Our interest is always piqued when activist investor Carl Icahn puts the moves on a company. As corporate raiders go, Mr. Icahn keeps himself busy.
Netflix (NFLX) has been on our avoid list since February of 2011, and our previous analysis on the company can be viewed here. NFLX shares are much cheaper now than when we were actively covering the company.
The options strategy being employed by Mr. Icahn in taking his NFLX stake is interesting. There has been much discussion regarding his plans and ambitions for the video and streaming content service provider.
At first glance, it appears to be a leveraged way for Icahn to maximize his reportable position while minimizing his capital risks. Does he want to see the business sold? Does he see potential for improving operating fundamentals? Does he want to shake up the board and bounce CEO Reed Hastings? One thing for sure is that he (Icahn) wants to make money.
Due Diligence: Mr. Icahn is no stranger to looking under the hoods of his target investments. His background in the credit markets has served him well. He also knows a thing or two about distressed companies, and the effect of liquidity issues on the value of underlying securities.
Thus, he has to be plenty aware of the poor state of NFLX's balance sheet and cash-flow capability. Yet, he obviously sees value somewhere down the line as a $169 million bet isn't chump change by any means.
Besides the usual strategic cost cutting and slash-overhead tactics, Icahn likely will focus on the mechanisms for NFLX to finance content acquisition costs (theoretical driver of future profit growth). Streaming media is the brave new world, but NFLX management and shareholders are keenly aware to the liability and cost of acquiring content.
Fix the balance sheet: Growing sales is an obvious goal for any earnings story, but managing the growth is equally essential. One area Mr. Icahn may focus on is to improve the quality of earnings being reported. The first step in this regard would be to generate (or extract) more cash from actual operations and be less dependent on non-cash financial engineering in constructing the earnings basis.
In the case of NFLX, improving the collection of receivables (shorter days-sales outstanding) and better management of payables would be good areas to start the cleanup.
Improve Capital Productivity: Expense controls are always helpful to the margin picture in any industry or enterprise. Managing the costs of asset utilization (per each dollar of sales) will be one tool to help meet this objective.
Sacrificing margins at the expense of growing market share is a reality of competition. However, costs to deploy income-producing assets need to be relative to the sales and earnings they produce. If, for example, inventory costs you $0.40 cents for each dollar of sales or receivables are $0.12 of each dollar of revenues, asset returns will be challenged.
At some point, the ability to recycle that capital efficiently will be a problem if the costs to deploy an asset rise at a faster pace than sales.
Accruals: Another area Mr. Icahn may address is how to strip out some of the noise in messy adjustments to the statement of cash flows. Things like depreciation, amortization and deferred "items" can distort earnings. Less reliance on non-cash and accrual accounting is one step to improving earnings quality.
If reconciliations to cash from operations, investing and financing (on statement of cash flow) don't correlate with the values represented on the balance sheet, net income may possibly be distorted.
How Icahn might benefit: Keep in mind that Mr. Icahn's interests are not always aligned with those of average shareholders. Sure, he wants to make money, but Mr. Icahn hunts with a bigger stick than most investors.
His 9.8% stake is a sign that a gorilla has entered the room. While his presence may be the catalyst for beneficial change going forward, Mr. Icahn has a tactical advantage many small investors don't have. We need him more than he needs us.
Yet, Mr. Icahn does his homework and it would appear he sees opportunity with NFLX. Aside from the competitive pressures, NFLX management and the board now realize they have a shareholder happy to help clean up the mess. Our guess is that Mr. Icahn will encourage stabilizing financial and liquidity issues as an immediate priority.
To the average investors wanting to ride on Mr. Icahn's coattails, pay attention to the events going forward. Activist investors can help to fatten your wallet, but they can also be out the exit as quickly as they arrived.