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After the bell on Friday, Netflix (NFLX) announced that it was giving CEO Reed Hastings a huge raise. Mr. Hastings will get a $2 million salary along with $2 million of compensation through stock options, the ultimate value of which depends on how Netflix's shares perform. This is up sharply from 2012, when Hastings received a $500,000 salary and a $1.5 million stock-option allowance. Now you may remember his salary in 2012 was cut after he received a $500,000 salary and a $3 million stock-option allowance in 2011. The 2012 salary was cut after the price hike and failed spinoff of Netflix's DVD unit, which made shares plunge from over $300 to well below $100 in just a few months. I've always questioned the moves of Netflix, and this is another puzzling one. I don't believe that Hastings deserved this raise, and here are a number of reasons why.

Domestic subscriber growth has severely disappointed

Netflix's target for 2012 was to add 7 million domestic streaming subscribers. They reiterated this target during the fiscal Q1 conference call, and I've extracted two quotes from Mr. Hastings below:

"If you look at adding 7 million net adds, which is our target for the year."

"So everything is consistent with what we've been hoping for, and so that's why we feel good about the year, continuing like this."

Netflix ended 2011 with 21.67 million streaming subscribers, of which 20.15 million were paying subscribers (don't forget about the free trial). It doesn't take a genius in math to figure out how to add 7 million to those totals. But here's what Netflix guided to for Q4 ending domestic subscriber totals, when they reported Q3 results.

  • Total subscribers: 26.4 million to 27.1 million.
  • Paid subscribers: 24.9 million to 25.4 million.

So for the total, they are guiding to growth of 4.73 million to 5.43 million, and paid subscriber growth of 4.75 million to 5.25 million. I wouldn't be as critical if the high end of their range was near 7 million, but it isn't even 5.5 million! Netflix has completely missed its goals for the year, and it won't get too much better going forward.

They still have no clue when it comes to the DVD:

Last year, Netflix really messed things up when they raised prices, because many subscribers who subscribed to both the DVD and streaming plans opted to ditch the DVD plan. Netflix had nearly 14 million DVD subscribers at the end of Q3 2011, which a year later was down to just over 8.6 million.

The original plan was to spin off the DVD business into its own separate unit. But after a bunch of public relations backlash, they scrapped plans to do so. I recently stated that the company should reconsider the DVD, but I'm guessing they won't listen.

Why is the DVD segment so important? Because it is a profit monster. Even after they've lost so many DVD subscribers, the following represents the segment results in Q3 of 2012.

  • Streaming: Ends with 25.1 million subscribers. Quarterly revenue of $556 million. Contribution profit of $91 million.
  • DVD: Ends with 8.61 million subscribers. Quarterly revenue of $271 million. Contribution profit of $131 million.

So DVD had only about a third of the subscribers, and despite half the amount of quarterly revenues, contribution profit was about 44% higher. Netflix's plan is to let this segment die off, let subscribers leave over time, and focus on streaming. It's a wonderful strategy, right?

Financial performance has been terrible

Netflix's financial performance has crumbled so far this year. The killing off of the DVD segment has a lot to do with it, as does the huge international expansion into the U.K., Ireland, and Scandinavia. The following table shows some key financial numbers through the first 9 months of the year. All numbers are in thousands, except per share and percentage data.

Netflix has grown revenues by $335 million in the first 9 months, but look at the rest of the numbers. Gross profit is down 15%, and that is good compared to the rest of the numbers! Net income has fallen by 95%. Before Netflix raised prices, analysts were expecting about $6.50 in earnings per share this year. Current expectations call for $0.04. Yes, that's four cents, not four dollars. Expectations for 2013 call for a profit of $0.43 per share. That would still represent a 90% decline from the $4.26 we saw in 2011. The glory days are gone.

When it comes to margins, you can tell that the situation isn't pretty. The following table shows Netflix's three primary margin categories through the first 9 months of each year.

On the gross margin side, things aren't likely to get better anytime soon. As Netflix moves to a more streaming business, the lower margin streaming side will represent a higher percentage of revenues. Also, after the first of the year, a postage hike will take down Netflix's DVD margins, as they told us last quarter.

The Wells Notice

A few weeks ago, Netflix and Mr. Hastings received a Wells Notice from the SEC. Mr. Hastings, along with the company, could be in trouble for violating Regulation Fair Disclosure. This has to do with Reed's posting of Netflix subscriber hours on his Facebook page that Netflix surpassed 1 billion viewing hours back in June. I questioned this issue at the time, and sure enough, the SEC is now looking into it.

Now, you could argue that Netflix bragging about subscriber hours is not totally material, because by itself, the hours number is useless. You can get 100 hours from 5 viewers watching 20 hours, or 100 viewers watching 1 hour. By itself, the Facebook post doesn't seem that bad. But the real issue is that Netflix could have easily released a formal press release at the same time. How long would have that taken to put together? I'm guessing less time than it would take to watch an episode of any of Netflix's original shows.

There may never be any penalties for Netflix or for Reed Hastings. But in today's world of social media, where everything you say can be read by millions in a matter of seconds, you need to be smart, especially when you are the CEO of a multi-billion dollar company.

Trust needs to be earned

When someone tells you that everything is okay, and it turns out not to be, that person's credibility is weakened. This happened to be the case with Netflix and its cash position during the second half of 2011. During Q2 of 2011, Netflix spent $51.4 million dollars to buy back 216,000 shares at an average cost of $238. During Q3 of 2011, they purchased 182,000 shares at an average cost of $218, for $39.6 million dollars total. Netflix then provided the following statement:

Historically, we have always run a very lean capital structure, returning all "excess" cash to shareholders in the form of buybacks. We expect to report a global consolidated net loss in Q1 '12 as well as to consume cash as we launch the UK. By pausing on further international expansion and halting buybacks, our current cash on hand is adequate to support the growth of the business. As we have done in the past, we will continue to evaluate the appropriate cash level for the business.

But just a few weeks later, Netflix went out and raised $400 million. Half of that came from selling stock at $70, and the other half came from convertible zero coupon notes. So the company that was buying back shares at well over $200 sold stock at a third of the price just two months later. Netflix then stated in its Q4 2011 investor letter that they had no intentions of spending the money, it was just a stronger safety net. To date, the money has just been sitting there. They ended last year with $798 million in cash and equivalents, and finished Q3 of this year with $789 million.

Netflix expects to start burning through some of that cash as they shift towards more original programming. They also said that they have adequate cash on hand to support the business and maintain a reserve. While I tend to believe them this time around, I still have some skepticism given their history. Last year's fund raising was a pure panic move, and it just adds to the pile of questionable decisions that this company, and its leader, have made over time.

Conclusion - A raise not deserved?

So let me get this straight. Netflix had a target of 7 million subscribers, and they'll be lucky to add 5.5 million. They have decided to kill off their most profitable business segment. Through the first 9 months of this year, operating profits are down 90% and net income is down 95%. Even with an expected rebound next year, analysts still see the company's earnings per share for 2013 being down 90% from 2011 levels. Also, the CEO is under investigation by the SEC for a possible violation of Reg FD.

Despite all of this, Reed Hastings is getting a huge raise. His salary is being quadrupled and his overall compensation package would be doubled from 2012. If all of this doesn't tell you what's wrong with Netflix, I don't know what will. All I want to know is where I can get a job like that. Apparently, you just have to be the CEO of Netflix.

Source: Netflix Gives Reed Hastings Huge Raise: Why?

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.