Netflix has reached maturity

Neflix reported Q1 financial results last night (April 19); the company reported a loss of 200,000 subs for the quarter but guided to a future loss of 2 m subs in Q2.  The market's verdict was swift and harsh, with the stock down by 36% to $222 late in the day on April 20.  The one-year decline is worse, down nearly 60%.  Despite the sharp declines, it is probably not the time to buy the stock.  Compare the stock performance of Meta (FB) since its "adjustment" in Feb 2022 when it reported its Q4 results.  The stock cratered a massive 31%, but since that date has dropped a further 10%. 

During its conference call after the release, the Company flagged 2 interesting issues.  First, its shutdown in Russia cost 700,000 subscribers.  Excluding these subscribers, the Company would have gained 500,000 subs, but still far below the 2.5m that it had guided to.  The second point was that password sharing might account for 100m additional shadow subs.  Of course, it would be great for the Company to find a way to curtail this, but it does not change the fundamental narrative of low future growth.  

These results signal that NFLX has reached maturity.  The days of large subscriber growth are over.  Perhaps this is a result of saturation of its TAM, or perhaps influenced by increasing competition.  One response from the Company was to suggest that it might add an ad-supported subscription to its offerings.  However, this would also come with competition from other streaming services such as DIS and HBO Max.  

As a mature company, the Company needs to change the narrative and focus investors on another metric: either Revenue growth or a profit metric.  The Company has more flexibility with profits since its content spending in 2021 amounted to $17B.  Apple had the same transition when it stopped releasing data about unit sales and focused on Revenues.  NFLX has reached the same point.   

Elon's Next Move

Confidence is the key to takeover battles.  Any Raider needs to project confidence to the "market" in order to muster investor support.  Generally, tender offers are about dollars and cents, but proxy fights, which generally accompany the tender offer and give it more teeth in the face of a poison pill, are about creating a sense of confidence.   

Apparently, Mr. Musk plans to obtain financing commitments and use these to support his bid, either in the tender offer or in negotiations with management.  But to succeed, he must become the "serious" Musk not the flaky "Musk".  This is as much about PR as it is about Finance.  Musk struggles to raise funds

What Will Elon Do Next: a case study in Current Takeover tactics

 

In early April, Elon Musk announced by filing a 13G that he owned 9.2% of Twitter inc (Ticker: TWTR).  On the same day, he accepted a seat on the Board of of Twitter and entered into an Standstill Agreements. Shortly thereafter, on April 9, he terminated the agreement and announced that he would not be joining the Board.

On April 14, Musk announced a proposal to buy the remaining shares of TWTR for $54.20 per share or $43B, a premium of 18% over the closing price of the stock on the day before, but 45% over the unaffected price prior to the announcement of his share stake.

On April 15^th, the Board announced that it would consider Muck’s offer but also announced that it had adopted a poison pill that would, among other things, prevent Musk from acquiring more than 15% of the firm without the Board’s approval. 

Twitter is a Delaware Corporation with a staggered Board of Directors divided into 3 classes with only 2 Directors standing for election in 2022.  Twitter has distributed Notice of its Annual Meeting of shareholders for May 25^th.  Nominations to the Board of Directors are closed (as of Feb 2022)

What will/can Musk do next?

Musk faces some significant obstacles but ultimately should be able to prevail if he is determined to own the company. 

Twitter is a Delaware Corporation.  Delaware is the most popular state for corporate charters in part due to the Delaware Chancery Court which is experienced in resolving issues of corporate law and has a well-developed law governing corporate takeover battles. 

Nominally the two major obstacles facing Musk are the Poison Pill and the fact that Twitter has already filed notice of its annual meeting to elect directors for May 25^th, and other nominations for Director are now closed.

Musk’s options include the following, which could be taken simultaneously or separately:

1.       File suit in Delaware Chancery Court asking that the Pill be redeemed by the Board or be declared invalid. Under Delaware law, the court will apply the standard of “enhanced judicial review” from Unocal.  Unless the Board is prepared to announce an acceptable price as required under the Airgas case, it is likely that Musk will eventually prevail. 

2.       Make a Tender Offer for any or all shares with a 51% minimum condition, although this would have to be subject to redemption of the pill.  To do so, Musk would not have to have procured financing but only a “highly confident” letter from a credible investment bank.

3.       Launch a proxy fight in the election of the two directors standing for election and ask shareholders to cast a NO vote on those directors.  This is unusual since Musk could not nominate his own Directors, but by obtaining a majority of the votes, he would force the Nominees to resign, which is required under Twitter’s Bylaws and market practice.  This would not directly gain control of the firm but would send a strong message to the Board and would most likely decide the battle.

Musk’s best option is #3.  To give his proxy fight more credibility, Musk should take actions designed to reinforce the view that he is fully prepared and able to buy the company either alone or in conjunction with a financing partner.  Given Musk’s personal wealth, management credibility and obvious connections in the financial community, this should be achievable. 

Jerome Powell never fails to disrupt the markets

 

Jerome Powell never fails to disrupt the markets

The Federal Open Market Committee quarterly update on Weds afternoon was supposed to be "baked in the cake".  The FOMC previously announced that its zero rate policy would be continued for the foreseeable future ("several years" according to a prior Powell statement)--until the economy was fully recovered.  This had been modified to say that even in the event that the economy ran "hot" (defined as inflation over 2%), the Fed Reserve was prepared to withhold rate increases.  Easy money is magic elixir to the financial markets. 

The FMOC meeting was held in the context of continuing high levels of COVID infections in the US and Globally, and slow return to work in the US during the summer months.  Nevertheless, economic data had indicated a slow but steady improvement in the most recent quarter, with unemployment modestly declining but remaining at a high level relative to historic trends.  Most investors, in my opinion, expect a continuation of those trends: modest economic improvement, but with the economy remaining well below normalized output levels pending distribution of an effective vaccine.  I believe investors know that there is a risk of a "second wave" in the winter flu season which would entail some new economic disruption. 

When the Fed Reserve announced its policy statement at 2pm, simply re-iterating the prior policy statements, the Dow immediately rallied about 70 points (presumably, there must be someone that is not paying attention). 

The Statement indicated that:

           "With inflation running persistently below this longer-run goal [of 2%], the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer term inflation expectations remain well anchored at 2 percent."

The real action began when the Chairman started speaking at 2:30p.  As his usual practice, Chairman Powell was unable to simply articulate a coherent regurgitation of what everybody knew and expected. Rather he spooked the markets by implying that conditions had worsened  and the economic outlook had become riskier.  Furthermore, when pressed on the specifics of the general policy statement for added definition to words like "moderately" and "some time", he was unable to add anything of value.  At one point, he insisted that the word "modestly" meant...well, "modestly" and "everyone knows what that means".  The result, the market, measured by the DJIA, sank from up 270 to down by the time the presser ended. 

Regrettably, Chairman Powell, a lawyer by training, is unable to perform a basic lawyering skill--forcefully advocating his own position. The next step is also well rehearsed at this point.  Fed Reserve Presidents will walk back his remarks over the coming weeks.  If past is prologue, even Chairman Powell himself will attempt to repair the damage he has done in his Congressional testimony next week. 

Rumor is that Chairman Powell has regained the confidence of President Trump and is likely to be reappointed if there were a second Trump term.  All I can say, is Please NO!!

Huge Pile of cash has missed the market rally

I noticed the following tweet earlier today:

Investors Are Sitting on the Biggest Pile of Cash Ever – Grappling with the most economic uncertainty in decades and a head-spinning stretch of volatility in the U.S. stock market, many investors have rushed into money-market funds. Assets in the funds recently swelled to about $4.6 trillion, the highest level on record, according to data from Refinitiv Lipper going back to 1992. WSJ 

While the cash is sitting in MMFs earning 0% interest, the SPX has rallied 30% off the March 23 low and the NASDAQ 100 has breached its all time high several times.  NDX100 currently is at 10,015.23.  SPX is at 3,126.84.  (12:29p)

This is a good reminder that nobody can time the market.  Some of the smartest financial minds have missed this market rally, including Warren Buffett.  The rally was initially led by the WFM stocks, such as ZM, NFLX, ZS, CRWD, AMZN, but rotated swiftly into the 'recovery' plays such as airlines, hotels, and cruise lines.  

With little corporate guidance, it is entirely possible that this move into cyclical recovery stocks is too soon too fast.  Personally, I don't try to pick tops or bottoms, but simply look to allocate assets to good companies at good prices.  I DO try to notice if the tide is moving in or out.  While the recovery stocks might be priced on a too-rosy scenario, it is likely that there will be a recovery over the next 18 months and all of these stocks and the underlying operating businesses will approach 2019 levels.  

On the other hand, the Pandemic-enforced WFM movement probably has changed or accelerated changes in our lifestyles on a permanent basis.  Video conferencing will grow; delivery/take out dining will grow, and of course, streaming will grow.  I am not opining on the current price levels, just pointing out that major secular shifts are evident to any careful observer and these shifts will be reflected in stock prices over a long period of time.  

Finally, being fully invested does not mean solely in equities.  If you are saving for retirement, a 50/50 split between high quality long term bonds and stocks is still a sensible path.  As a side note, at the market low, at the time that the SPX was down 40% from its high, a 50/50 portfolio would have been down only about 5% (measured as of March 23).  

Why the Stock Market is not overpriced

As of 10:30 am today, May 18, all of the major indices are in rally mode, with the SPX 2941.36 (+2.71%), NDX 100 9318.90 (+1.82%) and the DJIA 24,403 (+3.04%).

Early this morning, the three major indices were moving nicely higher, on the basis of improving virus news and Chairman Powell's interview on 60 Minutes on Sunday night, until news was released later in the pre-market period that Moderna (Ticker: MRNA) had positive early stage test results for its coronavirus vaccine.  Since that point in the time, the three major indexes have roughly doubled their gains for the day.

Recent Economic news can only be described as terrible:
      1. Industrial production -- lowest since 1919
      2. Retail Sales: April -16%,  far worse than the reduced expectations
      3. Continuing jobless claims: over 22 million
      4. First-Time unemployment claims: over 36 million in just eight weeks.

Within the last week, various stock market "experts", including Warren Buffett, David Tepper, Stanley Druckenmiller, and Ray Dalio, have said that the "market is overvalued".  You have to respect these opinions since all of the aforementioned are real investors.  In addition, many of the TV "experts" (not investing their own money) including the widely respected Mohamed El-Erian, have chimed in.  As a lowly finance professor, also investing my own money, I must say that I disagree with this conventional theme that the markets are overvalued.   I am not saying that the "market is cheap" but that generally stocks are fairly valued given the environment and expectations.

 Many are asking how can the stock market be going up (although it is still below the pre-virus levels) given the terrible economic news?

I assert that all of these things make sense.

It is a market of stocks, not a stock market.  Lets take a deeper look at market price dynamics.

Lets go back to fundamental principles as taught by every major business school in the world. 
First, the market is a discounting mechanism that looks to the future--specifically future estimated cash flows.  These cash flows can be in the form of dividends + stock repurchases, or implied dividends (using a variety of financial models, but the residual income model is the basic version).  Second, the indexes are constructed by either market cap weighted (SPX, NDX) or price-weighted (DJIA).  Index construction has an important impact on the movement of the index. 

Looking at the performance YTD of the indices, we see 3 very different pictures of the "market".  The NDX is up 1.02%, the SPX is -9.3%, and the DJIA lags down -15.1% (all YTD, without dividends).  These levels are well above the lows of mid March. For instance, the SPX dropped about 33% in the Mid-March decline and has recovered about two-thirds of that decline. Our first conclusion is that nobody should be talking about the "market" without specifying an index.  How do we explain this rather shocking divergence among the indices? 

It comes back to the impact of the virus on future cash flows.  The market is differentiating among three categories of firms: (1) those firms not affected by the Pandemic induced Lockdowns, or even positively affected by the "shelter in place" orders (examples: ZM & NFLX), (2) those that are currently impacted but perceived as recovering early after the Lockdown is ended (eg. DIS, SBUX); and (3) those that will not recover for some time (airlines, hotels, cruise ships, movie theaters etc).  Take this matrix and apply it to the indices.  The NDX is a market cap weighted index and the largest five firms account for over 40% of the index: MSFT (+15%), AAPL (+4.6%), AMZN (+31%), FB (4.4%) & GOOG (3.6%).  What do these firms have in common?  They are all less affected by the virus (MSFT & AMZN)  or perceived as recovering sooner (AAPL).  Lets take MSFT as an example:  its sources of revenue are its legacy businesses of windows, and Office, and its newer business of data centers.  None of these are very affected by the virus, and its cash flows are growing.  When we look at the SPX, the same firms account for about 20% of the index. In other words, 495 other stocks account for 80% of the index but this group includes airlines, cruise lines and hotels, all of which are 30-50% below their pre-virus highs.  The DJIA is down more because it is price weighted and affected by the sharp declines in BA (63%), RTX (40%) JPM (38%)  Dow (34%), AXP (34%) XOM (32%), WAG (34%) CVX (25%), GS (25%) and 3M (21%). 

As an investor, it is time to place your bets:  Which firms are going to recover faster post Lockdown? Which firms will lag?  Is the market too optimistic about the laggards?  The thesis of the "experts" is that the "market" is too optimistic.  But the laggards are well below their pre-virus levels.  Examples:  DAL (-63%), LUV (-50%) , MAR (-39.5%), HLT (-33.1%), are all far below their pre-virus levels. 

If we look at the leaders for the year, including SHOP, ZM, NFLX, NVDA, PDD, SRNE, BTAI, NVAX, MRNA, and DOCU, it is easy to complain that their prices are too high and that too much credit is already incorporated into the prices for future growth.  This is the group that is probably legitimately susceptible of the "1997" critique: good ideas, and even good firms, but much too expensive.  A good portion of these firms are engaged in the development of revolutionary pharmaceutical products.  These tend to be binary bets with a lot of downside risk.  Fair enough to say that the stock of these firms are overvalued.

My point is that there is a tier of stocks that are growing fast, and have very attractive prospects, but are priced at levels that seem much too high.  But many other stocks seem appropriately priced for the current environment, and the inherent risk to their future cash flows, and these are the largest stocks that drive the indices.  Can we have a correction?  Of course, and at any time for any reason, or for no reason.  Nevertheless, my conclusion is that the "market" is fairly priced--not cheap, but not expensive. 

March Jobs Report

The equity markets are placing great reliance on the improvement, i.e., the decline,  in the unemployment rate as confirmation that the US economy is slowly recovering from the impact of the Great Recession.  Nevertheless, the Federal Reserve, particularly its chairman, is warning explicitly that the trend in the unemployment rate is unsustainable.  For this reason, various Fed governors have asserted that QE 3 is still under consideration, and the Chairman has announced that interest rates will remain on hold until at least 2014. 

What is causing the Fed to be so cautious about employment trends?  Table 1 below shows the trend in month-to-month change since the onset of the Great Recession. 

Year	Jan	Feb	Mar	Apr	May	Jun	Jul	Aug	Sep	Oct	Nov	Dec
2007	236	93	190	72	139	75	-40	-18	73	79	112	89
2008	41	-84	-95	-208	-190	-198	-210	-274	-432	-489	-803	-661
2009	-818	-724	-799	-692	-361	-482	-339	-231	-199	-202	-42	-171
2010	-40	-35	189	239	516	-167	-58	-51	-27	220	121	120
2011	110	220	246	251	54	84	96	85	202	112	157	223
2012	284	227	120

As shown in the table above, job growth has shown a degree of acceleration only at the end of 2011.  Nevertheless, this rate of growth is below that which occurred after the 1990s recession which was not as severe.

Year	Jan	Feb	Mar	Apr	May	Jun	July	Aug	Sep	Oct	Nov	Dec
1991	-122	-302	-161	-212	-127	88	-48	17	32	12	-58	23
1992	50	-66	52	157	126	60	70	141	35	178	139	212
1993	310	242	-51	308	265	174	295	160	239	278	261	307
1994	270	201	462	353	333	313	364	298	355	208	422	272

As Table 2 shows, the monthly increase in employment post-1991 was over 300,000 jobs per month.  (all data is seasonally adjusted).

The first conclusion is that the rate of job growth has been slow compared to the post recession periods of prior recessions.  Notwithstanding the low rate of job growth, the unemployment rate has declined 1.5% since Dec 2010.  The Fed's conclusion is that that decline has not been fueled by job growth, but, in significant part, by the decline in the participation rate, which is down 2.5% since 2007.  In short, workers are getting discouraged and dropping out of the labor force and therefore do not fall into the unemployment rate.  This is particularly striking among workers with a high school education or less.  While the overall labor force is roughly equally divided between men and women, this category has a larger component of men.  As manufacturing and construction employment was severely affected by the Great Recession, this is not surprising. The March employment report continues these trends.  The number of new jobs added was only 120,000, a level that would not normally cause any change in the unemployment rate.  But the unemployment rate declined slightly to 8.2% as the participation rate also declined by 0.1%. 

Another reason for caution about the trend in unemployment is the large number of part-time workers.   The number of people working part-time for economic reasons is nearly 8m.  As the economy recovers, workers will shift from undesired part-time jobs to full time.  These workers are likely to be the "first hired" since they are the most motivated, and have current skills.   Again, the March report is a good example,  The number of workers in part-time jobs for economic reasons declined by over 400,000 significantly greater than the decline in the number of unemployed, 133,000.  In addition, discouraged workers are likely to be drawn back into the job market as the economy begins to generate, no matter how slowly, more low skilled jobs. 

This data is what underlies the Fed's cautiousness about further improvement in the unemployment rate.  Job growth would have to accelerate from its current level.  There is no evidence of that this is occurring.  Even at this low rate, it is likely that workers will be drawn back into the work force which will reverse the impact of the decline in the participation rate and cause the unemployment rate to stagnate if not rise.