Each quarter after Netflix (NFLX) reports earnings, I have plenty of fun not only writing articles about the report, but reading others.
Beyond the Three's Company-like antics of the last year, Netflix puts on nothing short of an entertaining conference call. For as many problems as I have had with it, I have to give it to the company. They have, even if not directly, responded to our complaints about the format.
I am not sure if the questions have just turned tougher as the company's fortunes swooned or if they're actively choosing more challenging questions for CEO Reed Hastings and CFO David Wells to answer, but, without a doubt, the duo fields more difficult queries this year than it did last. Plus, they've even opened up the end of the call to live phone-ins the last several quarters. Even more impressive, Netflix took at least two questions that I know of from Seeking Alpha contributors.
Bill Maurer is a long time NFLX bear. He writes of Netflix responding to his request for information:
Now, I submitted a question to the company for its conference call, asking about their convertible debt. If you go back to November, they raised $400 million. Half of that, $200 million, was purely selling stock. The other $200 million was zero coupon convertible debt, which, if conditions were met, could be converted after 6 months. My question to the company asked if they expected a conversion of that debt, and basically what the terms of the conversion were.
Netflix answered my question during the call with the following:
Yes. So the first convertible, 6 months after its issuance which was November, which places us in May, the company has the option of converting those shares at 30% over the conversion price, which is about $111. And the earliest we could do that would be July if the stocks had stayed above that price for 50 of the prior 65 trading days.
That's a better answer than Reed Hastings gave late last year at a conference hosted by UBS:
And then just to end on capital, you raised $400 million a few weeks ago as you mentioned, why did you do it as well as the need? Where does that leave you with your capitalization?
Well, we were probably adequately capitalized, but it was a touch in and the danger there is, when you're on the touch-in side is that suppliers get nervous. A conversation gets started, "How they going to pay their bills? What's going to happen," and then the suppliers get nervous and then they start wanting to cash upfront and that creates its own cycle, when you actually do have a cash flow problem that you didn't have before. So it's unfortunate on the 10% dilution, but it's worth it to sort of head that off, have plenty of cash and not have those set of issues come up.
Unfortunate. Yikes. Unlike Hastings' view, Maurer's analysis does not dilute the negative impacts of dilution:
At the end of the third quarter, Netflix had 53.87 million fully diluted shares. At the end of the first quarter, it was up to 55.456 million fully diluted shares. Add the 2.3 million more, if converted (the conversion price was around $85, so conversion not as likely now as it was yesterday), plus additional shares from exercised options, and we could see 58-60 million fully diluted shares by the end of 2012. To see what impact that has, let's just look at 2011, when the company made $226.126 (net income).
On the 53.87 million shares, the earnings per share number is $4.20. On 59 million shares, it would be just $3.83. That is a 37 cent difference, and that is with net income over $200 million. With net income for this year (and future years) expected to be much less, the additional share count will severely impact the earnings per share number, which will affect Netflix's valuation ...
That's one topic I did not cover in my initial Netflix post-earnings rehash. Plus, it's an SA question that Netflix bravely and ably tackled. And, as usual, Maurer does an excellent job adding color and a more sobering dose of reality.
Reed Hastings personally addressed two of my questions. Well, I think I inspired one. Hastings replied to it noting that with "No, we're not thinking of (selling our DVD division)."
I directly asked the other via email:
Can Netflix survive as a middleman? I define middleman as an intermediary between content owner and end user. Is the company's largely middleman status the reason for its apparent evolution to, at least in part, original programmer? How long do you think it will take to become a credible peer to HBO, which has had smash hit originals such as The Sopranos and Sex in the City?
Hastings attacked it head on.
In a nutshell, the CEO argued that plenty of middlemen are and can be successful. He made an analogy with retail, particularly supermarkets, noting that they largely serve as middlemen, but supplement these items with some of their own store-branded offerings. You know, like Whole Foods (WFM) selling its own line of Everyday 365 products next to brand names. That strategy has, undoubtedly, been one of the drivers of the high-end grocer's recent success.
Hastings went on to note that Time Warner's (TWX) HBO still licenses a majority of its content. He did not directly address the last part of my question concerning how long he thinks it will take Netflix to reach HBO status.
Analogies sometimes work out really well. Usually, they tend to miss the mark. And that's because, typically, when we make analogies, we water down comparisons. We leave out complexity. We ignore nuance. That's exactly what Reed Hastings did.
Horizon, the organic dairy company, does not limit the milk it will sell to Whole Foods. In fact, it only, presumably, gives Whole Foods the best it has to offer. To take that further, I have a better example.
I am not sure if these places existed where you grew up, but, when I was a kid, we had these Hostess outlets all over the place in Western New York. You could go in and buy Twinkies and Ho-Ho's at bargain basement prices, but you had to eat them fast. This was an outlet. And Hostess only provided the product it could no longer pass off on the major grocery stores and other retailers. It was about to expire so Hostess did not care if its product was marked down way below retail.
Speaking of analogies, you'll find a similar dynamic at play between Netflix and most of the companies it licenses content from. Generally, these companies sell Netflix content, on a non-exclusive basis, that they can no longer monetize. This explains why Netflix's streaming library is so thin and why Starz decided to pull its content from the service:
Starz will cease to distribute its content on the Netflix streaming platform. This decision is a result of our strategy to protect the premium nature of our brand by preserving the appropriate pricing and packaging of our exclusive and highly valuable content. With our current studio rights and growing original programming presence, the network is in an excellent position to evaluate new opportunities and expand its overall business.
At $8 a month, you're going to get the Twinkies and Ho-Ho's that are about to grow mold on them. Bottom line.
Companies like Horizon and Hostess go through middlemen, with virtually all of their product, because that's the most efficient route for them. It's even more efficient for a giant like Kraft (KFT). It's a different ball game in media, however.
The major content owners license middlemen like Netflix and Amazon.com (AMZN) product that's effectively about to expire. They keep the premium stuff to themselves to air via traditional channels and, where they see fit, on multiple platforms. They're also able to monetize that content in many ways.
I will not even address what Hastings said about HBO. I guess I will just eat crow when Netflix starts putting out original series that generate the sort of critical acclaim, mass publicity and ratings success programs such as The Sopranos command.
I am out of my NFLX June $40 puts for a loss. I made a nice gain on some January 2013 ITM puts in the $100,000 portfolio. If I played Netflix at all over the next several months, which I likely will not, I would consider using bear call credit spreads to generate income and profit from anticipated stagnation alongside slightly more weakness and fleeting bursts of strength.
If you're an experienced options trader, NFLX weekly options might make more sense than tying up equity and flirting with time on the monthlies.
Additional disclosure: I am long KFT in a custodial account managed for my child.