Netflix's 10K Financials

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By GusSmed
June 11, 2003

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I was seriously looking at NFLX as an investment, but after looking at the 10K I think David has overstated the case for the company a bit.

In his Fool Take article, and in the investment newsletter, he mentions $40M in cash flow from continuing operations. That's good, but it's not free cash flow. FCF, cash from operations minus DVD acquisition costs and purchase of property & equipment, plus cash from sale of DVDs, was $15M for 2002.

I don't see the purchase of DVDs as being a one-time expansion expense. If we look at prior years, this was a $23.8M expense in 2000, and a $8.8M expense in 2001. $22M (less sales of DVDs) is in line with those numbers. The amortization of the DVD library is $17M for 2002, which says that Netflix sees this as a continuing expense as well.

For that reason, I see characterizing the P/FCF of NFLX at 13 (Market cap of $539M / $40M in cash flow) as David did to be misleading. I think 35 is closer to the truth. At 35x FCF, Netflix is kind of pricey, more than I'm willing to pay for the company right now.

Depending on how you feel about stock options, the picture may be worse than that. Netflix has, quite admirably, chosen to expense options. They show it as a line item in the income statement, and back it out of the cash flow, since it's a non-cash expense. Should we, then, pretend that it doesn't matter for cash flow? This is a $9.8M item we are talking about here. The Fool frequently talks about how important it is to take option expenses into account. If we follow that advice, FCF is more like $6M, and P/FCF climbs to 89, nosebleed levels.

On the other hand, stock options really are a non-cash expense. Dilution is the real effect, not cost to the company, since the company is issuing the shares, not buying them on the open market. NFLX provides the total options outstanding, which is great compared to most 10Ks. This is 10M shares for 2002.

10M shares is a really significant amount of dilution. The total float for the company is currently 23.7M shares. If all 10M options are exercised, that's a reduction in current share values of 30%. P/FCF on that basis is 51. Not as bad as the expensed version, but still pretty darned high.

Note that I am not talking about P/E. I'm talking about the company's ability to generate cash, and the cost to buy that ability.

None of this has any bearing on how I feel about the company as a subscriber. I've been using Netflix for about a year, and I've gotten tremendous use out of it. I never rent movies from any other source, and I rarely go to the theatre anymore.

- Gus

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