July 11, 2017

NFLX’s earnings are not growing as fast as traditional EPS suggests, but this is because Uniform Adjusted EPS’ is already far greater, helping justify valuations


  • NFLX’s profitability is materially distorted by accounting for R&D
  • As such, their UAFRS EPS’ is expected to grow to $0.42 in Q2, and EPS’ over the next four quarters is expected to grow 26%, which is over 100% greater than as-reported EPS expectations
  • As-reported valuations imply NFLX is trading at over 100x traditional earnings, suggesting the firm is overvalued, but UAFRS-based P/E is only at 69x, indicating further upside may be warranted at current growth rates

 

Netflix, Inc. (NFLX) is expected to release Q2 2017 GAAP EPS of $0.15 on 7/17, which would represent 62% growth over EPS in the same period last year.  Additionally, full-year estimates are similarly optimistic, and are for EPS to grow by 41% in the next four quarters, from $0.76 in the four-quarter period ended Q1 2017, to $1.07.  However, even with an optimistic analyst outlook, NFLX shares have been roughly flat over the last several months, as valuations on an as-reported basis appear very expensive at current levels, even considering expected growth.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that while earnings growth will not be quite as robust as expected, this is because profitability is already far greater than traditional metrics suggest.

Specifically, under UAFRS, Uniform EPS (EPS’) is actually expected to grow to $0.42 in Q2, a 27% improvement from $0.33 in the same period last year, and is expected to grow by 26% in the next four quarters, following 70% growth last year. EPS’ is expected to reach $2.24 in the next year, up from $1.78 in the four-quarter period ended Q1 2017 and is 100%+ greater than as-reported EPS.  Considering NFLX’s strong earnings and earnings growth, at current valuations NFLX is not overvalued, and continued upside may be warranted.

The quarterly results show a similar trend, with EPS’ expected to remain above as-reported EPS going forward, as it has in each of the last four quarters.  Additionally, EPS’ growth should continue to be strong enough to support current valuations.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D. Once removed, it is apparent that NFLX’s profitability is improving, and greater than as-reported metrics suggest, and this suggests valuations are not overly aggressive.

UAFRS vs. As-Reported EPS

Investors make major decisions about which companies to own based on quarterly company earnings, the most common metric mentioned in traditional corporate investment analysis.

However, more often than not, the earnings that companies report in any given quarter can swing wildly and lead investors to completely wrong conclusions, because GAAP and IFRS rules force management to report results in ways that are not representative of the real operating performance of the business.

While there is a case to be made that some management teams can use “creative accounting” to adjust numbers, the research would show that more often than not, the real problem is with the accounting rules themselves, not management’s use of them.

The UAFRS Advisory Council has identified over 130 accounting and financial reporting inconsistencies (some of which can be found here), of which several have material impact on NFLX’s financials.

Impact of Adjustments from GAAP to UAFRS

One key UAFRS adjustment has the largest impact on NFLX’s income statement, to get from earnings to UAFRS-adjusted earnings. This is related to R&D.

GAAP and to a lesser extent IFRS (which allows for capitalization of a portion of R&D expense) treat R&D investments as expenses, when in actuality these are investments in a company’s future operations. They may be good investments or bad investments, but hard to think of R&D as cost of goods sold.

In the case of R&D expense, this is often a multi-year investment in a firm’s future offerings.  Expensing R&D violates the basic matching rule of accounting, that expenses should be recognized in the period the related revenue is recognized.

Expensing R&D can also dramatically increase earnings volatility, as the timing of R&D related to multi-year projects can create lumpy earnings volatility, distorting understanding of a company’s real profitability.

UAFRS-reporting adjusts for this traditional accounting distortion by treating all R&D as investing cash flows. This simple reclassification removes a tremendous amount of accounting noise related to investment activities and improves investors understanding of the operating earnings of a business.

Greater-than-reported EPS’ suggests NFLX is not overvalued, and further upside may be warranted

At current prices, NFLX is trading at a 129.7x traditional forward P/E, indicating at first glance that even with significant expected growth, shares may have overheated. As such, investors who use as-reported metrics for valuation may believe upside may be limited in the near-term.

However, after making the requisite adjustments, it is apparent that NFLX is actually trading at a 69.6x UAFRS-based P/E, which while still high, is much more reasonable when considering EPS’ growth that is expected to consistently be north of 20% annually. As such, should the firm meet analyst expectations for growth in EPS’, NFLX is likely fairly valued, and there could be further upside potentially warranted going forward.

By using Uniform Adjusted Financial Reporting Standards (UAFRS), investors see a cleaner picture that distorted GAAP and IFRS metrics cannot show. By standardizing financial reporting consistently across time and across companies, corporate performance and valuation metrics improve dramatically. Comparability of a company’s earnings over time, trends in corporate profitability and comparability in earnings power and earnings growth across close competitors and different sectors becomes far more relevant and reliable.

To find out more about Netflix, Inc. and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Research Committee, which is responsible for this article. Professor Litman is regarded globally for his expertise in financial statement analysis, fundamental research, and particularly Uniform Accounting, UAFRS.