What Is Netflix, Inc. (NFLX) Hiding And Why?

Netflix, Inc. (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, Inc. (NASDAQ:NFLX)

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.