Since I initiated coverage of NFLX, several investors have given me good feedbacks and inputs (most of them are positive to my analysis, and I appreciate it). Some investors mentioned some red flags in the company’s financial statements that I think are worth some discussions here. There are indeed numbers in their financial statements that may be indications of poor earning quality and/or manipulation on recording of accounting transactions and/or preparation of financial statements by the company in order to hide the deterioration of operational results/outlook from the attention of the public. All my analysis and estimates of course were based on an assumption that reported accounting statements so far are reliable and certain areas that require management’s assessments such as depreciation schedule, intangible impairments, timing of revenue recognition were prepared in an objective and unbiased way. If not, all analysts’ estimates of future financial results may be totally off.
One area of potential concern is the amortization amount that you mentioned. The radio of “Amortization of content library” to “Current content library” stayed at 62% - 63% in the first two quarters. So, the numbers were consistent in Q1 and Q2 reports. However, what many analysts have overlooked (or have noticed but not brought to investors’ attention) is that the value of current content library swelled 47% in Q1 and 88% in Q2 this year, and there is no stop of the bloating trend in sight. Meanwhile, revenue only increased by 9.7% from Q1 to Q2. So, going forward the company’s gross margin is going to be squeezed hard in the remaining of the year and beyond. As we know average per capita income and purchasing power in Latin America is a fraction of that in the U.S., but I don’t think movie studios will give Netflix, or any streaming provider, large discount on per subscriber or video view charge. So, I really doubt if the company can even break-even in their south America venture. For U.S. and Europe, tons of people are still unemployed and struggling to pay their debts, while inflation rates are high for commodities and staples but low for discretionary items (well, it is economy 101 – many people’s pockets are shrinking, and most people choose to cut vitamins fist before cutting life-saving medicines). So, overall I am just not feeling too good about the outlook of the company revenue growth and am very pessimistic about its margin.
Another area of particular concern from the standpoint of trustworthiness of the accounting reports is accounts payable. This line bloated by 35% in Q1 and 77% in Q2. The increase so far seems to be still in line with the increase in purchase of content library each quarter. However, the radio of AP to cash + short term investments has grown from 0.63 on 12/31/2010 to 1.42 on 6/30/2011. In other words, the company’s quick ratio has deteriorated significantly from AA to BB- in credit rating terms in my opinion. If some suppliers decide to tighten the invoice term to the company for whatever reason such as seeing better term from the company’s major competitors, the company can quickly run into liquidity trouble. What is even more alarming and suspicious to me is that the company suddenly erased the showing of change in accounts payable in its last quarterly report. In the statements of cash flows for Q1 (http://secfilings.nasdaq.com/filingFrameset.asp?FileName=0001193125%2D11%2D112061%2Etxt&FilePath=%5C2011%5C04%5C27%5C&CoName=NETFLIX+INC&FormType=10%2DQ&RcvdDate=4%2F27%2F2011&pdf=) this year and earlier periods, “Accounts Payable” is clearly shown as a line item under “Changes in operating assets and liabilities” in cash flows from operating activities section. However, in the statements of cash flows for Q2, (http://secfilings.nasdaq.com/filingFrameset.asp?FileName=0001193125%2D11%2D198669%2Etxt&FilePath=%5C2011%5C07%5C27%5C&CoName=NETFLIX+INC&FormType=10%2DQ&RcvdDate=7%2F27%2F2011&pdf=), the line for accounts payable was gone, evaporated! Of course the liability account does not stay flat QOQ. In fact it increased by a whopping $311K from $222.8K to $533.4K within the last quarter. I think its accounting team probably buried the change in AP into “Additions to streaming content library” line or “Change in streaming content liabilities” line. Either way, it is a very misleading way of presenting operating cash flows because AP has very different meaning from these other two accounts. AP is part of liability, which tells a company’s extension of borrowing capacity to its vendors and the danger of running into insolvency in the future. On the other hand, “Additions to streaming content library” and “Change in streaming content liabilities” are cost of revenues account that show how much new inventory was purchased and how much inventory was consumed or written down. The fact that the company decreased visibility of change in AP in its financial statement (sure people with enough accounting knowledge will still figure it out by doing the calculation I showed, but many investors have limited accounting knowledge or simply do not pay attention to the QOQ changes in balance sheet lines) tells me clearly that the management team themselves agree that the huge increase of AP was a negative to many investors.
There are a lot of other legitimate questions to ask for data to verify such as if the increase in subscriber number real? How do they count subscribers? Are inactive members (members who are suspending their accounts and not paying) counted as subscribers? Among all people around me – people in my office, my relatives, and my friends range from 17 to 70 years old – the total number of subscribers to Netflix have been roughly unchanged over the past two years. Few people newly subscribed to it, and few people dropped their subscription. I am really wondering where are the populations in the U.S. that the company claimed to have just discovered and loved the service so much that so many of them jumped on board in the past two years? I personally feel that the movie rental and viewing population is pretty much like the PC usage population and should already been pretty saturated in North America?
I did not go into details of financial statements and challenged the numbers because, unlike Muddy Water Citron Report, and many “professional shorts”, I normally give the benefit of doubts to the management team unless some numbers fall into the range of absurdness. Even if there is some chance that the values of certain lines in the financial statements might hold water, I’d leave the whistle blowing obligation to their internal accountants and auditor. In addition, I do not have as much resource and capital as Muddy Water and Citron to dig out some hard to get documents in order to expose a company’s accounting manipulations (yet I need to stress again that in my view not all their accusations are correct). This is a good example of what I meant by Wall Street’s discriminative treatment of American firms vs foreign firms in several posts including this one: www.staranalystonline.com/2011/02/specia.... If this is a Chinese company, all these shorting specialty groups will rush to jump on board to expose all potential accounting irregularities on company at this lofty level of valuation. I guess everybody assumes that everything is fine simply because it is an American company and the CEO looks so righteous. This is exactly how we get American scams with manipulated financial bubble bloated to such a big size such as Enron, Worldcom, Movie Gallery, Bear Stearns, Lehman Brothers, and Madoff before being exposed. Then again, who knows? Many of these famous short houses have expressed opinions lately that it is now very hard to profit from shorting Chinese companies because the valuations of even legitimate ones have been depressed to underground levels. Muddy Water in particular might be turning their attention to American mid to big caps because their appetitive seems to be becoming bigger and bigger - from RINO to CCME to SNOFF. Sino Forest (OTC:SNOFF) in particular is a company with substantial business activities in North America and traded at multi-billion capitalization after several years of high-flying and being pumped hard by several big hedge funds including Paulson & Co before being attacked by Muddy Water. For readers not familiar with the story of how these quite powerful shorting groups have destroyed many high flying Chinese stocks (some of them have more believable financial reports than NFLX in my opinion) this year, I encourage you to search online and read how RINO, CCME, and lately SNOFF stocks were destroyed by them in matter of days after they published negative reports on these stocks. Netflix of course has bigger market capital and supports from more I-banks and funds than SNOFF. However, on the other hand it has much higher P/E multiple then SNOFF before struck down and has brewed a bigger bubble. So, I think these two factors are pretty much a wash in terms of potential effects from Muddy Water / Citron Research attacks. Even if Muddy Water or Citron Research just publish an informal inquiry to NFLX management with a list of suspicions like they did to SPRD in June (blogs.barrons.com/tech...), I think the stock will fall to 200 or lower in a couple of days. If Muddy Water or Citron publishes a full report declaring seriously accounting misstatements in NFLX, the stock may plunge to 50 within a couple of days.
I have sent emails to Muddy Water Research analysts (http://www.muddywatersresearch.com), its founder Carson Block, and Citron Research analysts (http://www.citronresearch.com) telling what I have discovered so far on NFLX and asking them if they have taken a look at Netflix and if so what’s their view on its and whether they are working on anything regarding the stock. Right now I think it will help to have some very reputable whistling blowing and fraud detection specialists research on this stock for all investors.
Now, let’s leave concerns on accounting and financial side along and turn our attention back to business and economics. Basically there are two segments of Netflix’s business – physical DVD rental and online streaming. One the physical delivery side, I think there is no argument even from the pumpers that the outlook is pretty dire. Again, like PC industry, the market is completely saturated. Even assume what the subscriber number the company reported in the past two years did not hold any water, going forward new subscriber gain is likely to be small and will be offset by customer attrition. This is only the revenue side; the danger on the cost side is even greater. Inflation has been rising over the past year or so and is almost certain to be running high going forward. Gas price in particular has risen almost 50% in a year and almost doubled over the past two years. Meanwhile, USPS has kept the lowest mail delivery rate, the one that Netflix uses to transfer DVDs, at 44 cents for a very long time - more than two years since May 2009 (http://en.wikipedia.org/wiki/History_of_United_States_postage_rates), pretty much like China government rules retail gas price and always try to cap it at early stage of inflation in order to stabilize “social cost”. However, once the cost increase reaches certain limit the regulator will have no choice but to start raising the rates, often by quite huge extent in a series of raises. China government’s series of raises of retail gas and diesel price from Q4 2010 to Q1 2011 and USPS’ series of hikes on standard rates from 37 cents to 44 cents from 2006 to 2009 were good examples. In other words, the company has been taking advantage of this unusual generosity from US government and painting a false impression of artificially low and stable delivery cost for its DVD service over the past two years. Now, we all know that government subsidy to a lot of things including to USPS going forward will inevitably shrink due to current budget and national debt crises. What if USPS raises the rates to 47 cents next month, 50 cents in the end of the year, and 54 cents again at mid 2012? The impact to Netflix’ cost of goods sold will be quite material.
The other side of business – streaming video – isn’t fairing much better either. I just don’t know why some stock commentators and I-banks keeps on hyping the prospect of this chunk of business. Again, it is a pretty standard, low tech, stuff by now. Even I myself wrote a web application that provided online video viewing and video conference in three months when I did some system developments about 10 years ago. Today I can hire a team of five computer science graduates, purchase several high-end servers and racks of disk-storages and created a pretty professional Netflix, Youtube, or Hulu like video viewing web application in three to six months. There is a reason why we see online streaming service offerings suddenly sprouted over the past two years. It is not that this business is so lucrative or what, it is simply because this business has low level of entry. In fact, for many services the traditional brick-and-mortar model has higher barrier to entry than new online model because capital requirements and system development time are more stringent when companies are doing physical business. For example, in physical mail delivery several big players – UPS, Fedex, DHL – dominate the market and earn quite good margins, but in online form of mail delivery, e.g. emails, the situation is totally opposite. There are countless of email service providers online, nobody really dominate the market, and the worst thing is that nobody really earn any meaningful profits from the business because, well, most email services are free, and even big companies with huge base of customers in other service segments – Microsoft, Google, Yahoo, etc. – cannot do anything about it because if you don’t offer it free, nobody will sign up to your service since there are abundant free lunches out there. Same thing apply to web hosting, messaging (including “video” conferencing), image sharing, and even network connections (dial up, DSL, cable, wireless, whatever). Streaming video might fare a little bit better as least for now, but it pricing power for Netflix or anybody else is still very weak. That’s why we see free movies, TV, and other videos flooding everywhere on the web – Hulu, Youtube, Youku.com, Sohu.com, ppstream.com, BitTorrent sharing network, and more. If you think the number of new online video viewing portals over the past two years was large, wait until you see how many more will pops up over the next two years. I won’t be surprised at all if 20 more new or existing websites start putting movies online for people to view over the next two years. Why so many? Because as I said putting streaming videos on websites is not a high tech but a low tech for programmers now. However, something can be easily done doesn’t mean that companies can make a lot of money out of it. Actually, it is quite the opposite. When there are 30 online movie viewing sites out there, none of these sites, including Neflix will have any bargaining power with the upstream of the supply chain – the movie studios. People will be reminded again that the majority of value creation and critical point of the video entertainment business is the movie making, not distribution. The “concentration of value” and “imbalance of power” will become even more obvious when movies are distributed over the web rather than through physical means. I don’t understand why some people are selling the story that Netflix’ fate in this new business realm will be better than in traditional DVD mailing realm. What if most of its then remaining subscribers are using its streaming business paying $4 per month, and the company only owns 20% or less of market share in the U.S. two years down the road and has to spend a lot more on a much bigger content library to keep its customers satisfied? Honestly, I think Netflix right now is Yahoo in year 2000 at best and more probably AOL or Blockbuster in late 1990s.
I see that many speculators and momentum traders are still blindly jumping into the stock simply because a few TV commentators and I-banks are saying that nothing serious can go wrong to the company and there are still lots of potentials (in other words dreams). We’ll I won’t bet my fortune basing on their advice because most of them are not promoting the stock for the good of general public; most of them are pumping the stock for their own good because many of them and/or their friends have tons of shares on the stock to unload. I mentioned one CNBC commentator in my last post. How about Goldman Sachs? Well, the firm told investors that crude price would go to $200 (http://www.marketwatch.com/story/goldman-sachs-raises-possibility-of-200-a-barrel-oil) in 2008 when the commodity was already over $100 and close to $150 at its peak and when all economic signs strongly suggested drop in consumption, credit tightening, deteriorating financial system, and bubbling commodity prices fueled mostly by speculations. When crude pulled back from $150 to $130, just like NFLX has pulled back from $300 to $260 right now, GS and a couple other I-banks told investors that it was probably only a temporary pull back and that it was “healthy” for a run up to higher ground, like $200. Guess what? Woops, nope, their predictions were dead wrong. Crude plunged all the way to $30 before the bleeding stopped. It is only in the U.S. that most financial professional and firms producing this kind of damaging advice are not sent to jail, and hundreds of billions of tax payers’ money were spent to rescue them and went into their bonus pockets. I wonder how they can face themselves in the mirror if Netflix drops all the way to $60.
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