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  • Reflection on the Sokol Affair

    This blog assumes some familiarity with the Dave Sokol affair and Berkshire Hathaway.  Hearing Sokol on CNBC, it was unclear to me whether Sokol had acted wrongly given Lubrizol not being on Berkshire's restricted list, Sokol having no control over Berkshire's investments, and Sokol engendering nonpublic information in the form of a potential transaction only after his decision to invest in Lubrizol. 

    The potentially damning event from a legal perspective: "on December 17, 2010, Citi informed Mr. Sokol that Mr. Hambrick [Lubrizol CEO] had indicated that he would discuss Berkshire Hathaway's possible interest with the board."[1]  Is that material nonpublic information in itself?  If it is, then, and contrary to other commentaries, Sokol's Lubrizol buys thereafter might be considered illegal.

    Berkshire's "'Insider' Trading Policies and Procedures" may be further basis of discontent with the affair: "The trading of securities of Berkshire or any other public company while the trader is in possession of material nonpublic information is prohibited…. Other public companies to which this prohibition is applicable include those that may be involved in a significant transaction with Berkshire…."[2]

    In other words, Berkshire prohibited covered employees trading securities of a company with knowledge that it may be a Berkshire acquisition, and considered that knowledge material nonpublic information.  Sokol's trading may appear both contra Berkshire's internal policies and illegal from this standpoint.

    Others expressed severe disappointment with Sokol in early April, when I found potentially no fault with the affair.  I want to consider why.  I think it's due to three reasons.

    First, my unshared reaction in early April was before Lubrizol's April 11th filing.  Its March 25, 2011 filing made no mention of Sokol receiving feedback from Lubrizol in December: "On December 17, 2010, Citi called Mr. Hambrick and relayed the substance of the conversation between Citi and Mr. Sokol on December 13, 2010. Mr. Hambrick indicated that he would inform the [Lubrizol] Board of Berkshire Hathaway’s possible interest."[3]  That was the end of the December story.

    Contrast that with Lubrizol's statement filed April 11, 2011: "On December 17, 2010, Citi called Mr. Hambrick and relayed the substance of the conversation between Citi and Mr. Sokol on December 13, 2010. Mr. Hambrick indicated that he would inform the Board of Berkshire Hathaway’s possible interest and discussed that Citi would so inform Mr. Sokol. Later on December 17, 2010, Citi informed Mr. Sokol that Mr. Hambrick had indicated that he would discuss Berkshire Hathaway’s possible interest with the Board."[1]

    Sokol only instigated a potential discussion in the March 25th version.  He knew a material nonpublic discussion was underway in the April 11th version.  Sokol's trading may be contra Berkshire's policies in either case but also externally illegal in the latter case.

    I wonder whether Messrs. Buffett and Munger had a similar reaction to the revised disclosure.

    Second, the roughly $3 million Sokol profited on his Lubrizol shares struck me as immaterial relative to a typical investment banking fee for facilitating a $9 billion acquisition.  Viewing it simply, I thought Sokol must either have acted as an investment banker for Berkshire or not.  If he was, he should have received a transaction fee or compensation for acting in that capacity and it would have been obviously inappropriate to trade in a potential target, both because it would be frontrunning and because it would affect his duty of impartial analysis in the capacity.  If he wasn't, and had no control of acquisitions, why should he be restricted from investing in an unrestricted security before suggesting an idea to the acquisition department?

    That thinking was before I saw the full reported back and forth with Citi, which indicated that Sokol had not just potentially instigated but entered into an investment banking role regardless of his compensation terms, and was privy to consideration of a transaction.  That rendered his subsequent trading inexplicable.  I haven't seen this distinction between the March 25th and April 11th filings elsewhere highlighted.

    Third, as Michael Douglas' character Gordon Gekko says near the end of "Wall Street: Money Never Sleeps": "People are a mixed bag."  I've lost almost all of my heroes over the years as they've disappointed me in some way.  It's no fun to lose heroes.  I've tried to embrace that Gekko sentiment as a means of admiring in-many-ways admirable executives.  Sokol's actions disappoint me less than certain other actions that have yet to be widely criticized or rectified.

    I suppose the first two reasons were fair reactions to the facts presented in March.  The third reason bothers me a bit.  I want heroes.

    Notes and Disclosure

    [1] Lubrizol Corp PRER14A filed with the SEC April 11, 2011, accessed via 10kwizard.com.

    [2] Berkshire Hathaway Inc. memorandum from Warren E. Buffett "Re: 'Insider' Trading Policies and Procedures" accessed via Berkshire's website.

    [3] Lubrizol Corp PREM14A filed with the SEC March 25, 2011, accessed via 10kwizard.com.

    Disclosure: The author makes no commitment, and disclaims any duty, to update this disclosure.  The author does not intend to update this disclosure.  The author manages a limited partnership and separate accounts (collectively, "accounts").  None of the accounts owns any security of Berkshire Hathaway Inc. at this time.  The author may buy or sell any position at any time.  The author may change positions in light of emergent facts or considerations, including new price-to-value estimates of the author's current and prospective investments.

    Tags: BRK.A, BRK.B
    May 02 2:33 AM | Link | Comment!
  • Netflix Q1 2011: Imaginary Q&A Series

    Netflix (NFLX) is scheduled to answer select questions submitted by email to ir@netflix.com the afternoon of April 25, 2010.  Here's how I imagine a decent call would sound:

    OPERATOR: Welcome to the Netflix First Quarter 2011 Earnings Q&A session.  Please note your line has been placed on mute, because most of you tend to rant non-stop.  We may make forward-looking statements today….  Your first question comes from the line of Righteous Capital. 

    RIGHTEOUS CAPITAL: Thanks.  Netflix announced former CFO's Barry McCarthy's departure December 7th.  In November, he cashed in around $40 million – some 230,000 shares, substantially more than he'd sold in any prior month recently or ever.  Is knowledge of the impending departure of a public company CFO material information?  Should your executives sell Netflix shares while in possession of material nonpublic info?

    NETFLIX: I believe the shares were duly sold pursuant to a Rule 10b5-1(c) plan, such that the timing of his relatively large sales was a coincidence.

    RIGHTEOUS CAPITAL: Uh huh.  Just one more.  Your "Reference Guide on our Freedom & Responsibility Culture" urges salaried employees: "You focus on great results rather than on process."  Does this mean you focus on meeting earnings and cash flow targets rather than consistent accounting and working capital management processes?

    NETFLIX: Come on, it's a well-regarded management tool: set a target, give high-grade people latitude to innovate on the process that attains it. 

    RIGHTEOUS CAPITAL: So your answer to my question is … 

    NETFLIX: Next question.

    OPERATOR: And your next question comes from the line of Really Skeptical Capital.

    REALLY SKEPTICAL CAPITAL: Jim Pyke at Seeking Alpha notes that Netflix ended 2010 with about 20 million customers and has lost about 32.6 million subscribers in total.  Moreover, the subscribers lost each year were consistently 66%-75% of Netflix's starting subscribers in each of 2006, 2007, 2008, 2009 and 2010.[1]  Rob Fagen suggests "A great deal of those that leave eventually come back."[2,3]  Let "active subscribers" denote only subscribers with a Netflix account duly paid within the trailing 30 days.  What percentage of the 32.6 million subscribers who left Netflix were active subscribers at March 31st?

    NETFLIX: We're focusing on the current subscriber count as a key metric, which encompasses net churn.

    REALLY SKEPTICAL CAPITAL: Well, there are broadly two models of Netflix growth.  In what we might call the "Niche Leader" view, Netflix has developed a unique collection of content for a modest price point, has loyal customers, and is becoming increasingly valuable to customers and content providers alike.  In what we might call the "Death Spiral" view, Netflix appeals to most customers for less than a few years: Netflix subscribers catch up on select old content, then cancel the service for ages.  Rapid subscriber growth would mask churning through an addressable market toward net subscriber losses. 

    Do you consider whether Netflix subscribers' churn and rejoining more resemble a "Niche Leader" or "Death Spiral" to be material information?  Is it appropriate for Netflix employees to sell stock while in possession of material nonpublic info?  In light of our nation's securities laws, would you like to reconsider your declination to answer the 32.6 million question now and to break down churn in every future …

    OPERATOR: It appears we lost the connection. 

    NETFLIX: Bummer. 

    OPERATOR: Your next question comes from the line of Fundamentally Sound Capital.

    FUNDAMENTALLY SOUND CAPITAL: You wrote in January, "We think there are two fundamental questions for investors: (a) What will our domestic growth trajectory be over the coming years, given our strategy to maintain modest domestic operating margins so that we can invest aggressively in additional streaming content? (b) How successful will Netflix become outside of the United States?"[4] 

    You reiterated that view earlier this month: "Those are the two core investor questions … and then the question is 'Well, what's the appropriate discount to apply to those?'  That's where the investor judgment comes in.  And then once an investor answers those questions for themselves, then they can figure out if they want to be a buyer of our stock at the current price."[5]

    NETFLIX: That's right.

    FUNDAMENTALLY SOUND CAPITAL: Now in comparison with Netflix's 20-odd million customers, Google's (GOOG) YouTube has 144 million unique visitors in the U.S.[6]  Former CEO Eric Schmidt "told Google's board of directors that his estimate of YouTube's worth was somewhere between $600 million and $700 million" five years ago, "according to court records reviewed by CNET."[7]

    NETFLIX: Are you asking a question?

    FUNDAMENTALLY SOUND CAPITAL: Of course.  As you propose we can value Netflix simply based on its growth trajectory, should we consider Netflix worth $700 million – $13/share – if we think Netflix will reach 144 million American users in 5 years and even more abroad, delivering splendidly on what you call the "two fundamental questions for investors"? 

    NETFLIX: I think that's too simplistic.

    FUNDAMENTALLY SOUND CAPITAL: Of course it is.  Here's the problem: what you call the "fundamental questions for investors" – and consequently focus your reporting on – disregard earnings, cash flow, pricing power, the nature of subscribers' churn, and your view that "operating margins in an industry are really determined by the number of competitors.  So if there's three or four roughly equal-sized competitors at maturity, you'd expect pretty low operating margins.  If there's one firm that's the leader in the market, you'd expect higher operating margins.  So it really depends upon the competitive climate as opposed to something inherent in the cost structure."[8]  Those are your insighftful words.  Now would you like to recant your suggestion that Netflix can be valued on the basis of its headline growth without regard to earnings, cash flow, pricing power, the nature of subscribers' churn, or competition?

    NETFLIX: Okay, okay.  Let's talk about competition.

    Amazon (AMZN) looked into licensing every title we offer, and balked at the price.  They must not have seen a decent return on investment in what we're doing.  Of course they didn't.  Investors can we see we didn't generate cash net of our expenditures in the last year, even with the favorable Starz deal.

    FUNDAMENTALLY SOUND CAPITAL: Do you think you have a durable algorithm advantage?

    NETFLIX: Not really.  Desire, intelligence and resources held about constant, more data equals better algorithm.  We have leading data now, but Amazon or Google could catch up fast if they nearly match our streaming library and serve millions of users.  They're not incompetent at preference algorithms; they could just use more data.  That's one reason we hope YouTube won't license our streaming content this year.

    FUNDAMENTALLY SOUND CAPITAL: You consider Amazon and Google your main competition?

    NETFLIX: Well, let's not forget Charlie Ergen (DISH) with the potential triple-play threat from satellite and now Blockbuster brand, the model of Zediva that could render our streaming investment worthless if it works, or Wal-Mart's Vudu (WMT).  Vudu might offer an unlimited streaming plan with around 80% of proceeds divvied up among content providers in proportion to content consumed, like a consignment store that requires no outlay for inventory.  They could match our streaming service and price without investing a dime in content.  Wal-Mart's a bigger threat to us than Apple (AAPL), because it welcomes thin margins.

    Google meanwhile could spend our entire cost of 'net operations to replicate our streaming service on YouTube Live and take our subscribers who'd prefer free to not free.  Google could do that to become a behemoth in internet-connected TVs.  I doubt they will, but they could wipe out our streaming service easily now with I imagine less than 20% of their cash.  That would kill our business.

    OPERATOR: Your next question comes from the line of Churn Em & Burn Em Capital. 

    CHURN EM AND BURN EM ANALYST: I can't believe I'm hearing this.

    NETFLIX: Well, look, Salesforce.com (CRM) is priced at a gazillion times earnings.  OpenTable (OPEN) is priced near 100x EBITDA and could be displaced by a Google app.  Youku (NYSE:YOKU) is priced near 100x revenues.  Lululemon (LULU) sells patent-free spandex and is priced near 50x earnings.  On one hand, never bet against yoga shoppers.  But clearly the market's overheated.  Why begrudge me pumping NFLX through valuation-irrelevant growth stories to momentum junkies who never view our owner earnings?  

    Besides, there's an upshot to this.  We'll raise a billion in a smooth secondary offering, operate at weak margins, bulk up to 60 million subscribers, raise another couple bil, and have a streaming library that no competitor will match when they can see we're earning peanuts.  Then kapow: we'll hike our monthly price to $14.99 and most customers will stay because there'll be no better deal. 

    We'll remain a sweet deal.  We can even save marriages: we'll find movies rated four stars for both of you.  Of course, you'll each need an individual Netflix plan to enable that. 

    We'll go from about cash flow breakeven, or modestly bleeding money continuously, to boom: an extra $4 billion from that $14.99/month price plan dropping to the pretax line.  Investors can capitalize that at $50B.  Come on, cheer it with me: eff eye eff tee wy!  And the crowd roars, "billion baby!"

    CHURN EM AND BURN EM ANALYST: Billion baby!

    NETFLIX: Competitors wouldn't fully challenge us on the way up because they could see we weren't generating cash.  Then boom: we win. 

    We'll invest our several billion annual owner earnings in becoming bigger and better to our customers' delight, making it ever harder for anyone to reproduce our offering at our price point.  It doesn't matter that we're worth bubkis today and would die a slow death if we never raise another dollar from the capital markets for our streaming content licensing spree. 

    You see, we have a plan.  Now, would all the bears like to back down as fast as my friend Whitney?

    CHURN EM AND BURN EM ANALYST: Thanks, that was helpful color. 

    UNIDENTIFIED CROSSTALK: Dude, what does color mean?  I don't know, but analysts say it as if they know what they're talking about.  I like blue.

    CHURN EM AND BURN EM ANALYST: Just to confirm I'm hearing you right, you're saying Netflix isn't fundamentally worth anything today based on operating around cash flow breakeven in the foreseeable future, and Google could spend a fraction of its cash to replicate your streaming service if it wants to, basically wiping out the prospect that you'll ever earn big money.

    NETFLIX: Well, yeah.

    CHURN EM AND BURN EM ANALYST: Great, we'll raise our target to $300/share.

    OPERATOR: That concludes today's conference call.  Please kiss our derrieres after the call to be considered among underwriters in our upcoming secondary offering.  Finally, please note that today's call includes entirely imaginary statements that may bear no semblance to reality beyond verifiable facts. 

    Notes and Disclosure

    1. Jim Pyke, "The Netflix Churn Challenge" at Seeking Alpha, February 10, 2011 (here). 

    2.  Rob Fagen, "What Do You Get When You Buy Netflix?" at Seeking Alpha, February 4, 2011 (here). 

    3.  Seeking Alpha contributor Rob Fagen "exercised and sold about 8% of my employee options today" on or about January 27, 2011 (here).  Reed Hastings reported selling 5,000/61,500 = 8.1% of a tranche of stock options January 27, 2011 per a Form 4 filing with the SEC accessed via 10kwizard.com.

    4.  NFLX 8-K filed with the SEC January 26, 2011, accessed via 10kwizard.com.

    5.  Henry Blodget and Dan Frommer, "Exclusive Interview with Netflix CEO Reed Hastings," Business Insider, April 4, 2011 (here). 

    6.  Tiernan Ray, "Netflix: Google's YouTube A 'Substantial' Threat, Says Wedge," Barron's Tech Trader Daily, April 8, 2011 (here). 

    7.  Greg Sandoval, "Schmidt: We Paid $1 billion premium for YouTube," CNET, October 6, 2009 (here). 

    8.  "Netflix CEO Discusses Q4 2010 Earnings Call Transcript" by Seeking Alpha (here).  

    Disclosure: The author manages a limited partnership and separate accounts (collectively, "accounts").  Some of the accounts own put options on one or more of NFLX, OPEN and YOKU.  The accounts have no other position in stock or stock options of companies mentioned above upon article submission.  The author may buy or sell any position at any time.  The author may change positions in light of emergent facts or considerations, including new price-to-value estimates of the author's current and prospective investments. 



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Tags: AAPL, AMZN, CRM, DISH, GOOG, LULU, NFLX, OPEN, WMT, YOKU
    Apr 20 5:24 PM | Link | 15 Comments
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