Thursday, September 22, 2011

Netflix's Awful Buybacks

Corporations can be pretty poor allocators of capital. (As an aside, Warren Buffett's ability to allocate capital towards its most efficient use is one of the major reasons his company has risen to the top. While every other company at the top had to invent something brilliant to get there, he got there just by properly allocating capital!) This chart provides an example of just how poor at allocating capital corporations are:

So when the market was booming, corporations were falling over themselves to buy back shares. When the market was cheap, corporations in the aggregate felt that buying back shares was a poor idea. (Of course, there were some corporations that were left in terrible financial shape and so they really couldn't afford to buy back.)

Nowhere is this situation more egregious than at Netflix, where the company bought back its own shares at ridiculously high prices. Over the last year and a half or so, Netflix has traded with a P/E of between 60 and 90. Despite this, those in charge thought it made sense to spend not some, but all of the corporation's earnings on share buybacks. In the last 1.5 years, Netflix has earned $290 million; it spent $305 million on buybacks over this same period!

As with all stocks trading at sky-high valuations, Netflix has since come down quite a bit. Its P/E is now barely over 30, suggesting a lot of those aforementioned repurchases have cost shareholders deeply.

This isn't a case of 20/20 hindsight, however. It has been clear to value investors for some time now that Netflix shares were trading at an unreasonably high plateau. Even on this site, where generally only companies that are potentially undervalued are discussed, Netflix's decision to buy back shares at astronomical prices was derided while they were taking place. Netflix was also featured on this site as a "buy" in an April Fools Day write-up, a great contrarian indicator! (As another aside, if things stay as they are, Amazon would make a great candidate for next year's April Fools Day buy.)

There was one group, however, that made out well with the buybacks: those shareholders who sold their shares into the company's over-priced buybacks. Company insiders, especially CEO Reed Hastings, were one such group. Netflix's insiders have sold over $1 billion worth of stock in just the last two years! This reeks of impropriety.

Tax policies may also have played a role in how Netflix decided to return capital to shareholders. Dividends are taxed, whereas gains accruing to shareholders as a result of buybacks are deferred for tax purposes and often taxed at more favourable "capital gain" rates. However, in this case, the losses from the poor buyback decisions outweighed any tax consequences that may have applied. Fortunately, shareholders can protect themselves from buybacks at poor prices with a relatively obvious antidote: only buy shares in companies that are not ridiculously overvalued. Therefore, cross Amazon off your list!

Disclosure: No position


Anonymous said...

Good stuff as usual. I agree with you on Netflix wholeheartedly, but those buybacks in aggregate that occurred from 2004-2007 (and picked up again post-crisis) seem rational. There is a wide spread now between the average earnings yield on stocks and corporate bond yields.

Investors for whatever reason - maybe they are nervous after two massive bear markets in 10 years, or they are baby boomers retiring - have shunned equities in favor of fixed income. This has caused a spread between earnings yields and corporate bond yields that hasn’t existed in a long time. It has created an opportunity for some corporations (where there balance sheet can stand it and it’s a decent business) to issue debt and buyback stock and boost eps and return on equity. It’s balance sheet arbitrage for corporations. For those who ignore it, they make for attractive LBO targets.

I’m thinking the next 10 years will witness an unprecedented move by large corporations that end up going private as a result.

Hester said...

A lot of the buybacks were done to offset dilutive, extremely generous option grants to Hastings and other execs. So it's even worse. A lot were done as bad capital allocation and a lot were done to cover an expense that wasn't properly accounted for.