Stock-based compensation is an important part of many executive compensation packages. If employees and top management have a significant part of their own earnings and wealth tied to the company's stock performance, their interests will be aligned well with shareholder interests.
On the other hand, stock compensation leads to "dilution" of other shareholders; as more and more shares are issued, existing stockholders come to own a smaller piece of the business. Up to a point, this is a reasonable sacrifice, and can be justified when highly motivated management and employees are creating lots of value for all shareholders. However, in some cases, a company's management can become too generous with stock, so that the cost outweighs the benefit to shareholders.
The same is true for secondary share offerings and convertible debt. These tools can give a growing business access to low-cost capital. On the other hand, if the business is successful, its original shareholders will own a smaller piece of that success.
Netflix (NASDAQ: NFLX ) shareholders have experienced significant dilution of their holdings over the past two years from all of these factors, and this trend appears to be continuing. For now, shareholders are not complaining, because the stock has quadrupled since August. However, if the current run-up in Netflix stock turns out to be another bubble, shareholders may be dismayed to see that their ownership of Netflix has been diluted.
A stock bailout
Netflix had fewer than 53 million shares outstanding through most of 2010 and 2011 (roughly 54.4 million shares on a fully diluted basis), but the share count has been rising fairly quickly since then. The biggest factor was management's decision to use stock to "bail out" the company after several strategic missteps in 2011 led to a rapid drop in Netflix's profitability.
First, Netflix offered 2.9 million shares in a secondary offering in late 2011 to raise $200 million of new capital. (Ironically, while the shares were offered at approximately $69 each, Netflix had spent $200 million buying back stock at an average price of $221.88 earlier in the year.) Netflix also issued $200 million of convertible debt in late 2011. In April 2013, the company forced the conversion of that debt to stock, which added another 2.3 million shares of Netflix stock.
These two transactions provided a much-needed capital infusion in late 2011. However, Netflix created more than 5.2 million new shares in the process, diluting existing shareholders by nearly 10%.
Netflix has also maintained a fairly generous stock-based compensation plan for its employees. According to the company's most recent 10-K SEC filing, Netflix granted employees options for more than 1.8 million shares during 2012 at a weighted-average exercise price of $73.94. At Friday's closing price of $220.22, those options are worth $264 million; in other words, if employees exercised those options and then immediately sold the stock on the open market, they would earn a $264 million profit.
Indeed, Netflix employees are taking advantage of their stock options in light of the quickly rising share price. Whereas just 188,582 options were exercised in all of 2012, employees exercised a whopping 556,819 options last quarter alone, buying that quantity of Netflix stock at an average price of just $70.30 per share. There were another 4.26 million outstanding stock options with a weighted-average exercise price of $75.09 at the end of March. This implies that the dilution of Netflix shareholders will continue.
Who holds the value of Netflix?
As of last quarter, Netflix had 56 million shares outstanding, and the conversion of the company's convertible notes added another 2.3 million shares in April. Including Netflix's 4.26 million outstanding stock options, the company could soon have more than 62.5 million shares of stock, up from just 53 million shares two years ago: an increase of 9.5 million shares.
Those 9.5 million recently created (or soon to be created) shares are worth more than $2 billion at Netflix's recent trading price. By contrast, in the 10 years since it turned profitable, Netflix has earned a cumulative profit of just $800 million! The amount of stock being issued by Netflix is very significant in the context of the company's historical profitability.
Ultimately, Netflix may become highly profitable, but shareholders could rightly wonder how much of the company they will still own at that point. Netflix continues to have a seemingly unquenchable thirst for capital, which could lead to even further shareholder dilution. Will the eventual payoff be worth it? Only time will tell.
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