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AcF 606 FINANCIAL STATEMENT ANALYSIS

Question 1 (All parts of this question are required)
REQUIRED
i)    In  Netflix’s consolidated  balance sheets, the  largest asset  is “Content assets,  net” .  In succinct language:
a)  By reference to the Notes, describe how these assets are accounted for.
b)   Discuss why financial analysts may need to pay extra attention to them .
(5 marks)
ii)   Complete the Netflix’s reformulated balance sheet at 31 December 2020. You may need to check the Notes for additional information. Use the template below to organize your answer. Note:  The  original  financial  statements  are  in  thousands.  For  simplicity,  the financial statements in the supplementary spreadsheet are in millions.
Reformulated Balance Sheet
Netflix
2020
As of 31 December
Operating working capital
[item]
…
Non-current operating assets and liabilities
[item]
…
Net operating assets
Financial liabilities and assets
[item]
…
Net financial liabilities
Ordinary shareholders’ equity
Total
(10 marks)
iii)  Using the reformulated financial statement above, as well as the data below, calculate the necessary ratios for the Advanced DuPont Decomposition for both 2020 and 2019, including the components of return on net operating assets (RNOA). Show the workings.


For the year ended 31 December



2020
$m


2019
$m


2018
$m

Net profit attributable to ordinary shareholders Net financial liabilities
Ordinary shareholders' equity 2,761 1,866
*** 1 2,844 9,138
*** 7,582 5,239
Spread                                                                      8.6%            9.1%
(5 marks)
(continued overleaf)

iv)  Based  on  the  ratios  calculated  in  the  preceding  part,  analyse  Netflix’s  shareholders’ profitability  in     2020,  using  2019  as  a  comparison.  You  need  to  reference  relevant information in MD&A.
( 15 marks)

v)  At the start of 2021, Analyst Tom has forecasted and/or collected the following data for Netflix (“A”: actual; “E” : forecasted):




Common shares outstanding (million) Cost of equity


441.8
7.0%

a)  Assume ROOE (= net profit / beginning-of-year book value of equity) and dividend    payout ratio converge linearly from Year 3 to Year 8. Complete simplified forecasting for Years 4-8.
b)  Use the Residual Income Valuation Model to value Netflix’s equity per share as of the start of 2021. Show your workings.
c)   Briefly discuss the limitations of the assumptions for forecasting in part (a).
(a: 4 marks; b: 8 marks; c: 3 marks; 15 marks in total)

(TOTAL 50 MARKS)

Question 2 (All parts of this question are required)
REQUIRED
i)    By reference to Note 1, briefly explain what constitutes Netflix’s marketing expenses. From financial analysts’ standpoint, discuss potential benefits of reporting marketing expenses separately, as opposed to combining it with general and administrative expenses.
(5 marks)
ii)   Reformulate Netflix’s consolidated statement of operations (i.e., income statement) for  both 2020 and 2019. Revenues should be broken down into sources/regions. Use the template below to organize your answer.
Note:   The  original  financial  statements  are  in  thousands.  For  simplicity,  the  financial
statements in the supplementary spreadsheet are in millions.
Reformulated Income Statement
Netflix
2020           2019
For the fiscal year ended 31 December                                                                    $m               $m
Revenues
?
…
?
?
…
?
?
(10 marks)
iii)  Based on the reformulated income statements above, analyse Netflix’s revenues and two additional items which pertain the firm’s operating efficiency in 2020, with 2019 as the benchmark. You should calculate appropriate ratios and show them in the template below. Your discussion should reference relevant part of MD&A.



2020


2019


Common size         Growth rate         Common size         Growth rate
[item]                              ?                            ?                            ?                            ?
…
(15 marks)
(continued overleaf)

iv)  At the start of 2021, the following data is available for Netflix:


Share price, average in February 2021 $ 548.96
EPS1 (2021E) 9.57
EPS2 (2022E) 12.40
Assume:    The share price can be explained by the Abnormal Earnings Growth Model;
Netflix’s (long-term) dividend payout ratio is 60%;
Its abnormal earnings growth will increase by 5% in perpetuality.
Calculate the implied cost of equity based on the data/assumptions above. Show your workings.
(5 marks)
v)   It is well known that sell-side equity analysts, who are employed by brokerage firms to cover publicly listed firms, are subject to numerous conflicts of interest, and their professional opinions, in forms of research reports, forecasts, and stock recommendations, may be adversely affected.
a)  Briefly describe potential conflicts of interest faced by sell-side analysts.
b)  Due to the concern of conflict of interests, it would be interesting to investigate how clients view service(s) from sell-side analysts. Design a study to survey institutional investors  (mutual funds,  pension funds, etc.)  regarding their opinions on the  most valuable service(s) of sell-side analysts. Your description shall cover key methodological issues of survey-based research.
c)   Discuss main limitations of survey-based research.
(5 marks per part; 15 marks in total)

(TOTAL 50 MARKS)

Question 3 (All parts of this question are required)
REQUIRED
i)    Complete Netflix’s reformulated statement of cash flows for 2020. Use the template below to organize your answer. You may use the Notes in Appendix 2 for additional information.
Note:  The  original  financial  statements  are  in  thousands.  For  simplicity,  the  financial statements in the supplementary spreadsheet are in millions.
Reformulated Statement of Cash Flows
Netflix
($m)                                                                                   2020
Cash flows from operations
?
…
?
Cash investments
?
…

?
?
Change in financial assets
?
…

?
Cash flow to debtholders
?
…
?
?
?
(10 marks)
ii)   Discuss three (3) items in the 2020 reformulated statement of cash flows above, with 2019 and/or 2018 as the benchmark (see the key lines below). You should reference relevant content from MD&A.
($m)

(15 marks)
(Continued overleaf)

iii)  The astronomical rise of GameStop’s share price in early 2021 occupied news headlines. Popular narratives attribute this bubble episode to traders on the brokerage app Robinhood (“Robinhood traders”).
a)  Many stock market participants, such as institutional investors, major brokerage firms, and securities regulators, as well as popular media, were surprised by the seemingly outsized influence of Robinhood traders. Briefly discuss what implications one could draw from the episode of GameStop.
b)   In  a  mature  and well-functioning  stock  market,  a  majority  of  investors  understand implications of news on a firm’s fundamentals, and trade accordingly. For example, after a firm announces its earnings, if the earnings exceed stock market expectations (often in reference to consensus analyst forecast), investors buy the stock. Conversely, if the firm’s earnings miss stock market expectation, investors sell the stock. Briefly discuss how Robinhood traders may trade following a firm’s earnings announcement; you should provide a brief justification for the prediction(s).
c)   Using non-technical language, design a large-sample study to test the prediction(s) in the  preceding  part.  Your  description  should  cover  key  methodological  issues  in conducting large-sample research.
(5 marks per part; 15 marks in total)

iv)  At the beginning of 2021, Analyst Tom has the following forecasts/data for Netflix (“A”: actual; “E” : “forecasted”):



($m, except ratios)






Year 2 (2022E)


Year 3
(2023E)



…


Year 8
(2028E)

Operating income (OI)
OI growth rate
Free cash flow (FCF)
FCF/OI
68%
2,352
59% 4,799
21.3%
31
0.6% 6,017
25.4%
1,683
28.0% 7,327
21.8%
3,535
48.2%
…

…
15%

80%


WACC



5.5%


a)  Assume OI growth rate (= OIt  / OIt- 1) and the ratio of FCF to OI (= FCF/OI) converge linearly from Year 3 to Year 8. Estimate OI and FCF for Years 4-8.
b)  Assume  abnormal  operating  income growth  (AOIG)  becomes  zero  in Year  8  and afterwards. Use the enterprise-Abnormal Earnings Growth Model to estimate Netflix’s total enterprise value at the beginning of 2021. Round the final answer to integer; show your workings.
(a: 4 marks; b: 6 marks; 10 marks in total)
(TOTAL 50 MARKS)




END OF EXAM

Appendix I. Ratio Formulas and Discount Factors



Cash ratio


Debt-to-equity

Dividend payout
ratio
Financial leverage (Assets-to-equity)
Growth rate of an item
Gross profit margin Interest coverage
Inventory turnover*


Net financial
leverage

Net borrowing cost

Net operating
assets turnover


Cash and cash equivalents + marketable securities    
=           Current liabilities

Total debt             
Total equity
Cash dividend         
=                  Net profit
Total assets           
Total equity
Itemt – Itemt- 1               
Itemt- 1
Gross profit            
=             Sales revenue
Operating profit (or EBIT)
Net finance cost

Cost of sales           
=         Average inventory

Net financial liabilities   
=     Ordinary shareholders’ equity
Net finance exp., after tax
=      Avg. net financial liab.
Sales revenue          =        Avg. net op. assets


Operating working capital turnover*

Operating profit (income) margin

PPE turnover

Price-to-book

Forward price-to-
earnings
Quick ratio

Return on            employed capital

Return on
ordinary equity

Return on net     operating assets (RNOA)
Trade payable
turnover*
Trade receivable turnover*


Sales revenue          
=          Average operating
working capital
Operating profit (income) 
Sales revenue
Sales revenue          
=              Average PPE
Share price             
=   Book value of equity (actual)
Share price             
Forecasted EPS
Current assets – inventories 
Current liabilities
Operating profit         
=   Average employed capital
Net profit attr. to ord.      shareholders           
=                Average ord.
shareholders’ equity
Net operating profit
Average net op. assets

Cost of sales         Average trade payables
Sales revenue
Average trade receivables

Net profit margin          =   
* These turnover ratios can also be expressed in terms of days = 365 days/turnover ratio.
Discount Factor: 1/(1+r)n
At the annual interest rate r, the present value of $1 to be received after n years

Number
of years
4% Interest rate per year
5% 6% 9% 10%
1 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.676 0.614 0.558 0.508 0.463 0.422 0.386