Wednesday, November 23, 2011

Netflix: Buys High, Sells Low

The chart in this Bespoke Investment Group post says it all. Check it out.

Buybacks work in situations where a financially sound (strong balance sheet, reliable free cash flow, high return on capital) business with a proven and durable franchise has its shares selling comfortably below intrinsic value.

Netflix (NFLX) hardly meets that criteria.

Since 2010, the company has bought back $ 410 million of stock.

The Netflix buyback in Q2 2011 occurred when shares sold in the $ 224-270/share range (the shares later briefly hit a bit over $ 300 in July). On average that's 60x what turns out to be, at least for the foreseeable future, peak earnings.

Buying back the stock at a high multiple of earnings is bad enough, but the mistake would be at least somewhat mitigated if this was a proven franchise with rapidly increasing earnings. As of now, it seems the opposite is true.

Earnings at Netflix is now widely expected to shrink dramatically so over the next year.

That's actually an understatement. In an SEC filing on Monday, an S-3 shelf registration, Netflix recently said that it expects to incur a net loss in 2012 due to flat revenue and an increase in international investment.

Buybacks, if executed for the right reason and at the right time, are an excellent way to enhance shareholder wealth.

Unfortunately, all too often, buybacks are done for the wrong reasons and at the wrong time.

To make matters worse, Netflix is now apparently in need of capital.

In that shelf registration, the company announced it was selling $200 million of common stock. In a separate filing, the company said it is also selling $200 million of convertible notes.

With shares now selling at $ 70.45, a more than 75% drop from the stock's peak, the company is providing as good an example as any in recent memory of poor capital allocation.

It would seem to be a buy high, sell low situation but who's to say the stock is selling at a low price? Low compared to the previous value maybe but not necessarily compared to value. For me, it's not clear at this time at all what the intrinsic value of Netflix is.

What's the durable competitive advantage of Netflix? Considering the dynamics of its competitive landscape I think that judging what Netflix is worth is a fairly speculative game. Obviously, others who have a handle on the company's prospects may think it is less so. Still, even if Netflix ends up a winner, on a risk adjusted basis, I can create a long list of better places to put money.

Some owners of other high multiple stocks may want to take note. There will be exceptions, of course, but most fast growing, dynamic, yet unproven franchises tend to have a large speculative premium in the stock price.

It certainly may work out but, if some of the dreams aren't realized, the sheer force of the core long run economics that most great franchises possess will not be there as a backstop for the owners.

Where possible, eliminate the chance for permanent loss of capital and the rest usually takes care of itself.

I'm sure it's no fun for a shareholder when the speculative premium that is implicit in a high multiple stock drains away. When that happens it leaves only what is of more explicit value (hopefully there is something) to support the stock price.

Of course, buy a good business with no speculative premium in the first place and you don't have to worry about for how long that premium will be sustainable.

Adam

Related post:
Amazon Sells Kindle Fire Below Cost
Technology Stocks

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