How to Analyze Netflix's Income Statement

Upon its launch in 1997, Netflix Inc (NFLX) created a model for the future of television. Netflix is an over the top internet streaming media provider comparable to Amazon Prime Instant Video, Hulu, and YouTube, as well as a DVD and Blu-ray disc provider through the U.S. Postal Service. Netflix’s success is evident through its 130 million subscriber memberships and through its continual upsurge in profit and soaring stock price, both of which are reflected in Netflix’s income statement.

Importance of Income

The income statement is one of the three most crucial financial statements produced to evaluate the financial condition of a company. The income statement determines a summative supposition of a company’s overall profitability by reporting on its attained revenue and then cross-examining it against its corresponding expenses. Companies typically report both an 8-K and a 10-Q quarterly with a 10-K being the annual report filing. The income statement begins with top-line revenue and ends with a company’s earnings per share (EPS).

The Main Components

Information from the income statement usually gains the most attention from the media when the company’s report quarterly and annual earnings. Income statement reports will most often focus on a company’s revenue, net income, and earnings per share, which is usually projected by the company’s sell-side industry analysts.

The income statement can be broken down into three parts: direct, indirect, and capital. Revenue is the top line sales for the company during the reporting period. It is the most direct aspect of the income statement and immediately provides an assessment of the company’s marketplace performance. Here we will look at the income statement through the first three quarters for Netflix. Their company revenue through the third quarter of 2018 was $11.61 billion. This increased from $8.41 billion for a total percentage increase of 38%. Netflix had direct revenue costs (costs of goods sold) of $6.898 billion, leaving them with gross profit for the nine months of $4.71 billion. This equates to a gross profit margin of 41%, which is slightly higher than their trailing twelve-month (TTM) average of 38%.

Next, we move on to their indirect costs, which include marketing, technology and development, and general and administrative. These are costs that are spread across all of their revenue. In 2018, the company has been increasing indirect costs with the greatest increase in marketing at 68%. Subtracting the indirect costs from the gross profit gives us operating income, also known as earnings before interest and tax (EBIT). EBIT for Netflix was $1.4 billion, an increase of 134% from 2017.

From here, we move on to the capital portion of the income statement. This section of the income statement can get quite tricky since companies may report both GAAP and non-GAAP earnings, which may require certain adjustments to arrive at a non-GAAP EPS. In the October 2018 report, Netflix does not appear to have any adjustments. From EBIT Netflix subtracts out interest paid on debt for capital expenditures, interest earned on invested capital, and taxes. Below is a breakdown:

After including interest and tax, Netflix reported net income of $1.077 billion for a 189% increase. Using diluted shares outstanding of 451,283, this results in $2.39 of earnings per share. Net income growth can often be a better gauge for the company’s performance than EPS since EPS changes with company share management, but both are generally used. In 2018 diluted shares outstanding have increased from 446,367 to 451,283.

Current Analysis

Using information from the first three quarters of 2018, we see that revenue has increased by 38%, net income has increased by 189%, and EPS has increased by 185%. These all show that Netflix remains in a strong growth phase. Looking at some more historical information, we see that revenue growth over the past three years has averaged 29%, net income growth has averaged 28%, and EPS growth has averaged 26%.

Two key valuation measures that we can look at after analyzing the income statement include the P/S and the P/E. Netflix has a TTM P/E of 146, which is quite high, considering value companies usually average around 15-20. At 146 investors are willing to pay $146 for each dollar of the company’s earnings. Netflix has a TTM P/S of 10.14, which is also quite high. At 10.14, investors are willing to pay $10.14 per dollar of revenue per share that the company earns.

The chart below shows the P/S and P/E for the FAANG group:

For 2018 and 2019, Netflix appears likely to maintain its strong growth. Taking a quick look at analysts’ projections for 2019, we see that revenue growth is projected at 25% to 31%. EPS growth is expected to be 50% to 100%. From the projections, it appears that revenue and earnings growth could continue to constitute the higher P/S and P/E valuations in the near term. Analysts believe the stock has a little more room to gain with a one-year price target of $399.