Monthly Archives: October 2011

Netflix – a non-unique collapse

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The most talked about stock today is Netflix (NFLX) – which is down over 36% today and down over 75% from its peak in July. There are many media outlets and market pundits calling this historic in terms of the breadth of its spectacular rise and fall in the matter of months. Netflix went from around $50 in January 2010 to over $300 in July 2011 and today trades at less than $80. While these things don’t happen often with this speed, they do happen and the speed is probably now more enhanced because market participants react much faster today with advances in technology then in years past.  In fact, NFLX is not the only former high flyer that got crushed today. First Solar (FSLR)  closed down over 24% and has lost over 66% since February and is down over 83% since its high in 2008. Both Netflix and First Solar are former $300 stocks now trading at $78 and $43 respectively and these are not the first momentum stocks in history to crack, nor the first to decline in specatcular fashion,

But Netflix itself has collapsed over 75% before once in its life – it just took longer the last time. That happened between February 2004 and October 2004.  That this happened in 2004, probably should have given people pause as to what valuation (earnings multiple) to assign it in 2011, because obviously things can go wrong – but the momentum investors as usual had no caution and ran the stock up. Jim Cramer has a piece out today blaming short-sellers for this meteoric rise and fall, but I take exception to that and will delve into that later.

First of all we have had some large spectacular failures of loved companies – the most memorable are the frauds like Enron and Worldcom – all of which took somewhere between a year and 18 months to collapse and those were bankruptcies.  But I have seen companies that were not frauds go from investment grade to bankruptcy in less than a year and sometimes over night. I worked on a lot of distressed debt situations in the 1990′s – and names like Columbia Gas, Lomas Financial and even Orange County California come to mind. Just a few years ago we had Lehman, Bear Stearns and of course Countrywide – even Fannie Mae and Freddie Mac failed despite being able to borrow at close to US Government rates and if you would have told people that could happen as I did prior to 2007, people thought you were from another planet.

Then there all the internet stock collapses – and there were many and yes most did not have the American mindshare like Netflix. While not as well known to retail investors they were institutional darlings.  Remember Exodus Communications? it had a peak market cap well north of $20 billion during the internet bubble – this is several times Netflix’s peak valuation – but Exodus did not sell anything to retail customers like DVDs, so it is less well known.

Exodus was a web hosting company – its clients were other businesses, so it was sort of like a Go Daddy for large companies who wanted to outsource their web hosting.  One of the largest mutual fund companies back then was running TV commercials to tout how “in-depth” their research was – used Exodus as one of its examples – though it never mentioned it by name. They touted the same things all the people who loved the stock did – how “advanced” their data centers were – that they had elaborate cooling systems (air conditioning), fire suppresion systems (sprinklers) and smoke detectors. Seriously, never mind this company had negative free cash flow – they in 1999 had fire sprinkers and I am sure they had pretty good ones – but the fire sprinkler was invented in 1881 – James Garfield was President of the United States and this is what the bulls were getting excited about – and these were professional money managers.  In short the Exodus data centers had the same equipment as a standard Holiday Inn room, albeit more  of it and somewhat fancier;  but at is core air conditions, sprinkers and smoke detectors.

During the internet wonder years of 1997-1999, Exodus went from around $12 million in revenues to around $242 million in revenues. The revenues are in millions, the market cap is in billions and the more revenue this company got, the more money it lost. Its losses went from around $25 million in 1997 to losing $130 million in 1999.  What I found even more troubling was their capital expenditures which went from around $25 million in ’97 to over $350 million in 1999. So to recap we have a company with $242 million revenues with a net loss of $130 million and cap ex of of $350 million and a market cap around $20 billion.  In case anyone was wondering their depreciation expense in 1999 was around $50 million, so they lost money even adding back non-cash expenses.

Exodus was trading at below $20 in October 1999. It hit a peak just somewhere under $90 in March 2000. Three months later it was trading around $25 and the next year it went bankrupt. This was again not a small cap company – it had a valuation approaching $20 billion -and went from $18 billion market cap to bankruptcy in around 18 months. Netflix is not unique, these blowups of high flying rapid growth companies that are darlings of momentum investors happen all the time; they have always happened and remember this is Netflix’s second time in history it has lost over 75% of its market cap from the peak.

Now let me turn to Jim Cramer – at one time perhaps the most famous bull on Netflix – here is column today:

http://www.thestreet.com/story/11288102/2/cramer-short-selling-doomed-netflix.html

Rather than blaming himself and the rest of his “best of breed” momentum investing crowd, he is blaming the short sellers. The short sellers were not there he claims to cover as the stock tanked, because they had already been squeezed out and forced to cover at much higher prices. And who is responsible for the shorts being squeezed? – the bulls like Cramer, because the shorts have to manage risk and they had no idea what ridiculous price Netflix might close at next.  When you are short you have infinite risk on a rising stock, you can’t buy and hold or short and hold, because you risk complete disaster. What happened if Cramer put a $400 target price on Netflix?, well he did back in January: Watch the video embedded in the link below:

http://paidcontent.org/article/419-facebook-could-turn-netflix-into-400-stock-says-jim-cramer/

It is amazing to watch this video and then hear Cramer today blaming the shorts for the boom and bust cycle on Netflix.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Flat Tax is the Flat Earth of Public Finance

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Flat income tax proposals are back in the news again with Herman Cain’s 9-9-9 plan to Rick Perry’s soon to be announced flat tax plan. While flat tax proposals are often portrayed by the media as being provincial to Republicans – it is worth noting that both former House Democratic Leader Dick Gephart and California Governor Jerry Brown when he was a Presidential candidate proposed flat taxes.

Flat taxes are often promoted for their simplicity – that the tax code is too complex, riddled with exemptions and this will make it easy. It has also been suggested that mutiple tax rates make the code complex. The reality is the income tax is complex even if there were no deductions such as mortgage interest, state taxes etc. It is complicated because determining what is and what is not taxable income requires rules and one rate or ten rates, this will not change.

The hard part of the income tax is determining taxable income. Once you get that number Turbo Tax or any number of software programs will calculate the tax for you. Even before computers, most people looked up their tax in a tax table matrix based on their taxable income and number of dependents. Even for the upper income whose incomes exceeded those on the tax tables, the calculation on the actual tax was third grade mathematics.

Are gifts taxable? Does it matter if it cash or non-cash? What about insurance settlements? There are insurance settlements that are taxable, others that are not.  What about installment sales? How without rules would someone know they need to report all or only part of their gain on an installment sales in a given year? Certain employer perks such as company provided cars carry tax ramifications, other like employer paid health insurance do not. Maybe they should both be treated the same, maybe not – but you need rules – a tax code for anyone to know what to do.  The bottom line is any income tax is complicated because everyone left to own devices would not agree on what is income.

Bond investors are often faced with complicated tax situations because the IRS has determined that phantom interest whether in PIK form or OID is taxable. Would it not be easier to simplify the tax code by only taxing cash interest payments as opposed to “accreted value” ? How does a flat tax solve for this complexity?

That flat tax proposals are so popular is an indication that people do not have the attention span to deal with the granularity necessary in administering an income tax. This is not to say we cannot simplify the code, we can – but a flat tax will simplify nothing.

 

 

 

 

Pennsylvania’s Capitol City Files for Bankruptcy

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Harrisburg the Capitol of Pennsylvania filed for Chapter 9 municipal bankruptcy.  Before we jump the gun and people start talking about national implications = let’s look at what is unique about Pennsylvania.  Harrisburg filed to avoid the state placing it under receivership under something called Act 47. Now why Harrisburg wanted to avoid this is a mystery as it normally provides for solutions not otherwise available. In fact since 1987, 25 municipalities in Pennsylvania have come under Act 47 including Pittsburgh. In fact Act 47 is such a good deal that no local government has ever left it.

Now from the perspective of municipal bond holders a bankruptcy is worse than Act 47 because a bankruptcy may make it easier to not pay bondholders, but that is not clear. A bankruptcy judge could order a hike in property taxes similar to what the Mayor proposed to pay the bondholders – they Mayor by the way opposed the bankruptcy – it was the City Council that voted to file. What Act 47 does do is allow municipalities to impose commuter income taxes on residents who work in the jurisdcition but do not live there.  It also make annexations of nearby areas easier.

The core problem facing many municipalities in Pennsylvania beyond the general economic woes relating to the country of the rust bult is that Pennsylvania has thousands of towns and cities who lack the scale to efficiently deliver services and many of these boundaries were drawn prior to 1900 and it is not easy to get these boundaries redrawn or even dive into the political thorny issue of transferring most municipal functions to the counties.

This was precicesly the issue with Harrisburg – the city and the county it is located in Dauphin County.  They needed to upgrade their incinerator to comply with federal air quality rules and they issued municipal bonds to finance this and ideally the fees from entiities dumping their trash there should have covered the debt service. In order to get investors to buy the bonds though Harrisburg and Dauphin had to guarantee the debt in the event the users fees were insufficient to cover the debt service.  For a variety of reasons, the fees were insufficient and both the county and city were strained by their obligations under this debt issue, leading to today’s bankruptcy.