"It's always nice to have more money than you need," Netflix
How nice that mentality would have been earlier this year. Netflix spent $199.6 million repurchasing its stock in the first three quarters for an average price of $221.9 per share. Now that shares have plummeted and its cash needs are ramping up, it's selling those shares back to the market for a fraction of what it paid for them.
Companies have a poor track record of managing share buybacks, but this might be the most egregious example of wasting shareholder money in recent times. By selling $200 million worth of shares for 70% less than it paid for them just months ago, Netflix effectively flushed $140 million of shareholder wealth down the drain in nine months flat. That's the equivalent of losing 1.3 million subscribers for a year.
Netflix has a history of questionable buybacks. As The Wall Street Journal notes, "Between the start of 2007 and June 30 of this year, Netflix generated $507 million in free cash flow. Yet, over that same period ... it spent $994 million buying back shares." It did so in part by issuing debt.
This is virtually unheard of for young technology companies. Google
There are two reasons why, both of which Netflix can learn from.
Young companies, particularly in the technology field, need buckets of cash to guard against encroaching competition and a fickle economy. Years ago, Bill Gates noted that he always wanted enough cash in the bank to cover Microsoft's
You want to retain enough so that the company has the strength to be able to take big risks, even in the face of some economic uncertainty. So, I've always been a big believer in having a very strong balance sheet for the company.
It's been interesting, traditionally technology companies did not do that, but I'd say over the last five years, the Microsoft approach on that has become more typical, some having balance sheet[s] in some numeric respects with even more cash on them than we have.
This isn't to say one should hoard. A rapidly growing company like Netflix can put cash to work expanding operations. On a shareholder conference call this summer, one analyst asked Netflix CFO David Wells a simple question:
Given your relatively modest cash position relative to the size of checks you're writing for content, and the success you're having with that content investment, what is the rationale of buying back stock? Given the multiple you get for subs, won't you generate more value by investing and adding subs versus buybacks?
By any reasonable standard, the correct answer was: yes. Netflix generates more value investing in its business than it does repurchasing its shares. Instead, Wells rambled somewhat nonsensically, and then replied:
I'd say how we approach the buyback is, what could we do with that cash as an alternative use? Should we hold it as an insurance policy or should we return it to shareholders? And a buyback is the most efficient way to do that.
In hindsight, holding cash as an insurance policy was clearly the better option. But to Wells' point, are buybacks the most efficient way to return cash to shareholders? Several studies show that, on average, they unequivocally are not. According to The New York Times, over the last decade, "companies that spent the most on repurchases had a total shareholder return of 37 percent versus 127 percent for companies that spent the least."
The reason why is simple, as Netflix has demonstrated so clearly: Most CEOs are terrible stock market investors, buying high and selling low. As markets peaked in 2007, S&P 500 buybacks hit $589 billion. In 2009, when markets were as cheap as they'd been in years, they plunged to $138 billion.
This isn't surprising -- investing isn't most CEOs' specialties. Nor should it be. There is no reason to expect someone who is a genius at creating a digital media company to also be a genius at purchasing stock at the right price.
But that is no excuse for wasting money. It is a company's duty to stick to what it knows. Netflix is fantastic at executing its core competencies, and it should stick to them. Warren Buffett would never try to be Reed Hastings, and Reed Hastings should never try to be Warren Buffett. Alas, this is a lesson shareholders have learned the hard -- and expensive -- way.