Wedbush: Netflix's Decision To Amortize Less Than It Spends On Content 'Substantially Inflates' Earnings

In a report published Thursday, Wedbush analyst Michael Pachter reiterated an Underperform rating on Netflix, Inc. NFLX with a price target raised to $270 from a previous $245 following the company's first quarter results in which revenue and subscriber growth exceeded expectations. "While we acknowledge that Netflix's subscriber growth is impressive, we remain skeptical that it can deliver the leverage many investors expect," Pachter wrote. "Content costs are on the rise, as evidenced by the $626 million increase in streaming content liabilities in Q1." Pachter continued that Netflix has added over $2.6 billion worth of content to its library recently, while only amortizing $1.5 billion of this amount. This implies Netflix has deferred recognition of over $1 billion in streaming content spending in the last two quarters alone. The analyst added that Netflix's use of contribution profit to describe the health of its business "substantially understates" the company's real profit, and its decision to amortize less than it spends on content "substantially inflates" its earnings. Pachter does note that GAAP accounting does allow (if not requires) Netflix to manage its spending in this fashion, but the use of GAAP net income as a measure "distorts" the company's valuation by ignoring the "substantial" difference between reported income and free cash flow. The analyst calculated this gap has grown to $796 million over the last 11 quarters, or $0.72 in earnings per quarter. Bottom line, Pachter values the domestic streaming business at $205 per share (up from a prior $180 per share to reflect better-than-expected subscriber growth) while the International segment is valued at $50 per share (unchanged), and the domestic DVD business is valued at $15 per share (also unchanged).