1. Netflix (NFLX) had what we call economic velocity. Has management’s actions killed economic velocity the company once had and more importantly can NFLX regain it?
2. The company raised $400 million of additional capital during the quarter. Was this opportune for shareholders?
3. Have fundamentals underpinning the stock changed? What does the math say?
Big Question #1
Economic velocity is a concept we talk about all the time in our firm. We rarely see this concept in action however when we do its footprint is undeniable. NFLX had economic velocity from January 2010 to August 2011. NFLX went from $50 to $300 with relative ease. In our work, NFLX went from a break out of EBV+6 to EBV+10. In 2011, NFLX was one of the most expensive stocks in our database.
What is economic velocity?
Economic velocity occurs when the fundamentals of the business, aspects of the balance sheet, and price momentum all reinforce each other. Lighting in a bottle, one would say. Rarely does an investor capture an investment such as this in their portfolio but when they do – it’s a beautiful thing. The dark side of economic velocity is also displayed when a corporate action or some outside influence breaks these important self-reinforcing links and gravity takes over.
So the question remains, will economic velocity return to NFLX? Management quickly overturned very unpopular corporate actions that saw the company lose 810,000 customers in Q3, 2011. Also, surprising, management chose to issue equity. So before we answer the above question, let’s look at the financing and calculate its implications.
Big Question # 2
The below quote was given to the shareholders in a letter from management.
“Our standard practice with regard to managing our capital structure has been to evaluate on an on-going basis the appropriate cash level and capital structure for the business. In Q4, given the pain from our price changes and the impact to our 2012 outlook, this analysis led us to the decision to strengthen our balance sheet by raising $400 million of additional capital from two long-term oriented shareholders. $200 million was raised through the sale of equity (2.86 million shares at $70 per share), and $200 million was raised through the private placement of zero-coupon convertible notes. We have no intentions to spend this additional capital; it is merely a stronger safety-net for an aggressive, fast moving business with a big opportunity.
After the financing, we finished the quarter with $798 million in cash and equivalents.
Nothing in life is free. What was the true cost of this financing? Conventional finance thinks in terms of dilution. Yes, EPS will be less; rate of return will be lower however if you’re growing quickly – who cares!
Enter Theoretical Earnings (TE)
This financing boosted NFLX’s theoretical earnings (TE) by 44%. The TE of NFLX based on the September balance sheet was $1.43. Post financing TE is now $2.06. What does this mean? The bar has been raised. The company will have to have more in earnings, in order to create valuation. We like to use an analogy of a marathon runner. It’s easy to run a marathon at 143 pounds. However at 206 pounds, the marathon runner is still the same person, can still run marathons, but the runner will have to work harder to run the same race. More weight to move!
Convexity is a concept that may be difficult to grasp, but one we believe to be important as it represents a unique characteristic in model price. Under “Key Concepts”, and “Model Price” we have the description of model price. Point 2, in our 3- factor model, we state “The sensitivity of [the] company’s balance sheet structure to changes in its market value. (Structure)” We call this Convexity.
We calculate convexity for all companies in our database. This measure determines the sensitivity of the value of the economic structure to changes in market value. We have found that the more sensitive a company is per our measure (the higher the convexity), the higher the valuation in terms of the stock price.
NFLX pre financing had convexity of 2.44. Post financing convexity stands at 1.76, a decrease of almost 30%. This not only decreases our model price calculation but also decreases the feed back mechanism as the stock trades higher. More friction!
As one can see two key components of economic velocity have been altered with NFLX’s financing. Financing that in management own words, “We have no intentions to spend this additional capital …”
During economic velocity the market can and will give a company cheap equity capital to expand your business. The market has selected you, the winner, and will give you all the resources (capital) for your business model. Issuing equity at EBV+10, ($300) instead of under EBV+6 ($70), theoricatical earnings and convexity impact would have been minimal.
Our point here is that management could have been more optimal for shareholders and less damaging to the internal dynamics, which propelled NFLX skyward in the previous period.
Big Question #3
Model Price has collapsed.
The current model price is calculated at $15.60. This represents a staggering 87% below the close on Friday, January 28, 2012 of $123.79. Analysts’ are currently forecasting $2.89, mean estimate, for calendar and fiscal year for 2013. This brings next years’ model price to $88.14. Still down significantly from the close on Friday.
As Netflix reported their 4th quarter numbers on January 25, 2012, the company stated it added 610,000 customers, in the fourth quarter of 2011. This brings their Net Unique U.S. Subscribers, close to their record of 24.59 million subscribers set in Q2, 2011, to 24.4 million. Investors’ and analysts’ cheered the company is back on track and ready to scale, the previous mountain scaled, on the way back to $300.
Management cut significantly the earnings forecast for fiscal 2012, and that had a big impact on this year’s model price. However, also included in our model price calculation is theoretical earnings and convexity.
So back to our question, will NFLX re-achieve economic velocity? We don’t think so. Why. We cannot think of one instance in the last 15 years, with economic velocity reappearing at the same company at a different time. Yes, as we said lighting in a bottle. NFLX could have all the cheap capital it needed to aggressively expand their business, purchased companies, and heavily marketed to new customers. Management stumbled. The stock stumbled.
What do we think will happen to the stock?
NFLX will continue to trade in the zone of EBV+7 and EBV+8. Currently, these zones are between $102 and $184 dollars per share. Yes, we know this is a big difference. But in our world transits are the most important, not the daily ups and downs of market action inter-zone. However, the farther NFLX strays away from EBV+7 the more risk the investor is taking. (In technical analysis terms this is support.)
NFLX with weekly price bars, EBV Lines (colored lines) and model price (dashed line)
For those interested, a daily updated chart of NFLX subsequent to this post will be maintained on Facebook, here.
Just for fun we will make this prediction!
The more interesting question is what happens when NFLX transits downward through EBV+7. (See chart above $102.30) If and when this happens we think NFLX will find a more comfortable home at EBV+5 ($47.80). So when will this happen? We don’t know. When we have done similar work in the past, sometimes the stock price and the math can take years to play out. We are sure quarterly reporting of NFLX will be a nail-biter over the next year. This will be interesting and we will be following.
|Bonus Analysis for our Readers:
Just as an aside, just call it a bonus. We always look at net plant and equipment versus accumulated depreciation. (This ratio is in the calculation of model price). We get the impression that investors’ think NFLX is on the vanguard of high technology in terms of streaming videos. So when we see accumulated depreciation exceeding net plant & equipment we pause.
1) Why aren’t they investing in their business? (Buildings/Computers/Equipment)
2) Do they have a lot of old stuff (physical assets) lying around?
3) What are the barriers to entry here?
See what we mean, having fun with financials.