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Activists vs the SEC

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Good morning. Elon news? Really? We must have missed it. Meanwhile it looks like a 50 basis point interest rate rise is lined up for the Federal Reserve’s May meeting, which tech stocks didn’t take very well. More on tech next week. For now, the SEC and your thoughts on yesterday’s Netflix letter. Email us: robert.armstrong and ethan.wu.

Pushback against the SEC is getting louder

Back in early March, I wondered why there was so little debate about the Securities and Exchange Commission’s ambitious spate of new rules on private capital. Seems I just had to wait. The FT’s Nicholas Megaw reports that investor groups, and particularly activist investors, are up in arms:

Activist investors and their backers . . . say the rules would hamstring the industry by allowing other investors to front-run their strategies and give companies more time to plot defences against shareholders agitating for change . . . 

Paul Singer’s activist hedge fund Elliott wrote that the rules would protect boards of poorly-performing companies and violate laws protecting trade secrets, including a clause in the fifth amendment of the US constitution that prevents the government from taking private property.

Two proposed rules have attracted the most criticism:

  1. Public disclosure of the big swap positions made famous by last year’s Archegos implosion. Swaps would be included under “beneficial ownership” rules that mandate public reporting.

  2. Halving the window for beneficial ownership reporting — including big equity and swap stakes (usually about 5 per cent of total shares) in a single firm — from 10 days to five.

Once an activist campaign becomes public, the stock may rise, but management also scrambles to resist. The whole process becomes harder and more expensive. So activists want maximum time to build voting power (through stocks) and economic exposure (through swaps) unnoticed before launching a campaign. The two rules would slash how much time activists get.

But activists vs management isn’t the SEC’s main concern. It wants to eliminate what it sees as an information asymmetry. An activist accumulating a big position is in possession of information that usually makes a stock go up. The activist might mention its campaign to other firms, which could then get in on the pop. The public, meanwhile, has no idea, and might sell a stock that’s about to rise. It feels a bit too close to insider trading.

Instead of sparking grand dialogue about the merit of activism, the argument is becoming more narrowly focused on two areas. One is what a “group” means. Buried in one of the new rules is a wording tweak that could broaden who has to file group disclosures together. Before you needed an explicit agreement; now you don’t. Shareholders, even beyond just activists, do not like this. Suppose executives at BlackRock and Elliott, before any activist campaign was ever in motion, had a side chat at a conference about some company’s bad management. Would that make them a group?

This may be fiddly, but it could matter. Andrew Park of Americans for Financial Reform, who has been involved in lobbying the SEC, calls the argument over groups the “epicentre of the debate”. Because the line between insider trading-adjacent co-operation and normal attempts to collaboratively influence corporate governance is thin, the SEC needs to write its rules carefully.

The other growing area of debate is on, amazingly, how good the SEC’s legally mandated cost-benefit analysis is. Fresh off reporting his story, Nicholas Megaw shared this impression:

Even supporters of the SEC worry about its cost-benefit analyses. The agency already acknowledged in the original filing that the costs and benefits of these rules are ‘difficult to quantify’, and there’s precedent for proposals getting bogged down in court over analysis that wasn’t up to snuff.

Many companies are still run for the benefit of management rather than investors. Shareholder activism is one of the few solutions to this destructive problem. The SEC needs to tread softly, and explain itself better than it has. (Ethan Wu)

The people who maybe did see the Netflix mess coming

Yesterday I wrote that the sudden halt in Netflix’s subscriber growth, and subsequent meltdown in its share price, was not easy to see coming, because the company had seemed to be enjoying the self-reinforcing growth momentum enjoyed by so many other large tech companies. 

Several readers, in response, wondered whether Netflix was really a tech company at all; others argued that I had been hypnotised by the good results on the company’s profit and loss statement, and failed to look at the signs of trouble on its balance sheet. 

The two comments are related. Tech companies are great investments because they “scale”. While the product (software, web searches, social network) may be expensive or tricky to set up, the marginal cost of adding new users/customers/revenue is extremely low, so when the companies get big, everyone makes tons of money.

The most penetrating criticism of Netflix’s business is that it does not really scale. To grow, it has to keep adding new shows and movies, and these are expensive, creating strain on the balance sheet. Netflix is a media company, not a tech company. And the people who have been making this point did, in a sense, see the Netflix mess coming.

Some accounting geekery helps make the point. Netflix reports the costs of the shows it makes and licenses as “cost of revenues” on its P&L. This was a $17bn item in 2021. But this number does not reflect a cash outlay. Netflix’s accounting amortises (spreads) content costs over a number of years, so the $17bn reflects a fraction of the 2021 cash costs, plus fractions of the cash expenses from each of the past, say, four to six years.

On the cash flow statement, all the amortised content costs on the P&L are adjusted back, so that investors can see what is actually happening on a cash basis. In Netflix’s case, what this reveals is cash content costs in excess of reported content expenses. As a result, Netflix generates much less cash than accounting profits.

This happens whenever companies are investing more and more with each passing year, because current-year higher cash outlays (for trucks or servers or TV shows) are then higher than the (smoothed) amortisation of past years’ lower cash outlays. This is harmless so long as the process eventually reverses, investment falls, cash flow matches or surpasses earnings, and investors get lots of nice dividends, buybacks, and other things you can pay for with cash but not earnings.

The accusation against Netflix has long been that this reversal will never happen. It will have to spend ever more on content to keep up with competitors like Disney and HBO. Aswath Damodaran, who has argued that Netflix is overvalued for years, calls this the company’s “hamster wheel”:

The company . . . has always been on a hamster wheel, where its primary sales pitch to investors is its capacity to keep growing its subscriber base, and the only way it can keep doing this is by spending ever-increasing amounts of money of new content. The question of how the company would get off this hamster wheel has always been there, and now that user numbers are starting to slow, and new users are becoming more costly to acquire, the challenge of doing so has become larger. 

There is a numerical way to cash this out. Here are the valuations of the “Faamng” companies, showing price to 2021 earnings (accounting profits) and price to 2021 cash flow (actual cash generated):

Netflix looks cheap on its P/E multiple, but doesn’t even have a free cash flow multiple, because it generated no free cash last year. In that sense it is now, and has long been, much more expensive than its peers, with the possible exception of Amazon. Both companies have generated free cash only intermittently, for the same reason: they invest like crazy. 

You don’t hear anyone accusing Amazon of being on a hamster wheel, though. This is because people think Amazon’s investments create enduring competitive advantages, while Netflix’s just keep its rivals at bay for another quarter or two. On this interpretation, what happened this week was that Netflix’s investments stopped doing even that much.

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