A colleague/friend asked today how I thought the “FANG saga” would end. I replied that I don’t know about GOOG and FB, but AMZN is maybe worth $50/share as it burns cash every quarter despite manufacturing GAAP “net income” so it’s hard to tell for sure – it could be worth less. NFLX is eventually going to have to restructure its debt, which means the equity is worth zero.
NFLX soared $50 after-hours today after it reported an earnings “beat” for its Q3. But, per its statement of cash flows, NFLX’s operations burned $690 million for the quarter, 33% more than Q2 and nearly triple the operations cash burn in Q1. For the first nine months of 2018, NFLX’s operations have incinerated $1.45 billion. You can see the numbers here: NFLX Q3 financial statements. Note: NFLX uses an unconventional method of reporting its financials, posting them to its website in a read-only spreadsheet format that makes it a pain in the ass to read and analyze the numbers.
How does NFLX manage to show positive net income yet burn hundreds of millions of dollars each quarter? It’s the magic of GAAP accounting. I did a detailed analysis for my Short Seller’s Journal subscribers last year. Each quarter NFLX has to spend $100’s of millions on content. Most companies like NFLX capitalize this cost and amortize 90% of the cost of this content over the first two years. Amortizing the cost of content purchased is then expensed each quarter as part of cost of revenues. Companies can play with the rate of amortization to lower the cost of revenues and thereby increase GAAP operating and net income.
Of course, the accounting “devil” is always in the details of the cash flow statement, which Wall Street, financial media and bubble-chasing stock jockeys never bother to read. While NFLX shows increasing operating and net income each quarter on the income statement, it also shows a big increase in cash burn from operations each quarter. The cash burn is from money spent on content. The net income is generated by reducing the amount of content expense amortization each quarter relative to the amount spent on content each quarter. Despite the stock market-charming earnings “beat” each quarter, NFLX’s cash outflow exceeds cash inflow each quarter. In simple terms, NFLX is a giant Ponzi scheme.
In the analysis I did for my subscribers in July 2017, I demonstrated this accounting Ponzi mechanism:
The ratio of cash spent on content in relation to the amount recognized as a depreciation expense can be used to determine if NFLX is “stretching out” the amount depreciation recognized on its GAAP income statements in relation to the amount that it is spending on content. In general, this ratio should remain relatively constant over time.
For 2014, 2015 and 2016, this ratio was 1.42, 1.69 and 1.80 respectively. When this ratio increases, it means that NFLX is spending cash on content at a rate that is greater than the rate at which NFLX is amortizing this cash cost into its GAAP expenses. If NFLX were using a uniform method of calculating media content depreciation, this number should remain fairly constant across time. However, as content spending increases and GAAP depreciation declines relative to the amount spent, this ratio increases dramatically – as it has over the last three years. A rising ratio reflects the fact that NFLX has lowered the rate of depreciation taken in the first year relative to previous years. It does this to “manage” expenses lower in order to “manage” income higher.
In the first nine months of 2018, this ratio was 1.70, which explains largely why NFLX’s rate of GAAP “earnings” growth is declining.
To pay for its massive cash flow burn rate, NFLX has to continually issue more debt and stock. Earlier this year NFLX issued nearly $2 billion in junk bonds. For the full year 2014, NFLX had $5.5 billion in revenues, its operations generated positive $16.5 million in cash. The Company had $900 million in debt and $3 billion in non-current content liabilities. Fast forward to Q3 2018. The Company has $14.7 billion in LTM revenues and the operations incinerated $1.93 billion LTM. NFLX has $8.3 billion in long term debt, and $8.1 billion in content liabilities. Debt and content liabilities tripled.
Liabilities and debt obligations are growing faster than revenues and cash flow burn, the latter of which grows at a double-digit rate every quarter – sequentially. Cash out is growing at a faster rate than cash in. The difference is made up by borrowing from investors. This is the definition of a Ponzi scheme.
The problem with NFLX’s business model is that it keeps its subscription rate low enough to attract new subscribers every quarter at a rate that gives Wall Street and stock-jockeys a Viagra-induced erection. But NFLX does not charge enough for its product to cover expenses. If NFLX were to raise the cost of what it sells to a level that would cover its expenses, its subscriber-count would plunge.
NFLX exists thanks to the massive amount of money printed by Central Banks globally, which has injected more cash into the financial system than investors know what to do with. That’s enabled NFLX to continue floating debt. But this game is coming to an end and it’s only a matter of time before NFLX stock crashes and burns.
This is why insiders have been dumping stock indiscriminately. They were unloading shares up until October 11 – three business days ago – presumably the last day before the earnings blackout. I don’t care if the sales are “automatic.” If insiders thought the stock deserved to go higher, or was not going lower, they would turn off of the “automatic” sell switch. In the last three months alone, insiders have dumped over 400,000 shares and bought zero. Follow the money…
Excellent plain English analysis. As a darling of Wall Street, they will continue to shine since most folks won’t see or understand the impact of depreciation manipulation. Thanks for the great article.
That Netflix, Facebook, and other social media companies are driving the US markets instead of industries that produce actual goods shows why the economy is in such bad shape.
My latest piece.
appreciate you took the time to analyse and write this report but some points I’m unsure of… disclaimer: don’t have any opinion on NFLX except it’s a great date activity
1) content cost to amortisation has to be increasing as content cost is basically capex, so capex-to-D&A should be increasing for a growth company as they are investing growth capex on top of maintenance capex. It’s crucial for NFLX to increase content acquisition before competitors like HBO/Disney/Warner create a new site with their own contents
2) Cash burn is again another typical growth company bottleneck in that in the beginning lifecycle companies inevitably need to pay up to achieve scale/network effect. While this means there will be further dilution, ultimately it doesn’t make the existing shares valueless/overvalued UNLESS we are certain that the future cash flow is zero/below what we paid for today on a NPV basis
So while the title is gripping, I think the above points need another think. For sure NFLX is terrible from a value/cashflow point of view but it’s just not in that stage where a mature corporate drowns in cash so I feel it’s slightly unfair. A better short thesis is if we attack its fundamental franchise i.e. relying on contents it doesn’t actually produce, and first mover advantage being eroded by large content producers as content is king.
Cheers and happy to discuss!