Netflix Versus The SEC?

| About: Netflix, Inc. (NFLX)

For the last several weeks, I have been attempting to get a comment from Netflix's (NASDAQ:NFLX) investor relations department on a story I wrote for Seeking Alpha a few months ago. Netflix has refused to respond to my repeated requests for information.

All I want to know is if the company plans to go with or against the will of its shareholders and adopt the proposal that calls for a simple majority, rather than super majority vote on key corporate issues. I last heard from the company on the matter back in June via the following email response:

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Given that Netflix's business has been crashing around itself over the last few months, I should not be surprised that I have not received a reply to my latest query.

Around the time I received the June response, Netflix announced the "temporary removal" of Sony (NYSE:SNE) movies from its streaming catalog. Shortly thereafter, the company -- seemingly out of nowhere -- angered customers by changing its subscription pricing plan. Then the "temporary removal" became permanent when Starz (LSTZA) said it had cut off contract renewal talks with Netflix. And, of course, things fell apart even more this past week when Netflix slashed subscriber guidance for Q3, causing the stock to make $200 a distant memory.

Now comes the scoop from Steven E. F. Brown of the San Francisco Business Times that the U.S. Securities and Exchange Commission has been on Netflix's case regarding churn for the last few months. Brown published the news late Friday. He writes:

In late April, two months after Netflix filed its 2010 annual report with the SEC, regulators wrote the company asking it to disclose more detail about who subscribes to what (DVD by mail or online streaming plans or both) and about “rates of churn or any other statistics that would better enable investors to understand your business.”

...Investors, the SEC was saying, like to know how many customers quit Netflix service during a particular quarter or year, since the company’s business model is built on attracting as many customers as possible...

But Netflix disagrees. “With respect to various operational metrics, management has evolved its use of these metrics as the business has evolved,” it wrote the SEC in response. Because it is so easy to quit and then restart a Netflix subscription, it said, “the churn metric is a less reliable measure of business performance, specifically consumer acceptance of the service.”

The company told the SEC it planned to stop reporting churn for fiscal year 2012.

The SEC wrote back in late June, saying investors do indeed need to know about churn rates.

“We continue to believe that disclosure of rates of churn would be useful to investors since disclosure of the total number of subscribers who discontinued the service can high light important operating trends,” it said.

Netflix counterpunched again, saying that in a single year as many as a third of the people who buy a subscription are people who’ve quit that same year.

“We do not require long term commitments from our subscribers,” it wrote in July.

That easy-come, easy-go attitude “may result in a higher level of churn than we would otherwise experience, and could be viewed as a negative business development; however, we believe that this has actually been beneficial to our operating results.”

In its latest reply, the SEC kept its cards close to its chest. “We have completed our review of your filing. We remind you that our comments or changes to disclosure in response to our comments do not foreclose the Commission from taking any action with respect to the company or the filing and the company may not assert staff (i.e. SEC staff) comments as a defense in any proceeding,” regulators wrote in a terse, single-paragraph letter.

Again, great scoop by Brown. And this represents just another piece of the puzzle coming together.

While the SEC is at it, it should take a closer look at something the agency tends to ignore -- how senior executives like Netflix CEO Reed Hastings pay themselves and their employees. Consider what Tony Wible of Janney Montgomery had to say shortly after Netflix's guidance-triggered implosion:

Insiders have sold $67.6 million of stock over the past six months with much of this funded by options that were exercised at a $1.50 per share. The CEO has sold $1.0 to $1.5 million of stock on almost a weekly basis (total of $32 million) and continues to not own any direct shares. The Chief Product Officer, Chief Content Office, Chief Marketing Officer, Chief Talent Officer, and various Directors have also sold. We believe this activity is tied to NFLX’s unique compensation policy that minimizes the cost of options on the income statement but essentially allows NFLX to fund some compensation through the balance sheet at the expense of shareholders.

The entire Netflix tale -- namely too much, too fast market expansion and a sweeter than sweet deal for the CEO -- reminds me of a dot-com debacle that Netflix's eventual demise could rival. That's the story of Webvan.
Like Netflix, Webvan provided a service that lots of people, particularly in the San Francisco Bay Area, loved. I still remember the famous green bins and Webvan trucks littering my neighborhood when I lived in "The City."
Given his ability to cash out options practically every week, I wonder if Hastings employment contract looks anything like that of former Webvan CEO George Sheehan's. As CNET noted back in 2001, the contract calls for Webvan to pay Sheehan $375,000 per year for the rest of his life. I presume he receives that yearly take to this day.
The SEC thinks the disclosure of churn and related subscriber metrics would benefit current and prospective Netflix investors. I agree. In addition to the things many of us have discussed for months, such as Netflix's treatment of content acquisition charges, I wonder if the SEC should be equally as concerned with CEOs who fail, yet set themselves up for life on the backs of shareholders.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.