More on Netflix’s Valuation and How the CEO Doesn’t Own a Single Share

Netflix (NFLX) CEO Reed Hastings has certainly done a wonderful job running the company if you look at his entire body of work, despite recent slip-ups, but his handling of the stock leaves much to be desired. Buying back stock over $200 per share only to raise capital at 1/3 the price a few months later shows he is losing the pulse of his business, at least temporarily.

So exactly how much stock of his own company does Hastings own? Believe it or not, none. Hastings has been cashing out Netflix stock options to the tune of tens of millions of dollars, but he does not actually own a single share. This year alone he exercised options (strike price: $1.50) to the tune of over $1 million per week, or more than $43 million. He halted those sales in early October after the stock cratered. It should be troubling to investors that the company’s founder and CEO does not appear to have any real skin in the game here. He has just given himself millions of options at prices that essentially ensure he can continue to cash out at will as long as the stock stays above $1.50 per share, which is assured as long as the company remains in business.

All of that said, there does appear to be potential value here with the stock breaking $70 per share, providing Hastings can make the streaming business model work financially. Netflix’s enterprise value today (about $4 billion) is attractive if the company can continue to grow and make money at their $8 per month price point. Assume for a moment that Netflix can earn a net profit of $1 per subscriber per month and maintains its current base of 25 million customers. That comes out to a profit of $300 million per year. Netflix could fetch a $4 billion valuation with its existing customer base alone. Any further subscriber growth from here would be icing on the cake for investors.

I think that is the main reason why T Rowe Price, TCV, and others find the stock attractive at current prices. There are definitely sizable risks, mostly the question of whether they can continue to grow with intense competition, and even more importantly, if the company’s business model will allow it to reach something on the order of that $1 per month profit on a per-subscriber basis. Given all that we know today, Netflix is a high risk, high reward investment opportunity, but one that many people are betting on.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

Netflix Makes New Moves to Try and Regain Momentum

Shares of Netflix (NFLX) are getting slammed today (down $4 to $70) after announcing $400 million of financing transactions last night, consisting of $200 million in new equity at $70 per share to T Rowe Price and $200 million in convertible zero-coupon bonds to venture capital firm Technology Crossover Ventures. This move comes on the heels of the company’s recent deal to be the exclusive home to new episodes of the comedy series Arrested Development, which was canceled after a three-year run on Fox despite a cult-like following and strong critical acclaim.

Netflix may be facing headwinds after customer backlash from their recent price increase, but CEO Reed Hastings is certainly not standing still. Getting the exclusive for Arrested Development is a smart move, as it will be harder and harder for Netflix to compete strongly without original, unique content. Amazon, which offers a similar streaming service through Amazon Prime, along with Apple, which will likely launch a TV product sometime in 2012, are serious competitors to the Netflix streaming business.

While Wall Street clearly does not like these equity and bond deals, I think it is really the best possible way for them to finance the costs of deals like Arrested Development. Selling zero-coupon bonds gives Netflix 0% financing and the bonds don’t convert until 2018, which is a long time for Netflix to build up their business.

I would also point out that TCV, the investor in this bond deal, is making an interesting bet here. By taking convertible bonds that pay no interest, they are making a large bet on the direction of Netflix stock, plain and simple. TCV’s break-even point on these bonds is $86 per share, 16% above the market price when the deal was announced and more than 20% above the current quote of around $70 per share. While investors are selling off the stock today, the fact that TCV is making a pure stock bet here could be viewed as quite bullish (as would the move by T Rowe to buy new stock at $70). If Netflix was really in dire need of this cash and few investors were willing to lend it to them, you can bet that TCV or any other possible financier would be demanding a bulky interest rate.

With Netflix stock down more than 75% from its high of $300+ earlier this year, this one is surely one to watch. Of course, it is very concerning that Netflix was buying back stock in the 200’s earlier this year and now finds itself needing money and selling new stock at $70 per share. Investors likely won’t tolerate this “buying high and selling low” set of actions again down the road. The future for Netflix really depends on whether they can continue to grow the streaming business and make money on it at $8 per month. If they can, there is plenty of upside here. If not, TCV and T Rowe are going to have some losses on their hands a year or two from now.

Full Disclosure: Long Apple and no positions in Amazon or Netflix at the time of writing, but positions may change at any time

Sticking To Your Convictions As A Value Investor Is Hard, Just Ask Whitney Tilson About Netflix

Back in December, Whitney Tilson, a fairly well known value investor with T2 Partners, published a letter outlining a compelling bear case for Netflix (NFLX), a stock he was shorting at around $180 per share. After seeing the position go against him, Tilson was feeling pressure from his clients. After all, shorting a high-flying technology company with a cult-like following, as it is soaring in value, can be a tough psychological exercise. Tilson’s argument for betting against Netflix was clear, concise, and thorough. He boiled it down to this, in his December piece entitled Why We’re Short Netflix:

“We don’t think there are any easy answers for Netflix. It is already having to pay much more for streaming content and may soon have to pay for bandwidth usage as well, which will result in both margin compression (Netflix’s margins are currently double Amazon’s) and also increased prices to its customers, which will slow growth.

Under this scenario, Netflix will continue to be a profitable and growing company, but not nearly profitable and rapidly growing enough to justify today’s stock price, which is why we believe it will fall dramatically over the next year.”

The main bearish argument seemed reasonable at the time; customers were moving away from DVD by mail and towards streaming content. In order to secure content for their streaming library, Netflix would have to pay more than in the past, when they could just buy a DVD once and send it out to dozens of customers. But at the time subscribers were signing up at a record pace and were highly satisfied.

In February Tilson threw in the towel. The stock had continued its ascent, rising to $220. Again, Tilson went public with his changed view, writing a letter called Why We Covered Our Netflix Short. The bulls loved the fact that Tilson was admitting defeat. The stock continued soaring and hit an all-time high of $304 in July. Tilson summed up his reasoning as follows:

Our short thesis was predicated on the following stream of logic:

1) Netflix’s future depends on its streaming video business (rather than its traditional DVD-by-mail business);

2) The company’s streaming library is weak, which would lead to customer dissatisfaction and declining usage;

3) This would either cause subscriber growth to wither or force Netflix to pay large amounts to license more content, which would compress margins and profits;

4) Either of these two outcomes would crush the share price.

We are no longer convinced that #2 and #3 are true.

This was interesting because very little in the way of fundamentals had changed at that time. Tilson cited three reasons why he was doubting his earlier bearish thesis:

1) The company reported a very strong quarter that weakened key pillars of our investment thesis, especially as it relates to margins;

2) We conducted a survey, completed by more than 500 Netflix subscribers, that showed significantly higher satisfaction with and usage of Netflix’s streaming service than we anticipated (the results of our survey are posted; and 

3) Our article generated a great deal of feedback, including an open letter from Netflix’s CEO, Reed Hastings, some of which caused us to question a number of our assumptions.

In hindsight these reasons seem even more suspect than they did at the time, but it is worth pointing out the mistakes anyway so value investors can learn from each other.

First, Tilson cited that Netflix reported a strong fourth quarter. Tilson’s bearish view was never predicated on Netflix blowing the next quarter. It was the longer term trend of rising content costs, which would give Netflix two choices; maintain a weak streaming library and risk losing customers, or pay up for strong content and be forced to either raise prices (which would hurt subscriber growth and reduce profitability) or keep prices steady and lose profitability that way. The fact that Netflix reported one strong quarter really didn’t make a dent in the bearish thesis.

Second, Tilson surveyed 500 Netflix customers and found they were quite happy with the service. Again, his thesis didn’t claim that current customers were unhappy (after all, they were signing up in droves in part because streaming was free with your subscription at the time). Rather, it was about the future and how those customers would react if Netflix had to either raise prices or offer less in the way of viewing choices.

Third, and this one was perhaps the most bizarre, Tilson was evidently persuaded by Netflix’s own CEO, Reed Hastings. I find this one odd because I have never seen a CEO on TV or elsewhere who was publicly negative about their company’s prospects, regardless of how good or bad things were going at the time. In fact, many investors believe it is a huge red flag when CEOs of public companies take time to personally rebuff bearish claims from short sellers. Hastings did just that, responding to Tilson’s short case with a letter of his own that suggested that he cover his short immediately. Generally speaking, the fact that the CEO of a company you are short thinks you are wrong is not a good reason to cover your short.

And so we had a situation where Tilson’s short thesis appeared sound, albeit unresolved, but the stock price kept soaring and he was feeling heat for the position, which was losing money. Then, just a few months later, Netflix decided to raise their prices and customers canceled in droves. Tilson’s bearish thesis proved exactly correct, but he no longer had the short bet to capitalize on it.

Today in pre-market trading Netflix stock is down about 30% to $83 per share after forecasting higher than expected customer cancellations, lower than expected fourth quarter profits, and operating losses during the first half of 2012 due to higher content costs, slowing subscriber growth, and expenses for the company’s expansion into the U.K. and Ireland. Analysts were expecting Netflix to earn $6 per share in 2012 and in July investors were willing to pay 50 times that figure for the stock. Now it is unclear if Netflix will even be profitable in 2012 after forecasting losses for the first “few quarters” of next year.

This is a perfect example of why value investing is a tougher investment strategy to implement than many realize, but offers tremendous opportunity to outperform. By definition you have to take a contrarian view; either going long a stock that people don’t like, or shorting a stock that everyone loves. The bottom line is that your analysis is what is important. If you do your homework and get it right, the market will reward you. It may take more than a quarter or two, but you need to stick to your convictions unless there is extremely solid evidence that you are wrong. In this case, Tilson’s bearish thesis was never really debunked by the CEO’s defensive posture or the fact that customers were satisfied when they were getting streaming content for free. In hindsight, Tilson understood the outlook for Netflix better than the company’s own CEO. However, both are likely feeling very uneasy this morning.

Interestingly, the question now may be whether there is a point at which Netflix stock becomes too cheap and warrants consideration on the long side. I suspect the answer is yes, though probably not quite yet. If the stock keeps falling and we see $60 or $70 per share, maybe the time will be right for value investors like Tilson to go against the crowd again and buy the stock when everybody hates it.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

UPDATE: 3:00PM ET on 10/25

The WSJ is reporting that Tilson initiated a small long position in Netflix this morning:

Mr. Tilson tells us in an e-mail that he bought the stock this morning after it tumbled 35%:

“It’s been frustrating to see our original investment thesis validated, yet not profit from it. It certainly highlights the importance of getting the timing right and maintaining your conviction even when the market moves against you. The core of our short thesis was always Netflix’s high valuation. In light of the stock’s collapse, we now think it’s cheap and today established a small long position. We hope it gets cheaper so we can add to it.”

Coinstar Shares Look Very Cheap After Guiding Down Earnings Expectations

Consumers should know Coinstar (CSTR)very well as the maker of coin counting machines found at grocery stores and more recently the owner of the Redbox DVD rental kiosks found in even more retail locations such as McDonald’s and Wal-Mart. I believe the stock, which has gotten hammered lately after an earnings miss for the fourth quarter, represents tremendous value. CSTR gives investors a rare combination of value and growth potential.

At around $39 per share (down from $67 late last year), Coinstar stock fetches only 6 times trailing cash flow. To put that in perspective, Microsoft sells for 7 times, Cisco for 8 times, and IBM for 9 times. Investors are clearly getting a valuation that is otherwise reserved for larger, slower growth businesses. This despite the fact that the company just reported that 2010 revenue soared 39% on the heels of a 50% jump in DVD rental sales (the more mature coin counting business grew by 7%). Despite giving more conservative guidance going forward after the company missed Wall Street’s fourth quarter expectations, Coinstar expects 2011 revenue to jump by about 24% with cash flow rising by 18%, as it continues to invest in growing the business. If management can deliver on these numbers this year (and after an earnings miss we should think they might give out forecasts they feel quite confident in reaching), the stock trades at only 5 times current year cash flow, unheard-of for a company growing like Coinstar.

Now, as with any investment, expectations and forecasts of future growth and valuation are not the only things to consider. Analysts would be quick to argue (and I would not disagree) that movie rentals are moving from disc-based to cloud-based, with the emergence of Netflix and other streaming platforms. Any market share gains that Coinstar’s Redbox kiosks might see with the pending bankruptcy of Blockbuster could very well be negated by more and more people signing up for Netflix streaming.

However, I still believe that the market for Redbox kiosks is bright, for two main reasons. First, with nearly 25,000 kiosks installed in grocery stores and retail outlets across the country, the convenience and cost ($1 a day) of Redbox rentals will make them attractive to both cost conscience movie watchers (if you only watch a couple movies per month you will likely opt for Redbox over an $8/month Netflix streaming plan) and those who enjoy the convenience of grabbing a movie on their way out of McDonald’s, Wal-Mart, or their local grocery store (just picture how easy children can convince mom and dad to get a movie for $1 before they leave the store).

The second reason I think it will be years before physical disc rentals will become completely obsolete is that there are still millions of Americans who are afraid of technology to a large degree (either due to things such as identity theft, or simply out of not being comfortable with operating high tech toys such as wi-fi enabled DVD players). To illustrate this point, let me share an encounter I had with a woman a couple of weekends ago.

After noticing that several Blockbuster locations were being liquidated near where we live, my fiancee and I decided to stop by and see if we could land any ridiculous deals (they were literally selling the store’s shelves as well as the DVDs sitting on them). Everything was for sale, and if you had a spare $350 sitting in your bank account you could buy the giant gum ball machine from your local Blockbuster store (we saw one being carried out by a man as we entered the store).

As I was perusing the aisles I helped explain the pricing structure to a woman in her 50’s or 60’s who was confused. We got to talking and she was mostly rambling about how disappointed she was that this store was closing because all of the other DVD rental places had also closed and now there was nowhere for her to go. I mentioned Netflix and she immediately dismissed it as a viable option “because you need a credit card for the box.” She was clearly confusing Netflix with Redbox, but the fact that she refused to use a credit card to rent a movie told me that Netflix would not be any better in her mind.

I bring this up because I think people like this woman are exactly the ones who will shun new technology like Netflix streaming. Eventually she will have to cave and start using Redbox for movie rentals most likely, and think about how many people like her there are out there. Not only that, but even if she felt comfortable using the Internet to order movies by mail (I don’t see her using Netflix mail order anytime soon, given that her explanation for why that wouldn’t work for her was that her printer has been broken for months and she can’t figure out how to fix it), I really don’t think she would proactively adopt such a technology when there are other “lower-tech” ways of getting a DVD such as Redbox (granted, a credit card will still likely be required).

In short, I think there will be room for both technologies for several years to come. While I subscribe to Netflix and have never actually used a Redbox kiosk, there are plenty of middle aged and older Americans who will. Not only that, but the Redbox kiosk in the grocery store I visit is often crowded with college kids as there are several universities in the area. Cost is probably the main factor there, as young kids can certainly operate Netflix streaming movies, but more likely lack the discretionary income to afford an expensive box with wi-fi and a monthly plan. So, there is definitely a market for Redbox with younger people too.

With Blockbuster in liquidation, Redbox should continue to grow, although Coinstar’s current stock price seems to not fully be factoring in such strong demand for their kiosks. I do not see any reason CSTR shares should not fetch 7-8 times cash flow, which makes a stock price of $60 quite a reasonable expectation.

Full Disclosure: Long CSTR at the time of writing but positions may change at any time

Apple iPad is Nice, Probably Not a Game Changer Yet

After seeing Apple’s unveiling of the new iPad tablet yesterday my overall conclusion is that the product is very solid and will probably find a niche with certain users, but it hardly seems to be the game changer for old media that many had hoped for.

Essentially the iPad is a thin, light-weight, extremely mobile device that can be described as a supersized iPhone or a thin netbook computer. You can surf the web, check email, play iTunes, and download iPhone-like apps customized for the device.

The real issue I see is that the iPad is not all that different than a netbook or iPhone, other than its physical design. The only unique feature of the iPad seems to be a new e-book store. In addition to buying songs, movies, and television shows from iTunes you will be able to buy e-books from an e-book store, modeled after the iPhone app store and the iTunes media store. Think thin netbook combined with an Amazon Kindle.

The clear loser here is Amazon, whose Kindle overnight gets a strong competitor. The clear winners were supposed to be the content publishers, including magazine and newspaper companies, not just book publishers. On that end, I think the expanded distribution of e-books will be good for those publishers, but the gains for newspapers and magazines is less apparent.

The problem those publishers face today is that most are giving away their content on the web and the advertising revenue they earn from web visitors pales in comparison to the subscription revenue they used to collect. Some have been able to charge for web content (Wall Street Journal) and others are starting to put pay walls on their sites (New York Times) but with so many free news sources on the web, it will be hard for most publishers to convince consumers to pay a monthly fee for their content.

I am not convinced the iPad solves this problem. The content companies will build apps for the iPad, just as they did for the iPhone, but the core issue is the same; will people pay for the content when there are other free options? If the answer is yes, then the publishers will get stronger going forward. If not, nothing will change.

If you put your content on the iPad for free, that is no different than the free web site people are using to access your content. If people are not willing to pay to use your web site today, why would they be willing to pay for an iPhone or iPad app with the same content?

Even after seeing the iPad in action, I think the content game is unchanged. If you truly have valuable content that is unique and in strong demand (Wall Street Journal), you can make good money with online content. If not, people will simply go to free news sites and your profits will evaporate as subscription revenue continues to decline.

Where does this leave Apple stock? They will likely sell a good number of iPads going forward so the product is certainly an incremental positive for the company and the stock. Believe it or not, the shares have been treading water for a while now, and therefore are not overly expensive. At $207 per share Apple sports a P/E ratio of about 18x based on $11-$12 of earnings power this year. Add in the $27 per share ($25 billion) of cash that is wasting away on their balance sheet and you can see that the stock is not super-cheap but is not overly expensive by any means.

Full Disclosure: Peridot Capital was long shares of Apple at the time of writing, but positions may change at any time

Comcast Making Another Bid For Mega Content Deal

You may remember a few years back when Comcast (CMCSA) made a bid for Disney (DIS) only to be turned down. Reports today have them once again making a play for a blockbuster media content deal. Initial reports out of a Hollywood web site last night had Comcast buying NBC Universal outright from General Electric (GE) for $35 billion but that story has conflicted with more reliable news sources today that have Comcast forming a joint venture with GE’s NBCU division. Comcast would contribute cash ($6-$7 billion is the rumored figure) and combine its own content assets with NBCU, spin the new company off, and retain 51% ownership (with GE having the other 49%).

As Peridot Capital clients own shares in both Comcast and GE, this deal is of great interest to me. I am not convinced Comcast making a huge push into content is the right move (cable service and content creation are quite different businesses) but I can see why Comcast CEO Brian Roberts might want to expand his net.

After all, they are already the largest cable operator and moves to boost that position will draw anti-trust concerns. Given that phone companies like Verizon are making a big play into cable, not to mention the typical satellite competition, owning solid content providers would make Comcast less concerned with how many people are using their pipes for cable access.

How does this play out for investors? Well, in the short term it will be seen as a negative for Comcast as people wonder if content is really where the company should be turning its focus, especially if it means spending billions of dollars in cash to do so. Longer term, as long as Comcast does not make any significant changes that threaten the profitability of NBCU, it could contribute a nice chunk of stable cash flow and diversify their business.

The impact on GE is harder to predict. On one hand, investors worried about GE’s balance sheet would be happy to see the company unload some of NBCU’s debt and also collect some cash in exchange for giving up 31% ownership (GE currently owns 80% of NBC, with Vivendi owning 20%). On the other hand, GE would become even more concentrated in cyclical and financial services business lines for its earnings. In a weak economic environment, the stable cash flow from NBCU has been helping, not hurting them.

Overall, I would be slightly more bullish on Comcast should this deal go through, mainly because I think CMSA stock would trade down more in the near term. Comcast is a stock I really like already, and although people will question a foray into media, I don’t think Comcast’s long term profitability will be negatively impacted by this deal. The uncertainty might just provide investors a nice entry point.

As for GE stock, I still think it represents a good value longer term (assuming you think the global economy will slowly improve) but I don’t think reducing its NBC stake would warrant as much of a change for the company relative to the impact on Comcast). I would not chase GE stock if it moved higher on this deal, but if both stocks dropped on the uncertainty surrounding it, both would be good values at the right price. That said, I would give the nod to Comcast for value investors looking to make an initial investment post-deal.

Full Disclosure: Peridot clients owned positions in both Comcast and GE at the time of writing, but positions may change at any time

Time Warner Completes Cable Spin-Off, Sets Stage For AOL Split Next

Time Warner (TWX) has long been a media conglomerate difficult for investors to dissect. However, that may be about to change and the moves could finally extract some value for Time Warner shareholders. The company will complete its spin-off of Time Warner Cable at the end of the month, which offloads billions of debt to the cable company and frees up cash flow at TWX.

Time Warner is also making some moves at its AOL division. AOL has hired Tim Armstrong, formerly the head of U.S. sales at Google, as its new CEO. The conventional wisdom is that Time Warner will spin off AOL as well, in order to allow Armstrong to maximize profit and growth potential at the online unit.

All of this should be good news for Time Warner shareholders, whose stock has been cut in half over the last year and sits near its lows. Time Warner retains some very strong brands, including HBO. With less debt from the cable division, coupled with a $9 billion cash infusion from the spin-off and a new strong management team at AOL, investors might finally begin to look at the stock again in the intermediate term.

As a result, bargain hunters who prefer strong large cap companies might be interested in checking out TWX shares at $8 each. Not only do they sit near their lows, but they yield 3% and trade for less than 5 times trailing cash flow.

Full Disclosure: No position in TWX at the time of writing, but positions may change at any time

CNBC Documentary by David Faber, “House of Cards,” Is Worth Your Time

One of CNBC’s finest, David Faber, recently completed a two hour documentary about the housing bubble and the credit crisis. I had the chance to watch it on Sunday and it is very well done. For those of you who are interested in how the combination of mortgage brokers, Wall Street, and consumers led to the dire financial predicament we find ourselves in right now. Faber really hits on all of the major culprits and explains them well along with his superb guests.

CNBC replays House of Cards in prime time during the week and over the weekends. According to my Comcast program guide, the next airing is Wednesday from 8-10pm ET but check your local listings and set your VCR or Tivo.

With Consumers Paring Back, Netflix Business Gets Stronger

If people are looking to cut back on discretionary spending, the Netflix (NFLX) mail order DVD service can obviously help. Rather than spending $30 at a theater for a couple to see a movie and order some snacks, a Netflix subscription can cost half that for an entire month. Not surprising, fourth quarter sales and earnings at Netflix (reported last night) were very impressive and the stock is soaring today, trading up near $35 per share.

Despite being relatively recession-proof, Netflix stock at current levels doesn’t get me very excited from a value standpoint. One can certainly justify a 2009 P/E north of 20, as it is today, but as a value investor that is not cheap enough for me to get overly excited, despite the strong business fundamentals. I will, however, continue to make good use of my Netflix subscription, and I highly recommend it.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

Gift Idea

When I was growing up the gift option of choice was federal savings bonds. When I was old enough to be allowed to make my own financial decisions I promptly sold them and invested the proceeds in the stock market, where my long term inflation-adjusted returns would be much higher. Among both my high school and college graduation gifts were shares of stock and the returns from those have been impressive, but the advantages of such gifts often go beyond dollars and cents.

Garnering interest in the markets was never a problem with me, but that was clearly the exception. Giving children shares of stock not only gives them a valuable financial asset, but it also allows one to expand the financial education process with them at an early age. At some point (perhaps not at first depending on how old they are), recipients are going to ask what that framed share of Disney stock is, and at that point you can explain it to them. Such a conversation might, at the very least, start them toward a path of being very educated when it comes to the responsibility of managing their finances.