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Saturday, October 24, 2009

Netflix Buying Back Shares with No Room for Error; Probably Better to Hoard Cash

A WSJ article regarding Netflix (NFLX, $55.10), "Netflix's Stock Buybacks: Money to Burn" by Martin Peers, caught our attention. Mr. Peers opens with, "In the corporate world, there are savers and then there are spenders. Apple, for instance, has hoarded $34 billion in cash and investments with no dividends or stock buybacks. At the other extreme is Netflix." He then goes on to correctly summarize the following:
  • Netflix is spending cash more than it generates to repurchase shares at a very high multiple.
  • Management thinks buying even at current levels are a good "value" (*per CEO Reed Hastings on call).
  • Forward free cash flow growth is not a certainty in a competitive marketplace.
  • As excess cash is depleted, Netflix plans to borrow money to fund more share repurchases.
  • And, many companies made ill-timed repurchases in recent years.
Let's dig a bit deeper and look at the details. Some commentary from the conference call transcript (sourced via Seeking Alpha here):
  • Since inception of our first buyback program in Q2 of 2007, we repurchased a total of 17.8 million shares for a net reduction in total outstanding shares including stock option grants of 18%. In total, we have spent approximately $545 million, which is more than we have in total assets at the end of the third quarter [= average price per share of $30.62].
  • In Q3, we repurchased 3 million Netflix shares at a cost of $130 million [= average price per share of $43.33]. In the process, we completed the buyback authorized in December of 2008 and began repurchasing shares under the $300 million buyback authorization we announced in August.
  • Under the $300 million authorization, we have repurchased a total of 2.7 million shares at a cost of $122 million, including 1.2 million shares purchased Q4 to date [= average price per share of $45.19].
  • Last quarter, we announced plans to modestly leverage our balance sheet to fund future share repurchases and that remains our objective. We recently closed $100 million revolving credit agreement with Wells Fargo and BOA to begin the process of leveraging the balance sheet, and we will likely consider additional debt financing.

Here are the non-GAAP free cash flow figures reported by Netflix (essentially cash flow from operations less capex and necessary content purchases):

Based on weighted average fully diluted shares outstanding of 58 million during the September quarter, trailing twelve month free free cash flow as $2.03. Thus, during the quarter, Netflix repurchased shares at 4.7% FCF yield (21 times multiple). On an earnings basis, estimated 2009 EPS (midpoint) is $1.86, implying a repurchase yield of 4.3% and a multiple of 23 times. This is very different from Bidz (BIDZ, $3.00) or Youbet (UBET, $2.36) potentially repurchasing shares with FCF yields north of 10% (please see prior posts here and here, respectively).

As indicated in numerous prior posts (e.g. this Apple post), we view a powerful franchise trading at a FCF yield of 5% as fairly valued and prefer to purchase at yields north of 10%. Assuming Netflix is a powerful, durable franchise -- we know customers love the service and we like subscription business models -- Netflix was buying fairly valued equity in 3Q09 at $43 per share. If repurchases continue in the $50s, the company would arguably be buying overvalued shares.

Why would management do such a thing? Any yield higher than the 1-2% they can earn on cash balances should theoretically be accretive. Borrowing costs are also quite low -- per the new credit facility agreement, Netflix pays either a base rate plus a spread of 1.75% to 2.25% or an adjusted LIBOR rate plus a spread of 2.75% to 3.25%.

Clearly, the business continues to scale and deliver impressive growth. Management appears confident that growth can continue indefinitely. Still, at current levels, increasingly slim FCF yields leave little room for error (no margin of safety), especially in view of price volatility through the years:

Moreover, insiders and institutional holders are aggressively selling into strength:

We can't help but think Netflix might be better served by retaining a large net cash pile (unlevered balance sheet) for a better entry point. If such a point doesn't materialize in due course, then management could initiate a dividend to return capital to shareholders. Despite what corporate finance theory teaches about optimal equity/debt capital structures, we don't think a large, growing cash hoard is necessarily a bad thing.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BIDZ, UBET.
© 2009 Jeffrey Walkenhorst
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