Tuesday, 19 January 2016

Netflix, Going Concern or Headed Towards Insolvency - You Decide

I won't beat around the bush.  I despise Netflix.  I have a far fetched theory that they will eventually go bankrupt.  And I'm putting this out there here and now, based on the following trail of breadcrumbs. 
  1. The stock hovers pretty close to lifetime highs despite horrible free cash flow, and continuous debt and equity financings used to fund the business model.  The stock is up almost 8% after hours on ridiculous results which I'll look at shortly. And equity (and all of Wall Street + Cramer) lap it up and see nothing wrong and pump the stock.
  2. How sustainable is the fee for streaming model over time, and are investor expectations predicated on future growth not already reflected in the price at 120x EV / EBITDA?  Netflix invests heavily in producing and licensing content, but does the return on capital exceed the cost of capital here?  I recall Professor Bruce Greenwald discussing how growth at a cost of capital in excess of return on capital is actually destructive.  
  3. Equity investors are reflexive.  They want to own Netflix not because it's a fantastic business. They want to own it because a) the stock has gone up, b) it's pumped by Wall Street and Cramer.  There is a certain collective cult mentality surrounding Netflix which is unjustified.
  4. I think the play here is, don't own Netflix, own the companies that take a fee for monthly data streaming charges

I had a quick look at the reported results and I offer the following snapshots from the company's release:

Here are the free cash flows for the last three years.  Granted, in 2015, they invested heavily in content which is why free cash flows were negative.  The question I have is, to what end.  When does the pendulum swing.  Aren't they going to have to invest heavily in content on pretty much a go forward basis over time?  What needs to grow are top line streaming margins.  Interesting that for cash flow purposes, the net change in streaming content assets vs. content liabilities are deducted.  They aren't income, but they certainly are a use of cash. 

Next, here are the P/L and the Segmented Results:

Note that on a GAAP basis, consolidated operating income has grown at 16% over the last 3 years.  A far cry from the 32% CAGR growth in consolidated contribution profit.  The difference is a function of "other operating expenses" which eat up 78% of contribution profit.

Interest coverage has dropped from to about 2.30x, but the company will explain this away as a function of higher content costs incurred in 2015 while streaming revenues (and accompanying margins) haven't caught up yet.  Well, we all know how they paid for the content.  Debt.

Here's a note on debt, incidentally from today's 8-K

I guess the disclosure that the company will, once again, have to tap the bond markets to be able to pay for more content is being overlooked by equity who are scrambling to buy the stock at +8% after hours.

Well equity, here's what you have a claim to (in the event of bankruptcy):

Content liabilities of $7.6B to liquid assets of $2.3B, or $.30 on the $1, and then there's this from last year's 10K

At the time, $6B of off balance sheet content obligations weren't capitalized because the company decided that the asset side of the equation hadn't yet met the criteria for capitalization.  Thank goodness they disclosed the amount though.

Assuming off balance sheet content obligations haven't changed, that's $7.6B + $6B  = $13.6B to $2.3B of liquid assets, or $.17 on the $1.

Concluding Thoughts

I'm sure bullish equity participants will make the argument that I'm wrong b/c I have to look at the capitalized content assets because they produce future cash flows.  My rebuttal to this is, are these cash flows infinite or finite once the novelty surrounding current content wears off?  i.e., what type of impairment model are we into in respect of capitalized content that no one wants to watch.

In any case, I have no position, I'm just a casual observer observing manic participants doing what they do best.

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