Can You Trust Netflix's Cash Flow Statements?

I just came across an interesting article about Netflix (NASDAQ: NFLX  ) . And I think it needs debunking.

The author, Shmulik Karpf at Seeking Alpha, looks at how Netflix accounts for its rental inventory and comes away with this chilling conclusion:

I believe that Netflix's accounting practice greatly hurts the quality of its reported cash earnings. Personally, I don't like to hold shares in a company that's suspected of using dubious accounting tricks. Sooner rather than later, accounting games tend to catch up with the company that employs them. Unfortunately, it's the unsuspecting shareholders that get hit first.

Yikes! OK, so what did Netflix do to deserve this verdict, just shy of accusing the company of accounting fraud?

Karpf worries that Netflix is playing games with its cash flow statements. Specifically, Netflix accounts for its DVD library purchases under cash flows from investing activities rather than operating activities. This choice, the author says, masks these expenses from most investors, because the investing section is often ignored. DVD purchases are an important part of Netflix's daily operations, and therefore, the expense belongs under operating activities.

I'm no certified public accountant, but there are at least three things wrong with Karpf's conclusion.

This is business as usual
First and foremost, there's nothing wrong with rental companies placing their rental inventory acquisitions in the investing section of cash flows.

The article holds up two companies as paragons of virtue, placing their rental inventories in the operating section. One company was found to follow the Netflix policy, which means that some other companies also use this "accounting trick."

Well, it's actually a fairly well established practice in the rental industry at large. It's true that Rent-A-Center accounts for its rental merchandise under operating activities, just like Karpf's ideal examples. And it does make intuitive sense to balance these expenses against their depreciation, which definitely goes in the operating section. So Karpf isn't exactly wrong -- you can build your cash flow statements this way, and some companies do.

But it's also incredibly easy to find followers of the Netflix model, when you're digging in the rental services industry.

Take construction equipment manager United Rentals (NYSE: URI  ) , for example. In 2012, the company accounted for $1.3 billion of freshly purchased forklifts and construction lasers in the "investing activities" section of its cash flow statement.

This was balanced by $900 million in depreciation and amortization expenses, presented under "operating activities." $200 million of this was for "non-rental" equipment, and this fact was disclosed on the income statement. The company also provided a handy free cash flow reconciliation table that brings all of the disparate pieces together into one easily understandable non-GAAP figure. Much like the non-GAAP earnings calculations you see all over the stock market.

Rental car giant Hertz (NYSE: HTZ  ) works the same way. You'll find its "revenue-earning equipment expenditures" under "investing activities" and a rundown of free cash flow components right in the earnings release. No need to wait for 10Q or 10K filings here, but you do have to search for "levered after-tax cash flow" figures in a multifunction table of complex numbers. Hertz burned a cool $1 billion of free cash last year, including all the puts and takes around buying new cars and selling old ones.

And if you were looking for something more comparable to Netflix's video rental business, the old Blockbuster followed the same exact model. DVD and VHS purchases (and used media sales) went into the "investing activities" bucket, followed by a table that puts it all together into a free cash flow figure.

In 2003, the company reported negative earnings thanks to a massive goodwill adjustment, but collected $400 million of free cash. Those were the good old days.

Netflix simply follows a firmly established industry practice, including a reconciliation of free cash components in one simple table. In the recently reported second quarter, Netflix collected $12.9 million of free cash, and that figure includes $14 million in DVD purchases.

This model is a problem only if you insist on calculating your own free cash flow totals, and you forget about the investing activities. That seems like a rare combination of doing your homework and forgetting the details. Wouldn't "most investors and analysts," as Karpf puts it, fall back on the provided free cash flow calculations rather than making this very particular mistake?

No big deal
Karpf makes it sound like DVD purchases make up the lion's share of Netflix's expenses. That used to be true, but it's simply not anymore.

Netflix was all about DVD rentals up until 2007. Disc purchases peaked that year, just as streaming content deals were about to ramp up. Now, DVD purchases account for a measly 1.9% of the company's total content costs.

Data from S&P Capital IQ.

I think it's fair to say that DVD costs don't really matter to Netflix investors anymore. The company is amortizing its DVD library faster than it's refilled with fresh content, and that trend is not likely to reverse anytime soon -- or ever, for that matter. Hard-copy content is going out of style like bell-bottom jeans and pet rocks. Digital content is the new normal.

Netflix heard you already, Mr. Karpf
If this industry standard practice bothers Karpf, he'll be happy to see that Netflix is abandoning it.

You've already seen how streaming content costs outweigh DVD purchases by a massive margin. The streaming costs are presented in the operating activities section of cash flow statements, and that's not new: They've been there since 2010.

It seems like CEO Reed Hastings and his leadership team agrees with Karpf, and would rather report content costs as operating activities. But the common practice in DVD rentals was to lump it under investing activities, perhaps due to the physical nature and resale value of actual discs.

So the main content costs already go exactly where Karpf wants them, while the DVD operations get phased out over time. This "accounting trick" is as good as gone.

The Foolish bottom line
All things considered, I was never worried about the accounting practice here because everybody's doing it -- and the correct free cash flow figure was always reported in plain sight anyhow. The practice is fading away as Netflix goes all in on digital content, which carries no resale value and doesn't belong under investments.

If you dismiss Netflix due to its handling of DVD purchase accounting, you're just missing out on a fantastic investment opportunity for no good reason.

Digital media is a big deal, and Netflix is leading the industry into this new era. Americans reportedly spend nearly 34 hours a week watching television! With television viewing taking up almost as much time as the average work week, the potential for profits in the space is enormous. The Motley Fool's top experts have created a new free report titled "Will Netflix Own the Future of Television?" The report not only outlines where the future of television is heading, but offers top ideas for how to profit. To get your free report, just click here!

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  • Report this Comment On August 20, 2013, at 10:46 PM, MFMotleyStool wrote:

    More pumping BS from Motley Fool. We wouldn't have it any other way. Lots of pump and No and I mean no substance.

  • Report this Comment On August 21, 2013, at 1:59 AM, SimplerFool wrote:

    Doesn't the Content Cost graphic demonstrate the problem with NFLX? In another 12 to 18 months the amortization will have to catch up with the current acquisition costs. This is about 900 million/yr in addiitonal operating expense. Even at 100% gross margin this would take about 10 million more subscribers to just cover these increased costs. And they are adding well less than 1 million per quarter. Seems like big losses ahead.

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