Netflix Didn't Deserve This Walk of Shame

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We sent a company down the daily Walk of Shame earlier this week. In my eyes, it had no business feeling guilty.

On Wednesday, fellow Fool Jim Mueller lambasted next-generation movie maven Netflix (Nasdaq: NFLX) for running a share repurchase program with borrowed funds. As Jim noted, Netflix doesn't really have to buy back any shares -- the company isn't in the habit of using tons of shares or stock options to pay its employees. Dilution is kept in check. Any buybacks, then, must be motivated by a desire to return value to today's shareholders. It's not a self-serving move, because Netflix executives and other insiders together own less than 4% of the company's shares.

Here's the buyback history that makes Jim shoot steam out his ears:

	Shares Repurchased	Amount Paid	Cost Per Share
Since Q2 2007	17.8 million	$545 million	$30.62
Q3 2009	3 million	$130 million	$43.33
Q4 2009 to date	1.2 million	Not disclosed	$44 to $51*

Source: Netflix conference call. * Based on share price range from Oct. 1 to Oct. 22.

Management calls this a good investment; Jim disagrees with a passion. Netflix is getting less bang for every buck invested -- and is borrowing money to do more of it. Now let me show you why this is a good idea.

Always look on the bright side of life
Like Jim, I'm a Netflix shareholder, so I want the company to do the smart thing just as much as he does. It would be awesome if Netflix could buy back shares for pennies on the dollar, especially if we were free to sell our shares for a sizable gain at the same time. But that's not how the market works. When you think stocks are cheap, you buy. When you think they're expensive, you sell.

Yes, Netflix shares have risen a lot lately. As I see it, though, if the company is still buying the stock with gusto, then its managers must believe in further gains ahead. Granted, business leaders don't have a crystal ball and do make errors in judgment. But just because Dollar Thrifty (NYSE: DTG) and Select Comfort (Nasdaq: SCSS) mistimed their leveraged buybacks badly doesn't mean that Netflix is making the same mistake.

Other bets like this have worked out very well. IBM (NYSE: IBM) spent $15 billion on share buybacks in a single quarter back in the spring of 2007. Big Blue had to borrow about $11.5 billion to pull off a repurchase program that big. Fast-forward through the financial crisis and widespread panic of 2008, and IBM's stock has climbed 12% while spitting out $4.30 in accumulated dividends along the way.

IBM is still buying back shares, even at today's higher prices. Why? Because IBM's management doesn't think it likely that the shares will be significantly cheaper anytime soon. And that's exactly how Netflix CEO Reed Hastings feels about his own company, too.

Hastings is not mortgaging the house to buy poker chips. $100 million will come from new revolving credit lines with Wells Fargo (NYSE: WFC) and Bank of America (NYSE: BAC), and the company is considering additional debt financing. In other words, the company is taking advantage of attractive credit terms to make a shareholder-friendly investment. What's wrong with that?

"The consensus Street estimate for subscriber growth and marketing expense is too low," if you ask Hastings. "And the consensus Street estimate for operating income and EPS growth is too high." And that brings me to ...

Earnings? We don't need no stinkin' earnings!
I believe that for companies like Netflix and VMware (NYSE: VMW), earnings don't really tell the whole story. As a result, I think it's a serious mistake to make your decisions to buy, hold, or sell Netflix based primarily on earnings growth.

In particular, the problem with applying traditional earnings models to Netflix is that the company's management isn't just out to maximize short-term earnings, you see. Instead, it tries to balance subscriber growth -- which translates into revenue growth -- and earnings against marketing expense. The current goal is to keep the operating margin close to 10%. In the past, higher marketing expense has resulted in faster subscription growth, but it has also pressured net income.

As you've already heard, Hastings himself thinks you should care at least as much about subscriber growth as you do about earnings growth. Looking in the rearview mirror, annual subscriber growth stands at 28% today -- and the company is taking steps to boost that much higher. So as I see it, the metrics that matter tell me that Netflix is somewhere between fairly valued and darned cheap. If I could borrow a few hundred million to invest in a value like that, I might take it too.

No harm, no foul
Don't get me wrong: I respect Jim's views as an analyst and writer. In my humble opinion, though, Netflix deserves some credit for making a gutsy call. I'm just here to give the other point of view. Time will tell who ends up being right.

Whether I just opened your eyes to a whole new world or you still agree with Jim's critique of Netflix, you can discuss the finer points in the comments below.