6.84 % Yield to Worst 2015 Call at par
Netflix (NASDAQ:NFLX) bonds are one of our favorite bonds, and we appreciate the opportunity to buy them while the stock is showing weakness. Although this Netflix bond is only rated Ba2 by Moody’s and BB+ by Standard & Poor’s, its underlying fundamentals exceed the stringent criteria that we use to find better yielding bonds and it provides an ideal example of why we think these official rating agencies may occasionally be mistaken in their assessment of a company’s credit worthiness. After considering Netflix’s very conservative balance sheet and liquidity, perhaps you might agree with us that the with its very low debt, high coverage, and large cash ratios compare more reasonably to that of other Aa/AA rated corporations rather than what is typically expected and found in companies sharing the junk status it’s currently branded with.
At Durig Capital, we have developed a process to screen, review, select, purchase and monitor high yielding corporate bonds. The following overview and supporting document/link illustrates some of the review and selection criteria used after screening thousands of separate corporate bond listings to find what we believe is currently the best corporate bond for investors, and it shows why we believe this corporate bond makes sense for our clients’ income portfolios.
Step 1 – Yield Curve at 4-7 Years Out
With the uncertainty that is griping the investment community, we have studied the yield curve in order to maximize earning higher yields while trying to protect against principal loss. Investors are disgruntled with savings accounts that are currently yielding an average of only .51% (per Bankrates.com.) With inflation ticking up at an annual rate of 3.9 percent, our clients want to know how or where they can intelligently attain a higher return with a reasonably acceptable level of risk, rather than keeping their money in a saving account where it is “safely” losing buying power at 3.39% per year.
Step 2 - A look at the issuer
Netflix is an extremely popular and low priced service, and they have been very successful with their mail delivery service. Working to gain an advantage and be ahead of the curve, they launched their video streaming service. Although many customers like these services, there have been a number of missteps in implementation.
The video streaming element is still a small, but fast growing part of their business that provides faster delivery, lower costs, and superior margins than the US postal service used for DVD deliveries and returns. This migration is likely essential for the future of Netflix, and they appear to be a primary leader both in introducing this service and in providing a quality product. While they clearly have a marketing advantage, it also appears that they have had execution issues.
Step 3 – We like companies that are profitable
Netflix Inc has found a very profitable niche in the multimedia rental market. Considering that they have put up herculean numbers in the past, their more recent hiccups seems to have proved this year that they are mere mortals. With that said, they have still provided outstanding profits that are built on the superior business model of annuitized income. In the latest quarter, Netflix posted a profit of $62.5 million, or $1.16 a share, which is up from $38 million, or 70 cents a share, a year earlier. Revenue jumped 49% to $821.8 million.
Netflix projects that it will now lose money for a few quarters starting in the first period, due to costs associated with an expansion in the United Kingdom and Ireland, and the ongoing build out of their technology improvement for streaming. However, they believe their Stream technology will increase margins about 1% per quarter going forward.
Step 4 - Interest Coverage Ratios
Netflix had $120 million in operations income last quarter, an unbelievable 22 times coverage of the roughly $5.3 million quarterly interest expense resulting from their debt. But with projected short term loses, coverage will possibly go negative the next few quarters. Knowing that the last quarter was influenced by many factors, we reviewed the previous calendar years numbers and found they had about 13 times coverage, which is well above most of the companies we review. In fact, this is a stronger number than several AA rated companies we follow.
Step 5 - We like companies with lower debt to cash ratio
Netflix reported long term debt at $200 million, and when including its additional $32 million property leases, total long term debt sits at $ 232 million. Cash and short term investments grew to $365 million. Cash on hand exceeds long term debt by over $ 103 million dollars, meaning that they are able to pay off 100% of the debt at will. This is one of the best cash to debt ratios in a company we have reviewed.
Step 6 - We like companies that have flexible balance sheets
Netflix currently has about a $4 billion dollar market capitalization, while long term debt is around $232 million. This debt to equity ratio of around .06 is among the lowest we have reviewed, even after Netflix’s recent sharp decline. In comparison, if a home were valued at $ 100,000, a relatively similar debt ratio would indicate an owner only owes about $ 6,000 to the banks. This gives Netflix one of the most flexible balance sheets we have analyzed.
Step 7 - We like high yields
This issue is first callable at a price of 104.25 in November 15 of 2013, or two years, which would return a yield of about 7.38 % if bought today at the premium price of 105.75. At this point it is unclear whether Netflix will exercise this option, as rates then may allow them to refinance at a much lower rate and save substantially on interest expenses. The yield to worst, assuming the more likely call at par in 2015, is 6.845 %, which is an outstanding rate. If the bond is held to maturity in 2017, a time frame concurrent with our economic outlook, it would return a highly coveted 7.305% and represents a whopping 5.7 spread above the 1.6 of corresponding maturity treasuries. Enclosed is a link to current junk grade bond offerings one can use as a benchmark against Netflix Inc.
Step 8 - Risks Considerations
Even though Netflix provides a very specialized movie service, they are still a rapidly evolving company and business, in an industry that is renowned for having bankrupted both previous major players, Blockbuster and Hollywood Video. It is worth noting that the innovative leadership at Netflix has kept them profitable throughout this last downturn and has worked hard to lead them into next technology, an element that was missing and was perhaps the major downfall of their earlier predecessors.
The Technology and Rental industries are very volatile and market capitalizations can experience breathtaking swings. However, the debt to equity ratio is so low for Netflix it remains in the single digits. This extremely low ratio provides excellent balance sheet flexibility, even if the stock were to decline another 50%.
Netflix may not be profitable for several quarters as a result of their global launches, and this would reduce their interest rate coverage and possibly decrease cash. Since this is an annuity business, these short term expenses and build outs could be scaled back if needed, and the annuitized cash flow makes them a more stable business than most.
The 6.84% yield till worst case scenario is very attractive for a diversified portfolio within the current market conditions. Although Netflix Inc. lacks an investment grade rating, the combination of extremely strong operating cash flow, a solid annuitized business model, and current cash position gives them is a very solid foundation. With one of the highest cash balances, current interest rate coverage high, and the lowest debt to equity we have analyzed, we believe Netflix should perhaps be rated much higher. However, we are taking advantage of this low rating as it appears to allow our clients to obtain a higher rate of return because of risk which we believe others have assigned incorrectly.
More news, information and updates can be found here.
Coupon 8.5 %
Yield to Worst 6.845 % 11/15/2015 call at par
Yield to Maturity 7.305%
Disclosure: Durig Capital and certain clients currently do have positions in Netflix bonds.