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

Biglari Succinctly Criticizes Cracker Barrel’s Strategic Plan in Pursuit of Board Seat

As an investor looking for attractive places to allocate your capital, one of the biggest things you can try to avoid are companies where the management team takes actions that do little to maximize shareholder value. Oftentimes these same managers have very little “skin the the game” (stock ownership in their own company), giving them little reason to care about the stock price.

The operating performance of restaurant chain Cracker Barrel (CBRL) over the last decade or so has been dismal, which has led Sardar Biglari, CEO of Biglari Holdings (BH) to amass a 10% stake in the company and seek a board seat at next month’s annual meeting. This week Biglari wrote a letter to CBRL shareholders explaining why he wants on the board and what his ideas are for value creation. The letter is very well written and highlights issues that are all too common with public companies. Time and time again decisions seem to be made without much financial analysis. The end result is wasted shareholder capital and value destruction for equity holders.

You can read the entire letter to CBRL shareholders here, but I think it is important to cherry pick a few of Biglari’s points, as they apply to many companies, not just CBRL. Below are some direct quotes from the letter (in italics), followed by some of my thoughts.

“Cracker Barrel’s performance during Founder Danny Evins’ era was stellar. However, since Michael Woodhouse became Chairman and CEO, the underlying store-level operating performance has been deteriorating. Instead of restoring the formerly successful store-level performance, Mr. Woodhouse has spent over $600 million in capital over the past seven years while over the same time span operating profit declined.”

Biglari provides the hard data that shows 2005 revenues of $2.2 billion and operating income of $169 million, versus 2011 revenues of $2.4 billion and opearting income of $167 million. Indeed, the current management team has spent $615 million on capital expenditures since 2005, which has grown revenue by 10% (entirely from new store openings) but failed to add a single dollar of profit to the company. Biglari uses this data to argue the company should not be wasting money on building new stores today (the company’s current plan is to spend $50 million on them in 2012). All too often management thinks the best thing to do is to get bigger, even when doing so adds nothing to the bottom line.

“After all, it is easy to spend money to open new units. The trick and triumph are to achieve unit profit both sufficient and sustainable without a diminution of performance in existing stores. The principal reason unit-level performance has been dismal is that unit-level customer traffic has been declining. On this important measure, customer traffic has been consistently negative in each of the past seven years. There are currently about 960 customers, on average, that go through each unit per day, nearly 190 fewer than seven years ago.”

Again, Biglari provides traffic data that shows a 15% decline in customer traffic per existing unit since 2005. This is yet more evidence that opening new stores is a waste of money and is destroying shareholder value. It is clear that even ignoring new store cannibalization (which certainly exists at least to some minor extent), traffic at existing stores is falling. Why then open new stores?

“Mr. Woodhouse in essence has produced the same level of profit with 603 stores that Mr. Evins did with 357 stores. If Mr. Woodhouse could have simply returned the Company to the productive level achieved in fiscal 1998, there would be an additional $110 million in operating profit, and we estimate $1 billion added in market value or the doubling of the current stock price.”

Biglari shows operating profit per store of $462,000 in 1998 (357 stores), $319,000 in 2005 (529 stores), and $277,000 in 2011 (603 stores). He concludes that new store expansion should be halted and management should work on getting the existing store base back to the level of profitability that existed more than a decade ago. It seems so simple, but management is clearly clueless, which is why Biglari is seeking a board seat as the company’s largest shareholder.

“When determining where to direct capital, management should evlaute all options and then place capital based on the highest return after compensating for relevant risks. The math is simple: The cost of a new unit including land, building, and pre-opening expenses is between $3.5 million to $4.7 million. Cracker Barrel’s current market value is about $1 billion. With 608 units, the market value per store is $1.6 million.”

This is something that I see all the time with public companies that require large upfront investments to expand their unit base (restaurants, hotels, casinos, etc). It drives me crazy. In the case of CBRL the market is valuing each store at $1.6 million but management is choosing to spend tens of millions per year on new units at a cost of no less than $3.5 million each. Opening a new unit results in an immediate loss of $1.9 million for shareholders, or 54% of the investment! No wonder the stock has been in the tank. Conversely, if the company uses their capital to repurchase stock (essentially buying back their own stores at $1.6 million each), and then improves the profitability of those stores, the stock price will go the other way. Investors should always be wary of companies that spend “X” to build a new unit when the market is valuing their company at less than “X” per unit. Getting bigger for bigger’s sake without looking at the returns on invested capital is a sure-fire way to destroy shareholder value.

So why on earth does the CBRL management team seem to not care about deteriorating store-level operating performance or their poor returns from new store expansion? Well, in addition to the fact that management hardly owns any stock, Biglari points to their compensation system as a culprit:

“We believe in excellent pay for performance. But the Board has designed a flawed compensation system, one with a low bar for achievement. For 2011, executive officers were eligible to receive a bonus of up to 200% of target (target being median reflected by our peer group) if operating income met or exceeded $90 million. To put in context the absurdity of the $90 million bonus target, Cracker Barrel has not had operating income below $90 million in any year since 1994! Why would a Board set eligibility at a level unseen in nearly 20 years?”

Of course, the answer is it ensures they can collect maximum bonuses without showing any job competence. In this case operating income can decline by nearly 50% and they still collect a 200% bonus. It is not surprising then, that CBRL’s operating income has actually declined over the last seven years, despite new store growth. Management has no incentive to reverse that trend because they only own a little bit of stock in the company and they get their bonus regardless of what happens.

It’s not hard to see why Biglari Holdings has taken a 10% stake in CBRL and Mr. Biglari is trying to get on the board of directors. If he is successful, there is no doubt that taking even some of his advice would get the stock moving again, as corporate financial results would have no where to go but up. Also not surprising is the effort CBRL management is putting forth to defeat his election (if only they put that much time into improving the company!). To give you an idea of how much they value their shareholders, Biglari ends his letter with this final observation:

“I hope to see you at the annual meeting, a gathering for shareholders to learn more about the Company. Annual meetings represent another window into the culture of the organization shaped by top leadership. Unfortunately, even on this mark, the Board sends the wrong message: Cracker Barrel has chosen to hold its upcoming annual meeting during Christmas week on December 20, 2011. While we will attend the meeting regardless of date or time, it is not the way shareholders should be treated. It is time to change the ethos of the Company to one that cares about shareholders and respects their money and their time.”

Now, as a shareholder of Biglari Holdings this letter and proxy fight is a material development in which I have a keen interest. However, even if you are not in the same boat, I think it highlights important lessons for all investors who are trying to identify superior investment opportunities. Beware of companies like CBRL whose management teams seem to make one mistake after another. They usually claim to want to maximize shareholder value, but oftentimes take actions that ensure the opposite. Be especially wary of companies that have a desire to expand their unit base, at a huge cost, even when the public markets will ensure such capital investments never return a profit to shareholders.

Full Disclosure: Long shares of Biglari Holdings at the time of writing, but positions may change at any time

Numbers Behind Groupon’s Business Warrant Caution After First Day Pop

Daily deal leader Groupon (GRPN) is slated to go public today, selling 34.5 million shares at $20 each, which will raise $690 million in exchange for a 5.4% stake in the company. Combine a popular Internet start-up with a very low number of shares being offered (floating 5% of all shares is historically a very small IPO) and demand will far outstrip supply. We may not see a record setting first day pop, given the eleven-figure starting valuation, but the stage will be set for a solid jump at the open on Friday. And even without any first day gain, Groupon will be valued at about $12.75 billion.

As one of Groupon’s 16 million repeat customers, I was interested to dig into their IPO prospectus because I have already seen my use of Groupon decline meaningfully since I signed up to receive their daily deal emails last year. To me, Groupon has several headwinds facing their core business.

First, Groupon is dealing with many small business merchants who complain that they lose money when running a Groupon campaign. If businesses really see Groupons as a way to mint money immediately, they are mistaken about what role the deal campaign should play. A Groupon deal should be viewed as a marketing expense, not a profit center. A business should use Groupons to get prospective customers in the door. After that, just like any other marketing tool, it is the business’s job to treat them well and provide a good service, which should encourage repeat business. It will be those recurring customers that will grow your business long term and generate profits.

Generally speaking, profit margins for small businesses are hardly ever high enough to make a 50% discounted transaction profitable to the business. If you offer $50.00 Groupons for $25.00 each and only keep $12.50 per voucher (Groupon keeps the other half), the odds are slim you will make a profit initially. Unless it only costs you no more than $12.50 to offer $50.00 in goods or services, you are going to lose money. Let’s say you lose $20.00 per Groupon in this case. The real question should be, is a new customer coming through your doors worth $20 to you? The only way to answer that is to look at other marketing options you have. Do they cost more or less than $20.00 per new customer generated? If the answer is more, then Groupon is a worthwhile way to market to prospective new customers.

Along the same lines, I think Groupon will struggle once they have exhausted most of their small business merchants in any given city. As the example above shows, Groupons themselves are not money makers, which makes it less likely that a small business is going to want to run multiple campaigns. As a result, when you run out of businesses, your deal quality declines and fewer Groupons are going to sell. Groupon is probably facing these issues today, as the business is three years old and many businesses have already used the service. It is my belief that new businesses should probably strongly consider running a Groupon campaign, given that the biggest obstacle for new businesses is lack of awareness. But honestly, there are not likely enough new businesses cropping up to support strong long-term growth of Groupon’s core daily deals business. As a result, merchant growth could very well hit a wall sooner rather than later.

Groupon’s IPO prospectus provided a lot of data that investors may want to use to try and value the company. For instance, as of September 30th, Groupon had 143 million email subscribers. How many of those have ever bought a Groupon? I was pretty surprised by this number actually… the answer is 30 million. Only 20% of the people getting these emails have ever bought one, and that is a cumulative figure for the last three years! Investors trying to place a value on Groupon’s subscribers may want to forget the 143 million number, as only 30 million are generating revenue for the company.

The numbers get worse. Of those 30 million people who have bought at least one Groupon (Groupon calls them “customers” as opposed to the 143 million “subscribers”), only 16 million are repeat customers. So only about 10% of the people who get the emails have bought 2 or more Groupons since the company launched. This is hardly a metric that screams “loyal customers that generate strong repeat business,” which is what investors would want to see.

Why is this important? I think a good way to try and value Groupon (if you even want to bother) is to place a dollar value on each paying customer. After all, Groupon is not unlike a subscription service like Netflix or Sirius XM Radio, aside from the obvious fact that a paying customer of the latter two businesses are more valuable because they generate guaranteed revenue each and every month. In fact, both Netflix and Sirius get about $11.50 per month on average from their paying customers. Interestingly, Groupon earns about $11.90 in revenue for each Groupon it sells, but they are not even close to selling every customer at least one Groupon per month on a recurring basis. As a result, it is correct to conclude that investors should value a Groupon customer far below that of a Netflix or Sirius customer.

Which brings us to the stock market’s valuation of Groupon versus Netflix or Sirius. Each of Netflix’s 23 million subscribers are worth about $200 based on current stock prices. Sirius XM, with 21 million subscribers, is valued at about $600 per subscriber (considerably more than Netflix because Sirius XM has higher profit margins). How much is the market paying for each Groupon customer at the $20.00 per share IPO price? Well, $12.75 billion divided by 30 million comes out to $425 each.

It is not hard to understand why skeptics do not believe Groupon is worth nearly $13 billion today. To warrant a $425 per customer valuation, Groupon would have to sell far more Groupons to its customers than it does now, or make so much profit on each one that it negates the lower sales rate. The former scenario is unlikely to materialize as merchant growth slows. The latter could improve when the company stops spending so much money on marketing (currently more than half of net revenue is allocated there), but who knows when that will happen or how the daily deal industry landscape will evolve in the meantime over the next couple of years.

“Buyer beware” seems to definitely be warranted here.

***Update Fri 11/04/11 8:55am*** Groupon has increased the number of shares it will sell in today’s IPO to 40.25 million from 34.5 million. The figures in the above blog post have not been adjusted to account for this increased deal size.

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