Governance Issue: Netflix, Inc.

GMI Ratings
Governnance Issue: Netflix, Inc.

Region:   North America  

Sector:   Non-Cyclical Consumer Goods / Services

Industry: Personal Services

Market Cap:  $ 5,773.0mm (Large Cap)

ESG Rating:   D

AGR:   Very Aggressive (2)  

Reed Hastings, Founder, Chairman and CEO of Netflix, is an example of a powerful executive whose ability to dominate a board of directors can greatly damage shareholder interests.

In its latest nosedive, the Los Gatos, Calif. video subscription company’s stock price has plummeted nearly 17% this week to $88.50 per share as of the market’s open on Wednesday, according to Yahoo. Hastings said in a conference call Monday that he planned to add 7 million subscribers this year, or about the same as in 2010. He told investors that his business, which lost nearly $5 million during the first three months of this year compared with a profit of $60 million during the same time frame in 2011, was performing exactly as hoped.

Financial analysts responded by grilling him about his forecast and how he plans to accomplish it, particularly as he faces competition from behemoths such as the online retailer Amazon.

The market stopped trusting Hastings some time ago. After hiking his prices, he lost a million subscribers and had to change his third quarter forecast on September 15, 2011, according to news reports. A few days later Netflix said in a blog post that its DVD-by-mail service would operate separately from its streaming service on the website Qwikster. After that decision upset subscribers, the company backtracked on its plan within weeks. “There is a difference between moving quickly — which Netflix has done very well for years — and moving too fast, which is what we did in this case,” Hastings said in a statement on Oct. 10, 2011. About two weeks later, his company revealed that its obligations for content over the coming years had risen to $3.5 billion, with $2.8 billion due within three years.

Investors filed a class action lawsuit in the Northern District of California this January, alleging that Netflix concealed that it signed short-term contracts with content providers that backed the company into renegotiating in 2011 either at much higher rates or not at all. Netflix also allegedly hid that its pricing would have to increase to maintain profit margins and that it wasn’t on track to meet its 2011 earnings forecast. The stock traded at artificially inflated prices, reaching a high of almost $300 per share on July 13, 2011, and insiders sold their holdings for proceeds of $90.2 million, the complaint alleges.

For years Netflix insiders bought up stock – sometimes opting to use debt proceeds to do so – and boosted the company’s share price. They later sold ahead of price declines, as depicted in the chart below.

Since Hastings earns market priced options, he has an incentive to manage for short term stock price movements, rather than manage the company for the long term. Meanwhile, GMI Ratings had warned on June 7, 2010 that Netflix’s board wasn’t as accountable as it could have been, due to factors such as charter and bylaw provisions that made it challenging for shareholders to achieve control by removing board members.

“Netflix management decisions are made for the long term growth and benefit of the company,” the company’s spokesman Steve Swasey said in an email. He declined comment on Netflix’s stock price or pending litigation.

To be fair, Netflix’s board cut Hastings’ stock options to $1.5 million for 2012 — half what he’d gotten the previous year, according to a regulatory filing on Dec. 22, 2011. But that belated slap on the wrist wasn’t enough to save him from himself or to protect his investors’ wallets in recent months.

GMI Ratings gives Netflix a D on its corporate governance, in part due to the way the company communicates with the market about its finances.

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