just as it did for AOL, Yahoo, Google, etc.

Disclosure: I am short NFLX.

Additional disclosure: I am short NFLX bear call spreads, not the common (at strikes over $300 for the most part)