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What Is Netflix Hiding And Why?

By Shmulik Karpf - February 8, 2013 | Tickers: CSTR, NFLX, NWS | 0 Comments

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinions of our bloggers and are not formally edited.

Netflix (NASDAQ: NFLX) announced earnings for its 4Q 2012 on Jan. 23. The company had a terrific fourth quarter, posting revenues and subscriber numbers well above analyst estimates. The company reported $945 million for the quarter, up from $876 million last year. Wall Street’s consensus forecast for the quarter was $935 million. On the subscriber growth front, Netflix failed to disappoint, as it added 2 million U.S. subscribers for the quarter, compared to 220,000 in the prior year’s fourth quarter. Investors were quick to embrace the company once again, sending shares of Netflix up 40%.

The cashflow statement

The statement of cashflow (CF) in the quarterly report is designed to properly represent the inflows and outflows of cash during the most recent period and is usually a better gauge of the financial position of a company than the standard EPS. The cashflow statement consists of 3 sections: CF from operating activities, CF from investing activities, and CF from financing activities. The first of which is the most closely watched section by analysts.

Creative accounting employed by Netflix

In the Q4 2012 letter to shareholders, Reed Hastings, the company's CEO, emphasized the power behind the company's content library. He stated that it was one of the things that make it such a great company. In particular, Netflix has recorded $1.38 billion worth of content library. During 4Q 2012, the company added $18 million worth of DVD content to its library.

As every investor knows- the core business of Netflix is to buy DVDs in bulk and then rent them to its end-users. The proper way to treat this massive purchase is to record it as an asset on the balance sheet, and at the same time record the cash expense under 'Cash Flow from Operating Activities' (1st category) because this purchase naturally falls in the category of normal ongoing business operations of the company.

Netflix, though, doesn't think that way.

While the company recorded its library as an asset on the its balance sheet, it refrained from recording the expenses accrued by it as an operating cash expenditure (1st category) and rather decided to record it as an investing action to be included in the Cash Flow from investing activities (2nd category). This accounting decision does not correspond with the proper discretion that management is obligated to exercise: investing activities refer to expenditures on such things as plant and equipment, and NOT the purchase of standard inventory that is later sold to consumers.

The incentive behind Netflix's move

Cash Flow from Operating Activities is the most closely watched part of the Statement of Cash Flow, whereas the Investing section ("under the line") is usually ignored by most investors and analysts alike. By extracting normal operating cash outflows from the operating section, the Net Cash position misleadingly appears much more impressive than it really is.

Netflix stands alone

It's more than interesting to note that Coinstar (NASDAQ: CSTR), one of Netflix's rivals, perfectly understands that expenses for the purchase of a DVD library should be recorded in the operating section. In its most recent quarterly report, Coinstar reported the expenses of its DVD library under 'Cash flow from operating activities,' just as they should be recorded. Perhaps this explains why the darling of the video-rental world trades at an insane P/E of 570x and P/B of 2.6x, while Coinstar, its modest rival, trades at a P/E of 10 and P/B of 0.7. At these prices, Coinstar is well inside the value zone. The difference is even more striking when you consider the fact that Netflix's profit margin is a paltry 0.5%, while Coinstar shines with a profit margin of 8%.

Another much smaller competitor in the video-rental industry is Hulu. A combined creation of NBC Universal, News Corp (NASDAQ: NWS), and Providence Equity Partners, Hulu offers video rentals and streaming TV. In fact, Hulu is so dominant in its field that it accounted for 43% of total streams in 2012. The thing about Hulu is that it's a private venture, and therefore is not obligated to publicly disclose its annual reports. Hence, we have no way of knowing for sure how it classifies its video library content.

So, what's an investor to do?

Avoid holding the shares of a company that is suspected of using dubious accounting tricks. Sooner rather than later, accounting games tend to catch up with the company that employs them. Unfortunately, it is usually the unsuspecting shareholders that get hit first.