By: Sam Watry RIA of Durig Capital
5.386% Yield to Worst Call
Netflix Inc has forever altered the way movies will be watched. They currently have over 12 million household subscribed to their services which include DVD by mail and streaming video via Internet connection. The Internet based delivery method can be view with consumer electronic items like game consoles, televisions with Internet connectivity, and Blu-ray players. Subscribers currently have access to over 100,000 different titles. Netflix delivered its 1 billionth item in 2007 and the business continues to grow with the addition of the Canadian market in fall of 2010 for video streaming. They currently distribute over 700 million media items per year.
At Durig Capital, we have developed a process to review, select, purchase and monitor corporate bonds on an ongoing basis. Enclosed is our review, along with supporting documents/links, showing why we believe this corporate bond makes sense in clients’ portfolios. We reviewed thousands of separate corporate bond listings to find what, we believe, is currently the best corporate bond for investors. The following illustrates our selection criteria.
Step 1 – Yield Curve at 4-7 Years Out.
With the uncertainty that is griping the investment community, we have studied the yield curve and are going out to earn current yield while trying to protect against principal loss. Investors are disgruntled with savings accounts that are yielding on average .73% per bankrates.com. US Government issues are no better with yields approaching all time lows. When the current economic environment, weather you would like to call it a recession or depression, turns around, owning long term fixed income instruments could effect ones purchasing power. Inflation should be a concern for long term fixed income investors as interest rates have been held artificially low for to long to try to jump start the economy.
Step 2 – We like companies that are profitable.
Understanding that Netflix Inc has found a niche in the multimedia rental market is important as the growth they have demonstrated will continue albeit current levels should revert to industry mean. With that in mind, Netflix is very profitable and exhibiting growth in earning. Earning per share last quarter, ended June 2010, were $.78, an impressive 27% higher than a year before. The trend in revenues is upward as the last three years has seen over 18% annualized growth in revenues. This is impressive as the overall economy has been sputtering, as mentioned in last weeks This Weeks Best Bond article.
The niche that Netflixs has created in the multimedia market is interesting because it is defensive in nature. With household budgets being pinched around the US, a nominal $5 per month package allows subscribers two movies a month and this is cheap entertainment.
Due to the competitive nature of the industry, Netflix has consistently been in price wars. When Blockbuster and Hollywood Video realized Netflix was gaining market share, the three engaged in trying to undercut each others prices. With the weight of the expensive bricks and mortar retail locations that Blockbuster and Hollywood Video had, Netflix had more room to maneuver due to its cheaper to operate centralized nonretail locations. Price wars are not sustainable however and Netflixs seems to have endured the storm with the other two in real financial trouble.
The multimedia industry has low barriers to entry that will allow for increased competition. Competitors such as Amazon, Redbox, Comcast and DirecTV, to name a few, are or have already entered the market with similar product offerings. The bargaining power of suppliers, movie studios, is coming to light which could crimp margins. Recently, Netflix signed a contract with Warner Brothers delaying subscribers ability to obtain new releases for 28 days to boast hard copy purchasing demand. Similar agreements are on the table with other major studios.
Step 3 – We like companies with lower debt to cash and short term investment ratio.
As of the end of last quarter, Netflix has $200 million of long term notes outstanding. With $134.22 million in cash coupled with $186.02 million in cash equivalents, Netflixs fits Durig Capital’s bond models. We like companies that have short term liquid assets that more than cover long term debt. This gives Netflix bond holders an additional layer of protection.
Step 4 – We like companies that have flexible balance sheets
Although it is unlikely that they will, Netfix has the ability to repay the long term debt with existing liquid assets as mentioned above. Having a flexible balance sheet affords Netflix other options if capital needed to be raised. Currently there market equity value is over $7 billion with $200 million in notes issued. This gives them an enterprise value, removing the cash, of $6.5 billion. The debt to equity ratio is currently only around 2%. A low ratio like this allows the company to issue debt and/or equity with a secondary offering. As a comparison, when Netflix initially issued this debt, in November 2009, it shares were trading at $55 per share and having an overall market cap of about $3 billion. With the $200 million issue with a market cap of $3 billion the ratio was 6.66%. Understanding that the equity happened to be bullish and it could have been bearish, this illustrates that Netflix currently has control of the appearance of its balance sheet. Their investor relations website with balance sheet links can be viewed here.
Step 5- We like companies with strong operational cash flow.
Netflix has one of the stronger cash flows we have seen compared to their debt. For the trailing year, they produced $325 million in cash flow from operations. They haven’t needed to, nor does it look like they will, but they could apply this flow of cash from operations and pay off the long term notes in less than 8 months. In addition, cash flow from operations has increased year over year for the last three years.
Step 6 – We like higher yields.
This issue has a yield to worst of 5.386%. The issuer has a call option where they can call the bonds away starting 11-15-2013 at 104.25. They can call these bonds thereafter annually until the final maturity. This bond is rated Ba2 by Moodys and BBB- by S&P so it is considered a speculative issue. Enclosed is a link to current junk grade bond offerings one can use as a benchmark against Netflix Inc.
Important Yield Forecasts
**Current yield is 7.55%**
Step 7-We currently like shorter maturities.
This issue is first callable in as mentioned in November of 2013. It is unclear at this point, if Netflix will exercise there option. They could be able to call and refinance at a lower rate or choose to let the issue ride. The yield to worst, lowest current yield metric, is 5.386% and this factors in the bond being called at the first call date. The bond is callable, at diminishing price levels, until final maturity on November 15, 2016. If and/or when this issue were to be called or held to maturity, the time frame is concurrent with our economic outlook.
The 5.386% yield till worst case scenario is attractive for a diversified portfolio. Netflix Inc lacks an investment grade rating but has strong operating cash flow, solid business model, and cash which is a solid foundation. The call features of Netflix are comparable to those of Frontier Oil Inc. The issue has similar metrics to our previous bond reports such as Seagate Technology(SPX), Expedia(EXP), Interpublic(IPG) and Unitrin(UTR), which have done quite well for are clients.
Coupon 8.5 %
Yield to Worst 5.386% 11/15/2013 called at 104.25
Yield to Maturity 6.293% 11/15/2016
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Disclosure: Durig Capital’s clients currently do not have positions in Netflix Inc Corporate bonds.
To know more about this Netlix bond call our fixed income specialist at 971-327-8847