Recently, legendary hedge fund manager Whitney Tilson exhorted Netflix, Inc. (NASDAQ:NFLX) CEO Reed Hastings to do an equity offering as soon as possible. This was an unusual open letter written by Tilson, who is friends with and an admirer of Hastings, as well as long Netflix stock.
This is an interesting suggestion that solves certain problems for Netflix but may also create other ones. If you are a NFLX stock holder, it is very important to put this proposal in context.
Netflix stock has done enormously well over the years. However, its financial state has always concerned me, not to mention its valuation. Once management decided to move full force into original programming, it took the approach of drawing down a lot of debt in order to fund billions of dollars of original programming.
Drawing down debt may not be such a big deal for company with a lot of free cash flow. As Tilson points out in his letter, it is normally “well-established businesses with stable free cash flows” that take on debt. Companies with a depressed stock price may also often turn to debt over equity in order not to dilute shareholders.
But as Tilson points out, NFLX is neither well-established nor generating free cash flow. In fact, it is burning tons and tons of cash. The debt train is going to run out at a certain point, and any unexpected decline in revenues by subscription increases, could forestall the ability to meet debt service.
I don’t see that as a realistic possibility in the immediate near term, given that Netflix stock is backed by a couple of billion dollars of cash on the balance sheet.
Tilson’s argument is to do an equity offering. That does make some sense considering the valuation for Netflix stock is ridiculously high: trading at 12x revenues, 150x EBITDA and 250x trailing earnings.
I’m normally not much of a fan of equity offerings because of the extent to which existing shareholders are diluted. However, Tilson makes a very good point. With the current market cap of $137 billion, this outrageous valuation works to the benefit of an equity offering for Netflix stock.
Tilson suggests something like a $10-billion equity offering, which would allow NFLX to pay off all of its debt and give it a cash balance of close to $5 billion. However, the key to this offering is that it will only represent 8% dilution.
Tilson didn’t get to be where he is by making too many bad calls. I think, in this case, he’s right. The market is in the midst of a ridiculous bubble, which includes NFLX stock. If the Netflix stock price is outrageously overvalued, there is no better time to do an equity offering. An 8% dilution is a small price to pay for peace of mind.
Bottom Line on Netflix Stock
I don’t know when it will happen, but at some point, both the market and Netflix stock are going to experience a major correction.
While it is likely that both will recover in a relatively short period of time, a correction of 40% and unexpected economic news, could result in that correction lasting much longer. That would mean a substantially reduced valuation for Netflix and substantially greater dilution for shareholders.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance, and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at [email protected].