Analysis

Is Netflix Truly Unbreakable? Its Inflated Financial Results Tell a Different Story

The company’s financial results are inflated because its expenses on original content are deemed an investment in assets rather than ongoing expenses

The Netflix logo is displayed on an iPhone in Philadelphia, Monday, July 17, 2017. Netflixג€™s shows are pulling in new viewers and award nominations in droves, but the online video service is burning cash at a furious pace to support production. Netflix, Inc. reports financial results, Monday, July 17, 2017. (AP Photo/Matt Rourke)
The Netflix logo is displayed on an iPhone in Philadelphia, Monday, July 17, 2017. Netflixג€™s shows are pulling in new viewers and award nominations in droves, but the online video service is burning Matt Rourke/AP

One sign that the market is in a positive, even euphoric, frame of mind is the shift from talk based on facts and figures to one based on rhetorical superlatives. Suddenly it’s not dry facts that count but rather the stories purportedly surrounding them.

And when analysts, who during normal times should be presenting the factual and rational side of the market, are swept up in this trap, and base their recommendations on language that is more appropriate to discourse about literature than economics and finance, it’s a sign that this positive frame of mind has reached unusually high levels, which should set off alarm bells.

Last week I ran across an analyst’s recommendation for Netflix, the U.S. streaming video and entertainment firm.

Featured in an article on the Business Insider website entitled “Netflix is a ‘monster’ that’s just now ‘hitting escape velocity,’” it highlighted the comments of BTIG Research analyst Richard Greenfield.

The article noted that Netflix has had “no shortage of fans on Wall Street," but added that Greenfield has “just raised the bar to unprecedented heights.”

Netflix Chief Content Officer Ted Sarandos attends Jason Bateman's star unveiling ceremony on the Hollywood Walk of Fame, on July 26, 2017, in Hollywood, California. / AFP PHOTO / VALERIE MACON
VALERIE MACON/AFP

“The company is “hitting escape velocity,” it quoted Greenfield as writing to his clients. “It appears increasingly apparent that legacy media companies have indeed created a ‘monster’ that is threatening their financial future,” Greenfield added.

The Business Insider article was illustrated with an impressively frightening dinosaur-like picture of Godzilla, a connection that is not surprising in that the business media are enamored with superlatives and visual effects that are a lot more interesting than dry, terse language. That’s why stocks don’t just fall. They “plummet,” for example.

Such language makes following the markets more interesting. On the other hand, such turns of phrase should not let us get swept away and we shouldn’t rely on them when making investment decisions.

Escape velocity is a concept from the world of physics, referring to the speed necessary to escape the gravitational pull of a celestial body. When it comes to our own planet, the velocity necessary to launch a satellite and have it reach space rather than falling back to Earth is 40,000 kilometers (25,000 miles) per hour.

In the financial media, when you combine images from prehistoric times with those involving physics and outer space, you get coverage declaring that stocks are “in the stratosphere.”

But now that we have had our foray into science fiction and outer space, let’s get down to earth and look at some facts and figures regarding Netflix.

The company has just released its earnings for the second quarter of the year, beating analysts’ forecasts when it comes to subscriber numbers and leading to nice gains in the company’s share price.

The company gained 5.2 million subscribers in the quarter, 2 million more than analysts had generally been predicting.

But really understanding the business of Netflix requires a measure of understanding of its financial figures. Referring to accounting concepts such as ASC 900 and ASC 920, the company attempted, in presenting its financial picture, to give investors a lesson in accounting.

Netflix deserves credit for that. The main problem with the company’s results, however, is that traditional concepts of profit and loss don’t apply here, even though of course the company supplied those figures and a lot more.

A few years ago, the company shifted from providing content produced by others to creating its own. Netflix admirably explained the shift as one that was necessary due to the low value that it could create based on the old model.

Digital streaming eliminated some barriers to reaching customers directly but created another problem, in that the barrier was also eliminated for the competition. So if Netflix didn’t have original content of its own, the only way it could compete was on price. That meant that if Netflix was to grow, it needed this original content, but that requires huge investment on which the rate of return isn’t so clear.

And that’s where accounting practices came in. It hasn’t been recording the cost of content production in its profit and loss statement, making the statement irrelevant.

Instead it has been recording it as investment in assets that can be depreciated over a period of years.

That has created a huge disparity between the profits that it has been reporting and the negative cash flow from its operations.

If the company were even to accelerate from four years to three years its amortization schedule for the content that it produces, it would wipe out the profits that it reports or even result in an accounting loss. And who knows how long it will take for a specific series to generate respectable profits?

There are series that continue to generate a profit after 10 years, while others never return their investment.

To the credit of Netflix, it must be said that it has not been hiding all of this from investors. Its spending on content is clearly stated. This year the company says it will have a negative cash flow from operations of $2 billion to $2.5 billion. And it says it expects the negative cash flow to continue in years to come to be financed with increased debt. But investors seem to be ignoring this.

Companies are not spaceships that, after attaining escape velocity, can remain cruising through outer space even without their engines working. Share prices can only soar for so long. And if they are to continue to move forward, companies need fuel, in the form of a positive cash flow.

Doron Tsur is an independent financial consultant. This article should not be seen as a recommendation of any type of securities; and the writer may hold positions in securities of the type mentioned in this article.