An Open Letter to Reed Hastings: Do an Equity Offering Now

Whitney Tilson |

Image via Mondileinchen/Wikimedia

  • I am a huge admirer of Reed Hastings, a bold visionary striving to make his company a market leader in an enormous emerging global market
  • To do so, Netflix has been making big up-front investments, resulting in billions of dollars of negative free cash flow
  • To fund this deficit, Netflix has issued billions in debt
  • Carrying so much debt is risky – and makes little sense in light of Netflix’s richly valued stock
  • Therefore, the company should do a large equity offering immediately
  • The same arguments hold true for Elon Musk and Tesla

Netflix (NFLX) CEO Reed Hastings is one of my favorite CEOs. His bold and visionary leadership of Netflix has led the stock to increase more than 40 times in the last 5½ years. He’s also a great human being – a genuinely nice guy with a heart of gold (as a young man, he served in the Peace Corps (like my parents), teaching math in Swaziland, and currently serves on the national board of KIPP charter schools (I’ve been on the board of KIPP NY for more than 15 years)).

I have a long history with Netflix’s stock, starting with my foolish decision to be short it as it more than doubled from $11 to $26 in 2010 (adjusted for a subsequent 7-for-1 split). In frustration, I published an 18-page report, Why We’re Short Netflix, in December of that year, laying out my short thesis.

(If you’re interested in shorting – learning from two dozen of the best short sellers and hearing their best, actionable ideas – come to the one-day conference I’ve organized in NYC on Thursday, May 3, The Art, Pain and Opportunity of Short Selling. A list of speakers, further information, and registration is available at www.kaselearning.com; Seeking Alpha readers can get 10% off by using discount code SA10.)

To my astonishment, Hastings responded with an open letter only four days later, Netflix CEO Reed Hastings Responds to Whitney Tilson: Cover Your Short Position. Now., which began:

A great investor and a wonderful human being, Whitney Tilson recently posted an article about why he is short Netflix. Whitney, who is a major co-donor with me to charter public schools like KIPP, writes that he has lost money betting against Netflix, and that he is still short Netflix in a big way.

At Netflix we mostly focus on building our business and letting the numbers do the talking. But Whitney is such a big-hearted donor to causes that I care about that I am writing this open letter for him to try to get him to cover his short now. My desire is to increase his odds of making money next year so he can donate even more to the charter public schools that we both think are important to our country’s future. For the record, I think short sellers are a positive force in capitalism, and I acknowledge that CEOs are generally biased in their bullishness on their respective firms.

He concluded his detailed letter:

To wrap up, I have to agree with my friend Whitney that there are many risks ahead for Netflix, that our valuation is substantial, and that it is possible that one could make money shorting Netflix today. But shorting a market leading firm as it is driving a huge new market is a very gutsy call. On balance, I would rather have my co-philanthropists on the long side of this particular bet.

Whitney: Short or long, I look forward to dinner and drinks together in the New Year.

Respectfully, your ally and admirer,

-Reed

In all my years of shorting, I’ve never once had a CEO respond to me in such an open, friendly and thoughtful way. (Note to all short sellers: if you ever get a response like this from the CEO of a company you’re targeting, cover your short immediately!)

My partner and I accepted Hastings’ offer to meet and we had brunch with him six weeks later near his home in the Bay Area. He was such a great guy – and such a smart thinker – that we immediately realized we didn’t want to be short any company he was running – at any price! – so we covered our position and published another in-depth report a few days later, Why We Covered Our Netflix Short.

The stock subsequently rose to over $40 and then, amidst the Quickster debacle, fell more than 80% to a low of just over $7 a year and a half later. I can only think of a handful of times in my career when I bought a stock I had once been short, but I was so impressed with Hastings and had developed such deep knowledge of and appreciation for the company that I did so here.



I didn’t buy it the day it bottomed on October 1, 2012, but I pitched it that very day at my investing conference (to see my slide presentation, click here) and went on CNBC immediately afterward to share my view that Netflix looked very similar to Amazon 10 years earlier – and had a similar chance to go up 10x (little did I know that this prediction would prove to be so conservative!).

I made five times my money in less than a year before I (stupidly) exited and have been following the stock ever since, with a mixture of regret, admiration and amazement. It’s not often that one sees a company go from a $3 billion to a $137 billion market cap in such a short period.

An Open Letter to Reed Hastings: Do an Equity Offering Now

I am grateful to Hastings for the public letter he wrote to me in December 2010, which helped me see the errors in my thinking and spurred me to take action to protect my business, so I’d like to repay the favor with this open letter:

Dear Reed,

Congratulations on your company’s enormous success – well deserved!

I think you would be well served, however, to read the column that ran in the Financial Times recently entitled, This is nuts, when does Netflix crash?.

I don’t think your stock is likely to crash – but neither can I rule it out, especially from the extremely high valuation level it sits at today. It’s happened many times before and could certainly happen again.

What really caught my eye in the FT article is that Netflix has $6.5 billion of debt ($3.7 billion net of cash), which is primarily the result of an $11.9 billion investment in streaming content assets over the last five years, as this chart shows:

Investing so heavily in content was a bold bet that is paying off big time, as your market cap has expanded by well over $100 billion during this period. It has, however, led to $4.4 billion of negative free cash flow (operating cash flow minus cap ex) over the last three years, which has been funded almost entirely with debt, as this chart shows:

Raising Debt vs. Equity

Deciding whether to raise cash via debt vs. equity is one of the most important – and, often, tricky – decisions a company can make. Much value can be created – or destroyed – with the wrong decision.

In light of your stock’s performance, funding the free cash flow deficit with debt was the right call over the past few years.

But no longer.

Debt is risky. It’s easy to get lulled into complacency when your market cap is so high, but that can change – and quickly. You can’t pay interest and principal on debt with your market cap, only cash – and your company is burning quite a bit of it.

Additionally, your debt level, as measured by a commonly used metric, is now quite high at 7.1x trailing EBITDA (4.1x net debt).

It makes sense for well established businesses with stable free cash flows to take on debt –sometimes even a lot of debt. Additionally, even lesser companies may correctly choose debt over equity because their share price is depressed and they don’t want to dilute shareholders.

But neither of these things is true with Netflix today: it’s not a well-established business with stable free cash flows, nor is the stock depressed. In fact, just the opposite: it’s trading 12x revenues, 153x EBITDA, and 251x trailing earnings!

In light of this, I strongly recommend that you do an equity offering to: 1) pay off all of your debt; and 2) build a substantial cash hoard. I’m thinking something along the lines of $10 billion. This sounds like a lot of money, but with your $137 billion market cap, it would result in dilution of less than 8%. The significant strengthening of your balance sheet would not only reduce risk, but also send a message of strength to every company Netflix does business with and competes against.

You have one of the most valuable currencies in the world – your stock. The market is offering you an extraordinary opportunity available to only a few companies – it would be madness not to take advantage of it!

It would no doubt drop the stock a few percent in the short term, but remove a major risk that, under certain circumstances, could threaten your company’s future.

The best leaders are the rare people who, when the sun is shining and skies are blue, prepare for a storm.

Respectfully, your ally and admirer,

Whitney

PS—I would give the same advice, but even more emphatically, to Elon Musk right now. Like you, he is a bold visionary, investing heavily in the future, but piling up even more debt on Tesla’s balance sheet to fund even deeper negative free cash flows, as this chart shows:

He too should be using his richly valued currency to avoid the risks outlined in this cover story in last week’s Wall Street Journal, Tesla’s Make-Or-Break Moment Is Fast Approaching.

This article is published with permission of the author and was originally published on Seeking Alpha.

DISCLOSURE: The author has no positions in any stocks mentioned, is not receiving compensation for the article. He has no business relationship with any company whose stock is mentioned in this article.


The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
NFLX Netflix Inc. 351.29 2.00 0.57 7,817,400 Trade

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