I recently read a book called "Antifragile: Things That Gain from Disorder," by Nassim Nicholas Taleb. Some of you might remember him as the guy who wrote "The Black Swan," in which he examines the influence of highly improbable and unpredictable events that have massive impact. In "Antifragile: Things That Gain from Disorder," Nassim talks about something called "The Triad," which classifies things into three categories:
Fragile: does not like volatility and disorder
Robust: neither harmed nor helped by volatility and disorder
Antifragile: benefits from volatility and disorder
I will mostly focus on the two extremes -- fragility and antifragility. A simple example of antifragility is a profitable company that has billions in cash on its balance sheet and zero debt. An example of the opposite, fragility, is an unprofitable company that is heavily leveraged and with little to no excess cash. Which one of these companies will do better in a recession or volatile environment? I think the answer should be obvious to most investors.
A real life example of an antifragile company is Berkshire Hathaway (BRK.B). Right before the financial crisis of 2007-2008, Berkshire had billions in cash that it could put to work. Buffett invested tens of billions in such companies as General Electric (GE), Goldman Sachs (GS) and Swiss Re (OTCQX:SSREY). Most academics would argue that sitting on this much cash is inefficient, and this would be very true if we could predict the future. However, since it is impossible to predict the future (contrary to what most economists and analysts believe), we must strive to be antifragile. So, as you can see from my Berkshire example, Buffett was antifragile -- he benefited from the volatility in the market. Fragile companies that were trying to be "efficient" by using a lot of leverage went bankrupt (suffered from volatility in the market). It is also important to mention that these same companies, mostly in the financial sector, were using fancy models to make forecasts and measure risks. On the other hand, Warren Buffett, a man who can hardly use a computer -- outperformed all of these models using only his brainpower and a little common sense. Buffett understood two things: the economy was becoming fragile (because of the excessive leverage), and the stock market was grossly overvalued. And as we have learned by now, fragility and extreme valuations can cause severe recessions like the one we experienced. So, as can be clearly seen, Buffett made sure that Berkshire was antifragile so that it can benefit (profit) from volatility and disorder in the stock market.
Another company that I believe is extremely robust, and possibly one day could be antifragile, is Apple (AAPL). Say what you will about Apple, but this company has over $137 billion in cash on its balance sheet and zero debt. The company is still extremely profitable, which means that enormous cash pile will continue growing. If we have another economic downturn (which is very likely), a company with this much cash can benefit by acquiring its competitors and further strengthening its competitive advantage.
So far I have talked mainly about robust and antifragile companies. Now I will give an example of a fragile company, and it is this company that will be the focus of this article. As the title suggests, that company is Netflix (NFLX). I will analyze three things: the company's profitability, financial health and valuation. By the end of this article the reader will see that not only is Netflix grossly overvalued, but the company is also becoming fragile. And as I have shown above -- fragility and overvaluation are not a good mix.
Before I go on, I want to mention that I do not believe in making predictions. I am not trying to predict the exact date when Netflix will collapse and go bankrupt. I believe it is much easier to understand if something is harmed by volatility -- hence fragile -- than try to forecast harmful events. My model is quite simple, I identify fragilities and make a bet on the collapse of that fragile unit (in this case Netflix is that fragile unit).
Netflix has rallied close to 100% since reporting better-than-expected results for the fourth quarter of 2012. The domestic streaming subscriber base grew to 27.1 million (2.05 million net adds), and the international business grew rapidly (1.81 million net adds). In total, Netflix currently has 33.3 million video-streaming subscribers worldwide. This influx of new subscribers allowed Netflix to produce an unexpected fourth-quarter profit. However, as they usually tend to do, investors overreacted. They have ignored the company's deteriorating cash flow and ballooning off-balance sheet liabilities. It is these two things that are making Netflix more fragile, which will eventually lead to its demise.
It is also important to mention that Netflix will be adding $500 million of long-term debt to its balance sheet. The news was announced after the most recent balance sheet date, and this new debt should appear on next quarter's financial statements. In my analysis I do not include this new debt because I cannot know exactly how much of it will be used to retire old debt. Management has stated that "they might" use $225 million of the proceeds to retire $200 million in 8.5% senior notes that are due in 2017. However, I want to be conservative and will wait until next quarter before including this new debt in my analysis.
First, I would like to focus on Netflix's financial health. I will attempt to examine all of the company's liabilities, including the liabilities buried in the footnotes (off-balance sheet liabilities).
Below is a snapshot of the company's balance sheet as of December 31, 2012.
At the end of 2012, Netflix had $748 million in cash and short-term investments (19% of total assets). As should be expected, most of the other assets consist of streaming content -- close to $3 billion worth (74% of total assets).
Moving on to the liabilities section we see that Netflix has $400 million in long-term debt. However, the majority of the company's liabilities are streaming content liabilities, which totaled approximately $2.4 billion (76% of total liabilities).
If we were to just focus on the balance sheet and ignore everything else, Netflix would look like it is in decent financial health. However, Netflix is one of those companies that hide most liabilities off the balance sheet. This means that it would only make sense to also analyze these off-balance sheet liabilities in order to determine whether or not the company is a worthwhile investment. What I have attempted to do is bring these "hidden" liabilities back to the balance sheet so that investors can better analyze the company's financial health.
Here is a snapshot of what Netflix's balance sheet should look like. We will call this the "updated balance sheet." Stockholders' equity remains the same, because the balance sheet must "balance."
In this analysis I will only focus on the most recent year. The major change that was made is the addition of $3.2 billion in off-balance sheet streaming content liabilities, of which $2.3 billion is long term. According to the footnotes in the most recent 10-K, the reason these obligations are not reflected on the balance sheet is because they do not meet the criteria for asset recognition. So what are the criteria that management speaks of? Well, in another footnote we can find the answer. The license agreements that are not reflected on the balance sheets do not meet content library asset recognition criteria because either the fee is not known or reasonably determinable for a specific title or it is known but the title is not yet available for streaming to subscribers. In other words, this is just a clever way to hide $3.2 billion in streaming content liabilities off the balance sheet.
I have also added back "other purchase obligations" to the balance sheet. These are non-cancelable purchase obligations primarily related to streaming content delivery and DVD content acquisition. At the end of the most recent fiscal year, these obligations amounted to approximately $132 million.
Finally, the company's non-cancelable operating lease obligations have also been included on the updated balance sheet. Operating leases should be treated as debt and brought back to the balance sheet (the FASB is also working on changing this). In order to bring these leases back to the balance sheet we must capitalize them. I chose to use Moody's (the rating agency) method of capitalizing leases, which is simply "eight" times the current year rent expense. Rent expense in 2012 was $29.7 million. This means that at the end of 2012 Netflix had close to $238 million in capital lease obligations. I also want to mention that rent expense increased by about 76% from 2011. The reason for this increase is due to certain short-term facilities leases to house the company's content delivery network equipment. However, management expects rent expense to be about the same in 2013, which probably means that this is not a short-term increase.
Next, I will analyze the company's profitability, which, as you will see, has been deteriorating in recent years and making the company even more fragile.
Netflix's earnings have experienced some significant deterioration in recent years. In the most recent fiscal year the company had negative free cash flow of $67 million, and negative owner earnings of $124 million. The main difference between owner earnings and free cash flow is that owner earnings take into account stock-based compensation expense while free cash flow does not. It is for this reason I believe that owner earnings are a better representation of Netflix's true earning power (or "cash burning power" in this case).
In my opinion, these are huge losses and should be a red flag. Yes, Netflix did report positive net income; however, you cannot pay down debt with net income -- it is just an accounting number. I know of a lot of companies that had amazing net income and still went bankrupt. In the end it is cash that matters, and this is something Netflix is lacking at the moment.
Let us take another look at the company's current liabilities.
Netflix owes about $2.7 billion within a year (current liabilities). Where will this money come from? It certainly will not come from cash flow since it is negative. The company will be able to cover some of these current liabilities using the cash on its balance sheet. It will also be able to convert some of its other current assets into cash, which will also help. However, where will the rest come from? How will the company be able to buy additional content to stay ahead of the competition? There is only one rational answer to these questions -- more debt! And, as we have learned by now, more debt = more fragility.
Here is another look at the company's long-term liabilities.
Netflix has close to $4.1 billion in long-term liabilities. The company will not have to worry about these liabilities for now, with the exception of interest payments on the debt. However, one day soon -- these too will be current liabilities, but by that time Netflix will be in such bad shape that there is no guarantee that they will ever get paid.
The final thing that I want to analyze is the stock valuation. In my opinion, valuing Netflix is almost impossible. The valuation process is made especially hard considering that the company's earnings are deteriorating. Now, some investors might argue that this "earning deterioration" is only short term and that profit margins should eventually return to normal (revert to the mean). However, my counter-argument would be that even if profit margins do return to their long-term average, the stock would still be extremely overpriced.
As can be seen above, Netflix historically has had slim profit margins. In fact, the five-year average profit margin is less than 2.5%. I use owner earnings in the calculation instead of net income because, as I stated earlier, I believe it is a better representation of the company's true earning power.
To be totally honest, I do not even think that Netflix can return to historical profitability. There are three main reasons why I hold this belief: first, there is heightened competition for securing content, which means a greater portion of the economic profits are shifting to the content owners. Second, the continuing decline of the high-margin DVD business will also be a drag on profitability. The third and final reason, emerging competition will keep Netflix from the significant margin expansion that usually comes with strong top-line growth.
I will now attempt to show that even if Netflix did not have to face all of the challenges I just mentioned, even if the company's profit margins did return to normal -- the stock would still be grossly overvalued (even when taking into account optimistic and unsustainable growth rates). Again, I want to remind readers that the following analysis is simply to show how crazy the valuation really is. In no way do I believe that Netflix will be able to achieve this.
I forecast revenues to increase at 25% on a five-year CAGR basis (exact historical growth rate). I also forecast profit margins to average around 2.5% (historical profit margins) during the five-year forecast period. In the most recent year Netflix had revenues of $3.6 billion -- multiplying that by the average profit margin of 2.5% gives us "normalized owner earnings" of $90.2 million, or what the owner earning should have been for the year if conditions were normal. As of this writing Netflix had an enterprise value of $10.5 billion (including operating leases). Dividing normalized owner earning by the current enterprise value gives us an earnings yield of 0.86%, or enterprise-value-to-owner-earnings ratio of approximately 116x. Again, I am using normalized owner earnings and the valuation is still ridiculous! Assuming that the enterprise value remains the same, 25% annualized growth over the next five years will give us a forward yield of 2.62%, or a forward enterprise value to owner earnings ratio of approximately 38x. As I have just shown, if Netflix is somehow able to return to historical profitability, if the company does not take on more debt (increasing the enterprise value and making it even more expensive), if the company is able to sustain a 25% growth rate (unlikely considering the law of large numbers), even then the stock would be richly valued. In other words, even when assuming the most optimistic (best-case scenario) it still would not change the fact that this stock is grossly overvalued.
Buying Netflix at the current price is irrational. The upside is small (mostly relying on the greater fool theory), and the downside is huge. The company is facing many challenges in the near future; it has many obligations that it simply cannot cover, at least not without taking on additional debt. Furthermore, even as Netflix's balance sheet becomes more fragile and its earnings deteriorate -- the price that investors are willing to pay for the stock is increasing every day. This does not make sense to me. An extremely overvalued, fragile, and poorly managed company like Netflix will eventually crash and investors will lose a lot of money. There is no doubt in my mind that this will happen, it is just a matter of time.
As Netflix continues taking on more obligations (both on-and-off-balance sheet), and as the stock continues climbing higher -- those put options are looking very attractive to me. I know that the stock will eventually collapse, and options give me huge upside with minimal risk (limited downside). I will keep betting year after year until this company goes bankrupt. Actually, I hope that the stock becomes even more overvalued -- this just means that the eventual crash will be more severe and my profits will be higher. Put another way, why am I betting against Netflix? The answer to that question is simple -- taking the other side of fragility makes you antifragile, and my whole goal in life is to be antifragile.
I have just shown that even when using the most optimistic growth forecast, Netflix would still be extremely overvalued. Even worse, not only is the stock overvalued, but the company is becoming very fragile due to the ballooning liabilities and deteriorating earnings. These liabilities (especially the off-balance sheet ones), will continue rising, and it is very unlikely that the company will ever again return to profitability. In other words, the company is becoming more fragile while its stock is becoming more overvalued. This is a disaster waiting to happen. I strongly urge all investors to stay far away from this fragile house of cards!