United Rentals, Inc. (URI), Hertz Global Holdings, Inc. (HTZ): Can You Trust Netflix, Inc. (NFLX)’s Cash Flow Statements?

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I just came across an interesting article about Netflix, Inc. (NASDAQ:NFLX). And I think it needs debunking.

The author, Shmulik Karpf at Seeking Alpha, looks at how Netflix, Inc. (NASDAQ:NFLX) accounts for its rental inventory and comes away with this chilling conclusion:

I believe that Netflix’s accounting practice greatly hurts the quality of its reported cash earnings. Personally, I don’t like to hold shares in a company that’s suspected of using dubious accounting tricks. Sooner rather than later, accounting games tend to catch up with the company that employs them. Unfortunately, it’s the unsuspecting shareholders that get hit first.

Yikes! OK, so what did Netflix, Inc. (NASDAQ:NFLX) do to deserve this verdict, just shy of accusing the company of accounting fraud?

Netflix, Inc. (NASDAQ:NFLX)

Karpf worries that Netflix, Inc. (NASDAQ:NFLX) is playing games with its cash flow statements. Specifically, Netflix accounts for its DVD library purchases under cash flows from investing activities rather than operating activities. This choice, the author says, masks these expenses from most investors, because the investing section is often ignored. DVD purchases are an important part of Netflix’s daily operations, and therefore, the expense belongs under operating activities.

I’m no certified public accountant, but there are at least three things wrong with Karpf’s conclusion.

This is business as usual

First and foremost, there’s nothing wrong with rental companies placing their rental inventory acquisitions in the investing section of cash flows.

The article holds up two companies as paragons of virtue, placing their rental inventories in the operating section. One company was found to follow the Netflix, Inc. (NASDAQ:NFLX) policy, which means that some other companies also use this “accounting trick.”

Well, it’s actually a fairly well established practice in the rental industry at large. It’s true that Rent-A-Center accounts for its rental merchandise under operating activities, just like Karpf’s ideal examples. And it does make intuitive sense to balance these expenses against their depreciation, which definitely goes in the operating section. So Karpf isn’t exactly wrong — you can build your cash flow statements this way, and some companies do.

But it’s also incredibly easy to find followers of the Netflix model, when you’re digging in the rental services industry.

Take construction equipment manager United Rentals, Inc. (NYSE:URI), for example. In 2012, the company accounted for $1.3 billion of freshly purchased forklifts and construction lasers in the “investing activities” section of its cash flow statement.

This was balanced by $900 million in depreciation and amortization expenses, presented under “operating activities.” $200 million of this was for “non-rental” equipment, and this fact was disclosed on the income statement. The company also provided a handy free cash flow reconciliation table that brings all of the disparate pieces together into one easily understandable non-GAAP figure. Much like the non-GAAP earnings calculations you see all over the stock market.

Rental car giant Hertz Global Holdings, Inc. (NYSE:HTZ) works the same way. You’ll find its “revenue-earning equipment expenditures” under “investing activities” and a rundown of free cash flow components right in the earnings release. No need to wait for 10Q or 10K filings here, but you do have to search for “levered after-tax cash flow” figures in a multifunction table of complex numbers. Hertz Global Holdings, Inc. (NYSE:HTZ) burned a cool $1 billion of free cash last year, including all the puts and takes around buying new cars and selling old ones.

And if you were looking for something more comparable to Netflix’s video rental business, the old Blockbuster followed the same exact model. DVD and VHS purchases (and used media sales) went into the “investing activities” bucket, followed by a table that puts it all together into a free cash flow figure.

In 2003, the company reported negative earnings thanks to a massive goodwill adjustment, but collected $400 million of free cash. Those were the good old days.

Netflix simply follows a firmly established industry practice, including a reconciliation of free cash components in one simple table. In the recently reported second quarter, Netflix collected $12.9 million of free cash, and that figure includes $14 million in DVD purchases.

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