Cash Flow

Investors attempt to handicap the future, and in doing so, they heavily discount the present and recent past. What’s done is done. No one gets paid on what happened last week.

In the eyes of investors in technology, media, medicine and communications, potential earnings power and cash flow generation matters a lot more than cash EPS. Michael Batnick looks at the fact that Disney has earned $41 billion over the last five years while Netflix has earned a cumulative $1.2 billion over the same time frame – and yet both have the same market capitalization now. Disney’s stock has done nothing while Netflix has been one of the greatest performers in market history.

Investors believe that Netflix’s rapid gains in regularly recurring payments from users are more valuable than Disney’s customers – including ESPN subs which are not growing at all. They’re willing to forgo profits today because of the monstrous profit potential of tomorrow. This is a strategy the cable giants pursued in amassing huge customer bases and regional system dominance in the 1970’s and 1980’s, as personified by TCI’s John Malone. He had no interest in showing earnings, because to do so meant to pay taxes, the thing he abhorred the most.

Malone realized that programming costs and taxes were his chief enemies. He dealt with the former by spreading out these costs across a large and ever-growing subscriber base. He dealt with the latter by leveraging up and making more acquisitions. He referred to paying taxes on profits as “leakage” and once said he’d rather pay interest (on the company’s debt) than taxes. He even invented the term EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization), now in common use, to teach his investors to focus on cash flow over everything else.

Amazon figured this out a decade after John Malone’s pioneering strategy became apparent to the cable industry and he applied it to ecommerce. Had Bezos prized profits over scale, it would have been a trap – no one wants the mid-single digit profitability of a regular retailer. There is a meme out there saying that “Amazon makes no money.” This is false: Amazon’s cash flow is f***ing enormous.

Netflix has applied this to entertainment. Get big, grab a plurality of customers, worry about profits later once the lead is unassailable. Rather than buying up cable systems like TCI or selling products at deep discounts like Amazon, they’re plowing their cash flow into creating more proprietary content, which in turn fuels subscriber growth.

Onlookers should not look at Netflix and Amazon as though they’re freaks of nature. They’re just companies that have figured out, as Malone did forty years ago, that earnings can wait, and an investor base can be trained to focus on the right metric, so long as that metric is growing.

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