Unicorn Hunting: Season 1 Episode 1

Unicorn Hunting: Season 1 Episode 1

As bull markets age, investors often push growth companies to unsustainable valuation multiples. When this combines with aggressive accounting you get what is known in the trade as a unicorn. In the search for any mythical beast, disappointment is bound to follow for true believers.

We now invite you to play a game of “guess the company”. To state the conclusion first: when the end titles roll on this drama, we expect a share price to plunge from over US$100 to US$40. And that is our happy ending!

Scene 1: Mr Accounting and Mrs Cash have lost each other. Can they be reunited?

Pictures are better than words to illustrate the biggest worry with our mystery Company. Look at the diverging trends in two key performance indicators in its financial reports: profit and cash flow:

Figure 1 – Net Income and Cashflow of Company X

Source: Company accounts, internal analysis

The Company claims to have stayed profitable (just), since mid-2014, but cash flow has deteriorated sharply. A combined net income of US$334m for the last two years (from revenue of USD 13.7bn, a margin of less than 3%) has been funded by a combined negative operating cash flow of US$1,280m. This is a script for a financial horror movie.

Scene 2: Mr Accounting calls on Mr Enron for help

Zooming into the Company’s accounts it is clear that only aggressive accounting treatment of the firm’s biggest asset is propping up the reported profits.

The asset represents the largest cost in this business: broadcast rights. When the Company purchases these it pays upfront in cash but it recognises costs over what management judges to be their useful life. On average the Company sets this at about three years, but we think value decays faster. The Company also commits to buying assets in the future, in effect adding debt payable when they are used. As you can see below, recently both these costs are growing faster than revenues.

Figure 2 – Cost inflation exceeds revenue growth

Source: Company accounts, internal analysis

Scene 3: Mr Enron suggests a visit to the bank

The next scene demonstrates just how expensive this cost is by comparing the amount of cash the business currently spends per customer against the annual expense it recognises in the accounts and the revenue it earns.

Figure 3 – On an absolute as well as percentage growth basis!

Source: Company accounts, internal analysis

The low accounting expense enables a profit to be reported but the rising cash cost over the last year explains why liabilities are ballooning.

At this rate, the Company’s liabilities may soon start to become unsustainable. Our mystery Company can still choose whether this movie ends in a debt-induced tragedy. But herein lies the key twist in the plot.

Scene 4: Mr Enron suggests an Ouija board to find Mrs Cash

So far this script has been an enticing tale of a disruptive new business model, achieving a high growth with the opportunity to dominate a global market. Investors have lapped it up, rewarding the Company with an extraordinarily high valuation (118x 2017 PE ratio, 45x 2017 EV/EBITDA).

Scene 5: Mrs Cash returns to find her husband in a trance. She tries to shake him out of it

If you hadn’t already guessed, the company in question is Netflix, world leader in on-demand movies and TV series, and “disruptor” of traditional free and subscription-based television.
For some time Netflix has said 2017 will be the year it demonstrates significant profitability. Some of these plot variations are credible – but we believe to be so, they risk destroying the high growth narrative.

Without high growth, investors will de-rate Netflix sharply. In effect management will be punished for acting to reduce the cash outflow, even if it needs to do this for long term survival.

This will include recognizing that global markets will never be as profitable as the US. International expansion has excited investors but exposed the business to uglier cost dynamics. It has also coincided with changes in the company’s disclosures that make diligent analysis harder, raising another “red flag”.

Scene 6: The Final act – Mrs Cash engineers a mutiny? What can she do? Is this just a pilot episode?

To solve its low margins and debilitating cash burn Netflix has two choices:

1. Increase prices – but whenever it has tried this before customer growth has suffered. This time customer churn will likely be even worse due to intensifying competition including Stan, Amazon Prime, and Hulu.
2. Stop buying so much content – but without expensive House of Cards style blockbusters will customers stay subscribed at all?

In our opinion at least one of these actions must be taken next year in order to achieve the self-imposed profitability target. We believe that Netflix must urgently confess to investors that to achieve its 2017 profitability targets and staunch the cash haemorrhage (and the risk of eventual insolvency) it will have destroy the growth narrative used to justify its high PE. Alternatively, management can opt for another outcome, extracting a takeover premium from a willing peer, a key risk of any short strategy.