Thursday, November 24, 2011

Netflix Disgorges the Cash

For a great example of what I've been talking about, check out this Dealbreaker post on how Netflix spent the past two years buying back its own stock, and then just this past Monday turned around and announced that it was selling stock again. Matt Levine:
NFLX bought 3.5 million shares of stock at an average price of $117 in 2010-2011, at a total cost of $410 million, and paid for it by issuing 5.2 million shares of stock at an average price of $77 in November 2011, for total proceeds of $400 million – minus $3 million that we pay to Morgan Stanley and JPMorgan to place the deal. So 1.7 million extra shares outstanding for net proceeds of negative $13mm or so. 
The comical thing about this from the point of view of the financial press is the buy-high, sell-low side of it. And of course whoever was on the other side of Netflix's share repurchases this past summer, when the stock was at four times its current value, must be laughing right now. But as Levine says, this is what the system is set up to do:
Most companies are rewarded for squeezing every last penny out of EPS [earnings per share] – in executive bonuses, sure, but also in stock price more broadly. It’s what investors want. ... So with Netflix: when things are good and it’s rolling in cash, it pushes up its price by buying. When things are bad and it needs cash, it pushes down its price by selling. And its incentives are neatly aligned to do so: when things are good, it needs one more penny of EPS; when things are terrible – hell, who cares about dilution when you’re unprofitable anyway? (It’s a good thing!)
Another way of looking at this, tho, is that buying its own shares high and selling them low is exactly how a firm should behave if shareholders really are the residual claimants, operationally and not just in principle. In the textbook this doesn't really come out, since "shareholder as residual claimant" is just a first-order condition imposed on some linear equations. But if you take it seriously as a claim that shareholders own every incremental dollar that the firm earns or raises, and that management is a not just the solution to an Euler equation but a distinct group of people who may have their own views on the interests of the firm, then shareholders should want businesses to behave just like Netflix -- pay out more when more is coming in, and then ask them for some back when more needs to go out. Can't be a residual claimant if you don't claim your residuals.

Now, financing investment is going to be more costly when it involves selling and repurchasing shares, compared to if you'd just kept the savings-investment nexus inside the firm in the first place. And these transactions were also disastrous for the firm's long-term shareholders -- in effect, they transferred $400 million from people who continued holding the stock to those who sold in 2010 and 2011. So in this case, a system designed to maximize shareholder value didn't even deliver that. Shareholders would have done better with management who said, Screw the shareholders, we're going to build the best, biggest online movie rental company we can. If you own our stock just sit back, shut up, and trust that you'll get your payoff eventually.

As the man says, "When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."


  1. The logic of what one might call honest capitalism leads to a tendency toward a gradually diminishing rate of profit, no? The extractions of casino capitalism must have some other basis.

    If the nexus of power is in the hands of corporate executives and financial managers, who bear no risk, is it fair to label these villains, "capitalists"? The actual capitalists seem as much bag-holding victims, in the end, as anyone else.

  2. 1) Haven't we been through this one before? Stock buy=backs amount to insider manipulation to hoard "residual claims". If earnings had been distributed pari passu as dividends, then the stock price would have risen with high earnings and fallen with low earnings, but such a ridiculous outcome wouldn't have occurred. Dressing up EPS through buy-backs is not all that different than accounting chicanery to boost share prices, though since it's in the open market, it's amazing that anyone could be fooled.

    2) Insisting on retained earnings for corporate investment ignores the issue of inter-sectoral switching of investment. A firm in a declining sector (or with a declining model like Netflix) might desperately try to shore up its position against declining returns and prospects, rather than "right-size", whereas new emergent sectors, (say, e.g., building green energy infrastructure vs. oil majors' investment), might be starved for capital by the interests of reigning incumbent firms.

    3) There is a question of explanation of what has actually happened rather than prescription of what should happen here. IIRC back in the 1960's +60% of corporate investment was from retained earnings vs. less than 40% nowadays, and likely there was more such investment then as PCE was 64% of GDP vs. 70% nowadays. What are the structural changes, (including declining corporate investment), that account for the decline in retained earnings-based investment?

  3. Bruce-

    Yes, this is the big question -- I think one of the biggest questions of our current situation: What is the relations between finance and capital broadly speaking? My teacher Doug Henwood has always been very critical of the idea that you can draw a line between finance and productive capital, but I have to admit I'm more sympathetic to the populist view that you can, and it's important. (There may be a generational divide here.) Partly the question is whether finance and capitalists refer to distinct groups of people. But even the same people can be different actors if the norms & principles they organize themselves through change. One way I've been thinking about this -- just playing with -- is:

    Capital is M-C-C'-M', value in a motion of self expansion. Described this way, it's just an automatic, almost natural process. Where's the capitalist? Marx says, the capitalist is the personification of capital. OK. But seeing as capital is a process, which moment of that process is personified? My idea is we could think of periods when "productive capital" dominates, as being periods when the part of the process where the capitalist class happens -- where the process has a kind of self-awareness, a capacity to act on its interests -- is the C-C' segment. While the periods of financialization are periods where capital's self-awareness happens around the M segments. You could think of this, more concretely, as periods when the selective pressure on firms is mainly to improve the technical efficiency of their productive processes, and periods when the pressure is to convert M to C and vice versa on more favorable terms, or ideally to skip the C stage and just do M-M'.

    OK, talking about what moment of a process self-awareness happens sounds hopelessly woo. But I think something like it is unavoidable once we acknowledge things like interests at all.

    Whether non-financialized capital must experience a diminishing rate of profit. Well, maybe. There are two theories I know of. One is Marx's, that competitive pressure results in increasingly capital-intensive production processes, while the labor share of income remains constant. (The latter contradicts what he says in Vol. 1.) the other is Keynes, that consumption demand will be fully satiated after some finite time. Both are fairly appealing, intellectually, but empirical reality has not treated them kindly. But maybe you have something else in mind?

  4. I don't believe in a natural economy. I am an institutionalist.

    For me, the economy is almost entirely artifactual, and what I'm interested in, is identifying functional structure and mechanism. As JCH notes, there's a difference between describing what actually happens, and prescribing what ought to happen, but the constrast can be an enlightening means of explanation.

    Not believing in a natural economy, I don't subscribe to such queer notions as a natural rate of interest or a natural rate of unemployment. Still less am I inclined to embrace some millennial speculation about the natural rate of profit, even if I thought such a thing could be defined.

    My inchoate point derived from the observation that salient, non-financial capital investment is typically sunk-cost investment in production processes demonstrating increasing returns (scale economies, network economies). We expect sunk-cost investments to sink, and for the gains in total factor productivity associated with exploiting increasing returns to diffuse. To the extent that doesn't happen, the performance of the economy will be damaged.

    A sector can have its go-go days, but those pass, and we expect profit rates to decline to some systemic norm. (Let's not confuse a systemic norm with a natural rate.)

    If the financial system is re-setting the systemic norm to some dysfunctional standard, that's going to be a problem, and not just from the perspective of cheering for Team Labor over Team Capital.

    Separately, I don't look at the technology behind Netflix streaming, and expect the price to be going up.

    Maybe, there's an issue, here, of a two technologies passing like ships in the night. I guess it is as if Edison owned a candle factory, and he wasn't just being fanciful, when he promised to make candles, a luxury good.

  5. jch-

    1) I guess I just disagree here. I think to a first approximation it's simplest to think of stock buybacks as equivalent to dividends. Both are payments by the firm to shareholders.

    2) This is a valid point, altho it's not entirely clear why existing firms can't invest in new sectors. (And we can certainly think of cases where they have.) Schumpeter famously said that innovation requires "new plant, new firms and new men," but that's a sociological claim, not an economic one. But even granted, there's a tradeoff between the overall higher levels of investment (and greater role for other than narrowly financial criteria) where there's a larger role of internal finance, vs. more possibility of directing investment to new sectors where the surplus is cycled through the financial system, with the substantial associated costs in financial rents. In these terms, it seems like the case for the external fiance model was stronger ten years ago than today.

    3) Absolutely. I don't think there's any kind political base right now for a radical or even left-Keynesian macro policy, so there's no real point in debating what that policy should be. So I agree, it's most useful to frame this as a historical question. The answer I've been suggesting is that (part of) what changed is the increased power of rentiers in corporate governance. Bruce I know disagrees.

  6. jwm point 2)

    I immediately think of the particular case of the phone and cable companies, and the way they grabbed hold of internet connectivity and cellphone service. Is it really advantageous to the nation, to have a company with "telegraph" in its name, in charge of deploying cellphone services or internet connectivity?

    There's a good case to be made that it would be significantly cheaper to simply greenfield fiber optic systems. This could be sponsored by municipalities and local governments, creating common carrier systems on a natural monopoly, regulated utility basis, wholesaling the bandwidth to for-profit retail content or service carriers.

    AT&T, Verizon, Comcast et alia have done a remarkably deft job in state legislatures, of both jettisoning their municipal franchise obligations, and their unions, and preventing municipalities from organizing such development. This is the stuff of "entrepreneurship", in the trenches, of course, and always has been.

    I suspect, though, that, rather than cash from the old financing the new, something of the reverse is happening: old debts are being financed by limiting the pace of new investments and the pace at which the old is made obsolescent. Having AT&T and Verizon do the job is a decided drag on innovation and efficiency.

    I don't know that you need "rentier" power in corporate governance to explain this behavior, though. It seems to me that this is a case, where the political power of the executive class plays the leading role. Actual capitalist stockholders might well have been better off, cashing out of the utilities in decline, and investing in the new utilities as the opportunity arose, through the magic of venture capital and stock market liquidity. It is the executives, ensconsed in the hierarchy, who have the means and incentive to wield political power.

  7. "What is the relations between finance and capital broadly speaking?"


    "The logic of what one might call honest capitalism leads to a tendency toward a gradually diminishing rate of profit, no?"

    In my opinion those are two very related points:
    Let's suppose that there are some actors that we call "capitalists" that tend to reinvest part of their profits in order to mantain and increase their capital, defined as an amount of "value" (either financial or phisical) that is able to generate profit.
    They will spend their extra money only if phisical capital has an higer rate of profit than financial capital, otherwise they will retain their profit as financial capital.
    However financial capital is an asset for the owner because it is a liability for someone else: as the rate of profit falls, there is a lot of money that is not reinvested in phisical capital, but becomes financial capital. This makes financial capital cheap, and thus it becomes more likely that some other actor takes up some debt, either because he is a capityalist and needs capital to invest or because he is a consumer and wants, for example, a house. Thus the unspent profits caused by a fall in the rate of profit become consumption and sum up to the aggregate demand, but only through an increase of the total leverage outstanding in the system.
    In the end, this produces a financialisation of the economy.

  8. ". . . as the rate of profit falls, there is a lot of money that is not reinvested in physical capital, but becomes financial capital. This makes financial capital cheap . . ."

    Cheap for whom?

    Payday loans are not cheap. Credit cards are not cheap.

    In the absence of productive physical capital, financial capital must find ways to increase economic volatility, in order to increase the value of "insurance", and it must seek access to the fiscal capacity of the state -- it must find ways to transform private financial debt backed by nothing* into public debt, backed by taxes.

    *nothing in this case is the false promise of all ponzi finance, but also the false promise of increases in future income, increases that cannot occur in the absence of investment in productive** capital.

    **I don't want to say "physical", because a lot of productive capital is, in fact, intangible, but I understand that when people contrast financial capital with "physical" capital, they are making a point about the distinctive uses, possibilities and inherent limits of pure M > M' transactions.