Netflix Earnings: No Cash Flow … No Problem? (NFLX)

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Netflix, Inc. (NFLX) reported earnings Tuesday night, and considering NFLX stock is up some 15% in premarket trading, clearly it made quite a few people happy.

nflx netflix stockNFLX generated revenues of $1.48 billion in the fourth quarter, about $80 million ahead of expectations. Net income for Q4 came in at $83 million, ahead of $43 million last year.

Oh wait: You have to back out $39 million of that net income for Q4, which was a tax accrual release related to a tax audit resolution. So net income was actually $44 million, or about flat with last year.

On an adjusted basis, though, the per-share number of 72 cents easily beat expectations of 45 cents.

Netflix stock investors likely were happy about the subscriber growth number (which seems to be what they focus on, instead of the actual bottom line). NFLX said it wanted to add 4 million new subscribers during the quarter and hit 4.4 million subscribers instead, with a worldwide total of 57.4 million. 2014 saw 13 million total additions compared to 11.1 million in 2013. NFLX aims to end Q1 this year with 61.4 million.

Digging Deeper

Let’s hit the good news first. NFLX is a great service that offers great original programming and lots of great content for streaming and increasingly less for DVD. Total streaming revenues are growing year-over-year, and as the press release points out, revenues are also growing sequentially, and that’s true both in the U.S. and internationally.

U.S. streaming contribution profit rose from $174 million to $257 million and total streaming contribution profit rose from $117 million to $178 million. On the balance sheet, the company has $1.62 billion in cash, only down $100 million from the last quarter.

On the downside, international streaming still is not profitable, though the company says it will be soon. The segment’s loss widened from $57 million to $79 million. The higher-margin DVD business is slowly eroding, with the loss of a million DVD members to 5.8 million, and contribution profit falling from $110 million last year to $88.5 million this year. Also, interest expense rose from $29.3 million to $50.2 million.

Then there’s the Netflix earnings number I’ve been harping about for a very long time: free cash flow.

Netflix adds subscribers and generates revenue, but operating income is so insignificant compared to what’s needed to fund original programming and pay the $9.5 billion in content obligations that I question its sustainability. And free cash flow is dismal.

NFLX free cash flow was $78 million in the red in the quarter, down from -$74 million in Q3, from positive $16 million in Q2, and from positive $8 million in last year’s Q1.

Now, because NFLX has $1.6 billion in cash, that negative cash flow doesn’t mean much now and it won’t mean much for some time. Despite an ever-increasing off-balance sheet item called “content obligations,” which is now at $9.5 billion, investors do not care.

If you’ve been paying attention, though, some content deals are about to expire. As I’ve said before, the studios will continue to re-negotiate any deal with NFLX, as long as Netflix has money to pay. The choice is letting that content just sit in the library, generating nothing.

But Netflix is beholden to the studios for most of its content. Its original programming is terrific, and in fact the company is expanding its offerings, so it very likely accounts for new subscribers who stay on with the service. But NFLX doesn’t tell us just how many people watch a given show or how many signed up because of that show, and that adds a little too much haze around it.

That takes us to the price of Netflix stock itself, which soared back up to $400 in after-hours trading — and that’s what takes us to perhaps the most glaring stat.

Take $227 million in FY14 net income, and a market cap of about $24 billion — pretty amazing for a company with negative free cash flow.

That puts Netflix stock at a price-to-earnings ratio of about 120 or so.

I’d love to say that NFLX is insanely overvalued, but it doesn’t matter — that’s not the story here. Investors don’t care about cash or valuation, which means it’s momentum that matters.

And right now, momentum is squarely in Netflix’s court.

Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. He is the manager of the forthcoming Liberty Portfolio, has 20 years’ worth of experience in the stock market and has written more than 1,200 articles on investing. As of this writing, he did not hold a position in any of the aforementioned securities. He can be reached at TheLibertyPortfolio@gmail.com.

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