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Drunken speculation

22 October 2013 By Robert Cyran

Netflix stock has quadrupled since January. Chief Executive Reed Hastings warns that momentum investors have become too euphoric. Diluting the punchbowl by issuing more equity is a better way to calm this rowdy party – and answer doubts about the online video company’s balance sheet.

Netflix and Hastings have seen similar surges in the company’s value before. The stock quintupled in 2003. But Hastings knows the market can be manic-depressive – he points out the headlines today about its stock performance are “exactly the same as in 2003.” The stock lost two thirds its value in 2004, and saw another surge and plunge in 2011.

Such upward spikes carry problems. Equity grants may de-motivate employees if they soon fall massively underwater. Managers face intense shareholder pressure to deliver unrealistic earnings improvement commensurate with the stock’s multiple. That increases the temptation to fudge financials or invest too much in speculative projects to deliver extraordinary growth.

Hastings’ simple warning won’t be sufficient. The stock rose 11 percent in after-hours trading as investors reveled in the firm’s quarterly earnings, which were four times as high as a year ago. Instead of using the power of the pulpit, Hastings should consider issuing equity.

Netflix’s balance sheet contains just over $1 billion of cash and short-term investments. It also had $6.4 billion of off balance sheet agreements to pay content producers as of June 30, with $2.5 billion due within a year. Selling stock would give the company cash it could use to pay off obligations, sign more movie deals, keep for a rainy day – or buy back stock should sentiment turn against Netflix again.

This is the kind of troublesome stock euphoria that, if managed wisely, could make for a happy ending.

 

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