Netflix (NFLX) CEO Reed Hastings is a spin-master, second only to Jeff Bezos. No matter what results Netflix reports, things are always sunny. Those who mock the old price increases and Quikster debacle forget that the stock rose on the day of the announcements. The latest slight of hand is the move to explore taking advantage of the current low interest rate environment, while stating that Netflix has sufficient cash on hand to fund expenses. This is not true. In fact, if Netflix had not issued additional debt, there is a strong likelihood of financial disaster in 2013.
This same argument was used last time Netflix sought financing in late 2011, but this time around, people seem to fully believe the argument. Ironically, Hastings' spin is more misleading than in 2011. I will provide a look at the massive content obligations due in 2012 (minimum of $2.45 billion). For those looking for a good story about Netflix, I suggest Rocco Pendola's piece from early January. Rocco is a story investor, not a numbers guy, but I believe few people in the world have a better grasp of the business model situation.
This might seem like fluff, but I believe it's important to understand an analyst's history and potential bias.
I shorted Netflix from 2010-11, and I played a series of out-of-the-money earnings puts during 2012. The first time, I entered around $170, rode to $300, and back down to around $90. My thesis has always been overvaluation on a bad business model -- last January I predicted that Netflix would need major financing to avoid bankruptcy by 2013.
In hindsight, my subscriber growth estimates were way off. I predicted averages of 19.5 million domestic and 2.5 million international; instead we saw 23.5 million and 3.5 million, for a yearly run revenue difference of $480 million. For Q1 2012, I suggested a massive out-of-the-money (1w) "lottery ticket" put play on earnings. This turned into a massive profit. I then lost interest in Netflix for the next few quarters.
The Debt Deal
Netflix announced yesterday the pricing of $500 million in eight-year notes at 5.375%. The current commercial yield index is at 3.38% and high-yield index is at 5.89%, placing NFLX just shy of junk territory. The debt deal by itself makes sense. The bond markets are starved for yield and Netflix needs the cash. I'm not decrying the offering; my point is that this isn't a Microsoft (MSFT) or Intel (INTC) type of advantage play -- this cash was needed to ensure operations, and Netflix is extremely lucky to receive it.
Netflix redeemed the $200 million 8.5% senior notes due in 2017 (issued November 2009), for an estimated expenditure of $225 million. This move changes annual interest expense from $17 million to $29.45 million. Essentially, Netflix is only paying $12.45 million, or 4.53%, on the new $275 million -- a huge win for it.
The Need and Spin
I've tracked relevant quarterly Netflix stats since Q1 2009 and highlighted the best (three) results in green and the worst (three) results in red. Pay close attention to the Rev/AP and Quick/AP.
Click to enlarge image.
Coverage by Quick Ratio
The dark red marks the quick/AP ratio Netflix faced prior to the November 2011 financing. As you can see, Q4 2012 is the second worst level in history. My definition of Quick/AP ratio is (cash+sti)/(current content liabilities+ap). If you include the total liabilities from a quick perspective Netflix had a ratio of 0.30 prior and 0.42 post debt issuance. Comparatively to Netflix's 2011 "disaster phase" Netflix had ratios of 0.39 prior and 0.82 post.
Coverage by Revenue
Assuming annual run-rate revenues, NFLX had revenue coverage of 3.51x in November 2011. In January 2012, NFLX has revenue coverage of 1.54x. Netflix needs to keep other expenses (non-content gross costs, marketing, tech and development, G&A, legal, and interest) below 35% of revenues just to break even in 2013.
Netflix is clearly in a worse liquidity position than during the horrendous fall 2011 phase.
Managing the Enormous Liabilities
As I stated earlier, all other expenses must stay below 35% of revenues for Netflix to break even in 2013. This assumes three things: 1) sub growth will be flat across the board, 2) Netflix will not incur any additional liabilities, and 3) Netflix will not pursue any large expansion plans. I believe sub growth will continue slowly, with a spike this quarter due to the new content, but I also believe content liabilities will increase at a similar pace. As an additional precaution to already referenced content costs, Netflix states: "For agreements with variable terms, we do not estimate what the total obligation may be beyond any minimum quantities and/or pricing as of the reporting date." In other words, the $900 million-plus that is due in 2013 might actually be much larger -- it's very likely that these variable contracts are tied to subscriber counts.
In 2012, Netflix spent $485 million on marketing, $329 on tech and dev., $120 million on G&A, and $923 million on non-content gross ($2.625 billion gross exp-$1.591 billion streaming-$65.4 million dvd-$45.5 million depreciation). This equates to 51.4% of revenues -- this year Netflix needs to hit 35% to break even.
As I admitted above, last January I missed poorly -- very poorly -- on sub counts. Please take my revenue estimates with a grain of salt.
DVD: Avg. 6.5 million at $11, Streaming-dom 27.5 million at $8, Streaming-intl 6.5 million at $8 -- total revenues of $4.12 billion.
$500 million marketing, $320 million tech and dev., $125 million G&A, $30 million interest -- $975 million.
Gross non-content expenses of $1 billion.
Liabilities of $2.695 billion (assuming 10% growth above the current level).
Cash Position Update
Drop of $550 million vs. Netflix Quick of $498 million -- Netflix needed more cash to avoid bankruptcy or restructuring in 2013.
I'm assuming massive blowback on my model/projections, especially considering my miss on subs last year. I encourage challenges on my numbers, primarily on the "gross non-content" since this is really a huge black box. It is possible that the GNC could drop a tad and equally possible that the liabilities will remain flat, or be renegotiated back a few months.
It's also possible that we could see 30%-plus annual growth in subs. To be clear, my model predicts 27% average year growth, a number that I consider to be already very high.
My Investment Recommendation
The premiums are ugly on this one -- assuming it takes six months for the Street to figure out the ugly picture here; Sept. 13 $170 puts are priced for $137 (18% drop). If it takes a full year, a 21% drop is baked into atm. Clearly the one-year is a better offer, if you must go with options.
If you prefer straight short, buy insurance. I've been here before and the momentum potential is still huge. I recommend the April $190 at $10 -- breakeven drops to $159, but maximum loss is capped at $31 (18%).
I'm a risk lover who prefers a short with a hybrid/momentum insurance. Short 25 shares per contract of April 13 $190 at $10. Your cost of execution will be just under $10 per spread with a maximum loss of $2,050, or roughly 24%. Breakeven will be approximately $129 (24% drop), but the beauty is if NFLX surges to $200-plus on content success or hype, profits are also made at the top.
For example, if NFLX hits $250 prior to April, the options will gain $4,000 and the stock will only lose $2,000. At this point you increase your short and move the peak to $300 in September or on Jan. 14. I've been using this same strategy to short Amazon (AMZN) (30/100, 40/100 as of yesterday) and LinkedIn (LNKD) (50/100).