Royal Bank of Scotland to investors: 'Sell everything'

Right. They are fairly saturated in the U.S. There are still some developed markets elsewhere, where they still have room to penetrate pretty far. It's been a part of their narrative for a while. That, how much money they are spending on content creation, are their two big themes.

 

I don't agree. Netflix raised its prices. ... and the number of subscribers grew impressively during the quarter. They have been growing subscribers quarter after quarter.

Their problem isn't their value model. They are offering something that people love and they have saturated the U.S. market, and are trying to snatch up subscribers all over the world. I'd argue there are two problems not related to the actual product: A financial model problem and a valuation problem. But in terms of the product itself? It's great. The results bear that out.

In terms of the financial model, though, they have achieved their growth on the back of a massive amount of debt accumulation -- being allowed by manipulated debt markets that are funding things recklessly. The company now has about $22 billion in long term debt and other obligations. ... and it is not slowing down on the borrowing. The market won't cut them off (as a free market would if lenders perceived being on the hook for the risk), because price discovery in the credit markets has been thoroughly destroyed. Same as it was to a much smaller degree, when short-term interest rates were administered to be way too low for years in the name of "stimulus". ... and it led to banks giving half million dollar mortgages to people with no verifiable income in 2003 and 2004 and 2005 and 2006. This is what happens when you have a small group of price czars administering the most important price there is -- the cost of money. And honestly, "administering" is a charitable way of describing their actions. It's not like they ever act as the party pooper. They only know how to spike the punch bowl and create credit messes.

In the wake of their last self-induced credit mess, we needed a deleveraging. But they didn't have the fortitude to allow the necessary "failure." that was necessitated by what THEY did. So they dropped interest rates to nothing, and because that wasn't enough anymore to prop up their mess, they stepped into worldwide debt markets one by one and started buying up trillions of dollars of bonds (with money they created out of thin air) to drive up the prices and drive down yields. They are still at it. Close to a decade later, central bank balance sheets are still expanding and financial conditions are looser than they were when they first jumped into their rabbit hole. ... they are left blowing the bubbles bigger and bigger (and setting up the fall to be bigger and bigger).

That keeps it too cheap to borrow, and will make the next credit crisis much more severe. It allows governments to keep racking up debt, and most are at debt to GDP levels we have never seen before. It creates a trillion dollars and growing of student loan debt in the U.S. A looming subprime auto loan mess of more than a trillion dollars. Record amounts of revolving credit card debt. And it allows companies that would never be able to attract financing to borrow at will, and do it at rates that don't reflect their risk.

Netflix has been a borrowing machine. And it's cash burn rate has been staggering the past few years. That works great as long as the junk debt market will keep financing what they are doing and not care about cash flow. There is no organic growth there. ... yet, at least. And even if they can turn a corner and finance their growth via self-generated cash flow (something they themselves are saying they can't do, as they prepare to borrow billions more this year), their massive debt load isn't going to go away. Just servicing that debt in a normalized interest rate environment not being price fixed by monetary authorities is going to be a huge problem.

Without a giant credit bubble that has been spurred on by central banks price fixing borrowing rates, there is no way Netflix would have gotten to where it is. If (and really, it is more a question of when) there is a credit crisis because of all of the misallocated capital that has created ghost companies and overleveraged entities and borrowers on the hook for their crap, Netflix's debt is going to be an anchor on the company. When rates rise, because the BOJ and the ECB and the Federal Reserve can't keep their thumbs on the scales of finance any longer (whatever the catalyst that creates the next panic), Netflix is going to have difficulty servicing that much debt with that financial model.

As for the company's equity valuation. ... all of that money I mentioned that central banks created out of thin air to buy bonds (overpaying by definition)? That has created a giant casino in risk assets as that money filters through the banks. Companies that are growing their earnings anemically or not at all, borrow money and buy back their own stock in order to engineer higher stock prices (the stock market, which SHOULD be fueled by earnings no longer has anything to do with them). Big banks and high frequency momentum traders loaded with free central bank money (and at huge leverage ratios because there isn't a free market to keep them in check), chase things without any regard for price. Which is how you end up with a company living on borrowed money trading at 250 times its trailing earnings. i.e. -- a valuation problem. Anyone who buys the stock at that valuation without any understanding of how expensive the company's earnings are, is treating their money like its at a roulette wheel.

 

Pete, Everything you pointed out about them spending billions to try to be a subscription-based movie studio is correct. And your analysis about whether that is the way to go in the big picture, is probably pretty astute. My only point with regard to that was that you can't argue with their subscriber growth. They are selling something that people are buying.

But take a step away from that, because what started this was the panic buying in Netflix last night. You have a company that is burning through cash (doing what you pointed out), has something like $22 billion in long-term debt and other obligations already. ... it has plans to take on several billion more of debt this year. ... and oh, by the way, the company's stock is trading at 250 times its trailing 12 month earnings. What would you say about those fundamentals if I described ANY company that way? What other periods in the history of equity markets have we seen that kind of thing and what was the eventual result?

 

Amazon, Google and Facebook are all very expensive stocks, and Amazon is at at a valuation that will go down as ludicrous when the everything bubble pops.

But a major difference in their financial situations is that all three of them have positive free cash flow. Netflix doesn't. That includes Amazon, which has increased its debt dramatically over the past 3 years, in particular to finance the Whole Foods acquisition (it chose to, though, it didn't have to).

If you look at those companies on a spectrum, you have Netflix that is burning through cash and has borrowed heavily. You have Amazon which has borrowed quite a bit too, but has positive free cash flow, meaning it has an actual business that isn't being predicated on escalating debt-fueled growth. Facebook is virtually debt free, generates way more income than Amazon or Netflix and has much greater free cash flow. It's something of a free cash flow machine. And Google (Alphabet), which generates way more income and revenue than Facebook, has close to twice the free cash flow, but is carrying a bit of debt.

Google is by far the strongest of those businesses. Facebook is second (it has a pristine balance sheet). Amazon is a very distant third. And Netflix doesn't belong in any conversation related to any of those others, EXCEPT if you are discussing stock valuations that are out of whack. And even there, it is a matter of degree. Amazon trades at a trailing P/E of something like 350. Netflix at 250. Those are stock prices that are in batshit crazy territory given the earnings. Facebook and Google, on the other hand, are at 12-month trailing multiples of 37 and 39 respectively, which make them very expensive stocks. But at least someone trying to rationalize owning them can try to make a fundamental case for those valuations without getting completely into pets.com sock puppet territory.