If you run an investment bank, which basically takes a cut of economic prosperity, it's good to have a backup plan for when there's not so much prosperity. So you try to build some countercyclical businesses. In boom times you lend lots of money to people to let them buy McMansions. In crises you make lots of money on widening bid/ask spreads and volatility. In recessions you, I don’t know, get free money from the Fed and hunker down and ZIRP and buy gold! That’s the theory. Sometimes it doesn’t work.
Now of course that theory is not equally good for everyone in all of those businesses. The ranks of cupcake bakers and artisanal dog walkers these days are filled with former MBS structurers. Guys who set up distressed commercial real estate funds in 2009 were often shut out of the market by the time they’d raised money.
The smart move is to be in a business that makes money in boom and bust. Some whole firms look like that. Places like Lazard and Greenhill are basically in two businesses, M&A and bankruptcy, and bankers who can do both well are relatively insulated, stitching together big levered deals in the good times and selling off the bits when they go bankrupt. I worked in a group that did both equity-linked issuance and stock buybacks. Buybacks tend to be done when companies are flush with cash and investment opportunities are limited; equity-linked securities often come from companies that are a bit down on their luck but still have ways to put money to work. So you've gotten long some economic volatility, and you've got both peaks and troughs covered.
But, of course, if someone is making money both ways, then someone is losing it both ways. Companies build empires at expensive prices and divest them cheaply, paying transaction costs both ways. And boy do they ever sell stock low and buy it high. Still, it is rare to see an illustration of that quite as breathtakingly perfect as Netflix's announcement yesterday that it was issuing $400 million of equity and convertible bonds, after spending most of the last year and a half buying back stock. Now, first of all:
But it's better than that. Not only were their decisions terrible, but they had perfect symmetry of terribleness. As Kid Dynamite puts it:
Netflix bought back $199.7 MM of its own stock during the first nine months of 2011 @ an average price of $222 per share, and then sold $200 MM of stock this week at $70 per share. Ouch. Buying back stock that later plummets in price is bad enough – but buying back stock that then falls in price and issuing a notional amount of stock at the lower price equal to the total sum you bought back at triple the price is inexcusable.
Simplifying further: the company bought back about 900,000 shares at an average price of $222, spending about $200 MM. Then they sold 2,857,000 shares at $70, raising $200 MM. Net cashflow: zero. Net share issuance: 1.957MM shares. Nice trade. (/sarcasm)
Also it's, like, fractals of ridiculousness. If you take into account (1) the buybacks in 2010 and (2) the fact that NFLX issued a convertible struck at $85.80 along with its stock deal, the symmetry is less embarrassing but almost as perfect. NFLX bought 3.5 million shares of stock at an average price of $117 in 2010-2011, at a total cost of $410 million, and paid for it by issuing 5.2 million shares of stock at an average price of $77 in November 2011, for total proceeds of $400 million – minus $3 million that we pay to Morgan Stanley and JPMorgan to place the deal. So 1.7 million extra shares outstanding for net proceeds of negative $13mm or so.
Netflix investors are not the only people who are not so jazzed about how companies are handling their capital structures these days:
[S]hare buybacks have not fulfilled their stated purpose of rewarding investors over the last decade, experts say. “It’s a symptom of a deeper problem, which is a lack of investment in the long term,” said William W. George, a Harvard Business School professor and former chief executive of Medtronic, a medical technology company. “If we’re not investing in research, innovation and entrepreneurship, we’re going to be a slow-growth country for a decade.” ...
“It’s an extraordinarily unimaginative way to use money,” said Robert Reich, a former secretary of labor under President Clinton who now teaches public policy at the University of California, Berkeley. After diving in the wake of the financial crisis, buybacks have made a remarkable comeback in recent years, with $445 billion authorized this year, the most since 2007, when repurchases peaked at $914 billion.
I disagree, as it takes quite an imagination to dream up the Netflix trade. Still, they have a point:
The principle behind buybacks is simple. With fewer shares in circulation, earnings per share can rise smartly even if the company’s underlying growth is lackluster. In many cases, like that of the medical device maker Zimmer Holdings, executives are able to meet goals for profit growth and earn bigger bonuses despite poor stock performance.
“It’s clear there’s a conflict of interest,” said Charles M. Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. “Unless earnings per share are adjusted to reflect the buyback, then to base a bonus on raw earnings per share is problematic. It doesn’t purely reflect performance.”
I'm not sure Charles Elson's theory of return on equity is that much more sophisticated than Reed Hastings's, but let that go. He's basically probably right that most companies are rewarded for squeezing every last penny out of EPS - in executive bonuses, sure, but also in stock price more broadly. It's what investors want. So they get buybacks. And by reducing cash cushions and/or "investment in the long term," those buybacks increase the likelihood that those companies will eventually need to come back to the markets to raise cash.
Wall Street is long volatility here: smooth, flat markets and plodding companies don't create many trades, while volatility, even directionless volatility, shakes things loose and creates opportunities for mergers and divestitures, buybacks and issuances. If Wall Street is long, then someone is short.
A sad fact of life is that hedging a short volatility position increases volatility. If you sell a put, you need to sell more stock to hedge it as the stock price goes down - and your selling pushes the price down further. So with Netflix: when things are good and it's rolling in cash, it pushes up its price by buying. When things are bad and it needs cash, it pushes down its price by selling. And its incentives are neatly aligned to do so: when things are good, it needs one more penny of EPS; when things are terrible - hell, who cares about dilution when you're unprofitable anyway? (It's a good thing!)
Of course Netflix's troubles aren't really Evil Wall Street's fault. Sure they issued 1.7-1.9mm shares for literally nothing, and paid fees to MS and JPM for the privilege, and sure the banks were probably pitching both the buybacks and the issuance - but Netflix had no trouble losing money all on its own. After all, it lost $2 billion of market cap in three weeks by announcing and then reversing its Qwikster ekscapade. We can only hope that no one advised Netflix to do that. Still, though, Netflix's endlessly repeated knifepoint muggings at the hands of the capital markets do help explain why some people don't think those markets are all they're cracked up to be.
There is some good news, though. If you believe that a lot of companies operate on the principle of "buy at peaks, sell at troughs," then this deal at least suggests that NFLX may have hit a bottom. Which could mean that a new unlimited Metrocard is in somebody's future.
Netflix – How Not to Manage Your Capital Structure [Kid Dynamite]