Netflix and the Usual Suspects

Netflix (NFLX) reported second quarter earnings last week. While Wall St. focused on their earnings per share I believe there are a few other items worth considering that go beyond their print of $1.15 per share – which puts them a shade under a price to earnings multiple of 100-1.

Usual Suspects

The usual suspects are out with their price targets on NFLX. Most recently JP Morgan came out with their price target of $500. I question the motives of a JP Morgan price target of a price to earnings ratio of ~115-1. The Company has shown growth slow down dramatically with quarter over quarter revenue slowing to 5% growth. The Company has accumulated negative free cash flow over the last 2.5 years of $65m. I believe free cash flow is an important metric for an equity stakeholder to show a pathway to an actual return on investment.

I suspect that JP Morgan has ulterior motives in their $500 price target. Could it be that they want to maintain a good standing with the Company to generate significant fees and commissions for their investment banking division? Look no further than the recent bond offering led by JP Morgan and Morgan Stanley (the Usual Suspects). There was a recent case where Morgan Stanley issued bonds to Tesla Motors. It has been reported that Tesla requested to be indemnified from a “smoking gun” email related to the pumping of Tesla’s stock price target by Morgan Stanley in front of this bond offering. The inherent relationship conflict of investment banker and sell side analyst is very evident here with both of the Usual Suspects.

http://www.sec.gov/Archives/edgar/data/1065280/000119312514037000/d671121dex101.htm

http://www.teslamotors.com/fr_CA/forum/forums/morgan-stanley-upgrades-stock-then-underwrites-convertible-offering

At least a common stakeholder should be able to call into a quarterly meeting and ask about any such conflict of interest or maybe get some insights onto how the Company views their negative cumulative free cash flow. Or can they? I tried to dial-in to their most recent investor call only to find it being held on YouTube with two investment banking moderators lofting up softballs to management. Odds that one of the two was an investment banker representing the Usual Suspects….

GAAP

Since I didn’t have a chance to ask management on their investor call about a few accounting questions that a sensible stakeholder may have – I decided to outline a potential accounting issue here. NFLX has become a streaming content delivery service. As such, a streaming content obligation is incurred at the time a Company signs a license agreement to obtain future titles. Once a title becomes available a content liability and corresponding asset are recorded on the balance sheet. The Company then amortizes the cost of this content using management estimates as to when the viewer will actually be viewing the show. A quick example is NFLX licensing the content rights to Breaking Bad from AMC. A streaming content obligation is incurred when the Company signs the rights from AMC. When they make Season 1 available they book the cost of that to the balance sheet and then amortize it over the estimated period for which the customer will watch the show, to match the revenue coming in from the customer with the expense of them watching Season 1. The content library is stated at the lower of cost or net realizable value. As of their latest reporting period the Company reported a content library asset of $4.1b and a content library liability of $3.2b. The company will have to credit their asset account and debit an expense account to true up managements estimate and this will have a negative impact on earnings, possible to the tune of $900m. The sheer nature of the accounting treatment being used where management uses such estimates should cause a sensible stakeholder to ask some questions.

Supplier Holdup

Lastly, the business model of NFLX as an over-the-top (OTT) service provider, should be discussed in the context of justifying a price to earnings ratio for where the stock trades today. NFLX is subject to Supplier Holdup as a majority of their content is obtained from a supplier. NFLX serves as the middle man between the content producer and the consumer. Also notable in the recent JP Morgan $500 price target report was the hype around licensing of Smurfs 2. While I don’t claim to know much about the Smurfs series I can suggest that their parent company, Sony Entertainment, can “holdup” the Company through content acquisition cost increases. By all means, since NFLX is simply pushing the content over the internet for free*, Sony Entertainment could simply choose to do it themselves, increase their pricing regime or distribute through another OTT offering (https://www.google.com/webhp?sourceid=chrome-instant&ion=1&espv=2&ie=UTF-8#q=smurfs+2+streaming). Supplier Holdup is a complicated topic but is covered in a recent blog post by Tren Griffin who understand the issue well:

http://25iq.com/2013/06/12/wholesale-transfer-pricing-and-the-free-parking-business-model/

*OTT at this scale isn’t truly free and a lot of people point to net neutrality as a benefit to NFLX. While they to have some OTT benefits, when you use 35% of internet capacity as NFLX does, you will have to pay interconnect and peering fees.

Netflix is a revolutionary company and will likely be viewed from a historical perspective as the Company that helped break up the bundling in the television market. I am just not sure that a Sensible Stakeholder would want to own the stock given the items outlined above.

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