Netflix Managing Earnings? Fuhgetaboutit!

Those who follow Motley Fool Stock Advisor recommendation Netflix (Nasdaq: NFLX  ) , or listen to Overstock's (Nasdaq: OSTK  ) earnings calls, have probably heard of journalist Herb Greenberg.

Last week, in an article published on MarketWatch.com, Greenberg presented a bearish take on Netflix's 2005 second-quarter earnings report. While I disagree with a number of his arguments, our differences fall primarily in the realm of interpretation and opinion. Ultimately, we could probably agree to disagree on all but one point: the title of the article and its implication that Netflix managed its earnings. I just can't let this go because I don't agree.

Referring to Netflix's surprisingly strong second-quarter earnings, Greenberg wrote: "Most of the gain, however, came from lower marketing spending -- a convenient lever companies can use to boost earnings." Indeed, marketing spending can be manipulated in such a way. But I think Greenberg has to be careful about how he frames his argument.

Remember that operating margins grow fatter when operating expenses don't scale as fast as revenues. Compared to Q2 2004, Netflix's revenues grew by 36.7%. This implies that any expense line item that grew at a rate less than 36.7% resulted in net-margin gains. If you multiply each of the Q2 2004 expenses by 1.367, you'll see how much the company would have spent on each line item had the expenses scaled along with revenues. Subtract from this figure the amount Netflix actually spent, and you have a clearer picture of the basis for the cost savings. Here's how the expenses broke down:

Op.* Expen.

Q2 2005

Q2 2004

% growth

Cost Sav.

% total sav.

Fulfillment

$17,560

$14,373

22%

$2,090

37%

R&D

$7,513

$5,652

33%

$214

3%

Marketing

$26,338

$20,477

29%

$1,657

28%

G&A

$4,898

$3,280

49%

$-414

-8%

Stock-based comp

$3,423

$4,134

-17%

$2,229

41%

Totals

$59,732

$47,916

25%

$5,776

100%

(*All dollar figures in thousands)

If you lump all of the operating expenses into "marketing," as I think Greenberg is doing, then you can see his point. But can all of those operating expenses be classified under the marketing umbrella? I don't think so. Judging by the numbers, the story for this past quarter was about lowering fulfillment costs, something Netflix works hard to reduce every day, and stock-based compensation, not marketing spending.

In fact, marketing expenses as a percentage of sales were only slightly lower than last year's second quarter, 16% vs. 17%. And it's not like they dropped outside the range of 15.9% to 26.6% over the past six quarters.

Having bearish sentiments about a company is one thing. But being loose with the definition of terms used to make an argument is another. Breaking out this information did not take long, and I think Greenberg should have done the same before spinning a tall tale about manipulation of earnings by Netflix management (to whom he now owes a public apology, in my opinion).

If you're looking for good companies at great prices, consider subscribing toMotley Fool Stock Advisornewsletter. Netflix is a Stock Advisor recommendation.Overstock.com is aMotley Fool Rule Breakers pick.

Fool contributorMarko Djuranovicowns shares of Netflix, but no other company mentioned in this article. The Fool has an ironclad disclosure policy.


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