One of the most influential voices on Wall Street used Netflix to show why markets are overheated
At one point in his sprawling, 22-page memo, the billionaire founder of Oaktree Capital Management zeros in on high-flying tech darling Netflix to explain why many investors - specifically debt investors, in this case - have lost their mind in the pursuit of ever-higher returns.
Marks says that many are complacently giving a pass to low-grade debt because it's attached to a sexy stock pick.
"The credit investors of today clearly aren't gun-shy, leaving investment opportunities to languish at excessive yields and yield spreads," he said. "At best these investments are fairly priced today in relative terms and fully priced - offering low returns like everything else - in absolute terms."
Here's Marks setting the scene:
"I'll use an example to illustrate the acceptance being accorded low-grade credit instruments. In early May, Netflix issued €1.3 billion of Eurobonds, the lowest-cost debt it ever issued. The interest rate was 3.625%, the covenants were few, and the rating was single-B. Netflix's GAAP earnings run about $200 million per quarter, but according to Grant's Interest Rate Observer, in the year that ended March 31, Netflix burned through $1.8 billion of free cash flow. It's an exciting company, but as Grant's reminded its readers, bondholders can't participate in gains, just losses. Given this asymmetrical proposition, any bond issue should be characterized by solidity and a meaningful promised return, not the sex appeal of its issuer."
Netflix stock has been on a monster run, giving the company a more than $80 billion market valuation. Betting that Netflix's stock will continue to soar - it's up 53% this year - in the short-term is one thing.
It's a completely different animal to lend cheaply to Netflix because of its mighty stock performance, since as a debtholder you don't reap the same upside as stockholders.
As Marks points out, Netflix is a riskier bet than some might think. The company is blowing through cash and doesn't have a stranglehold on its market. A fellow FAANG competitor like Amazon or Google could feasibly take a bite out of Netflix's customer base.
Here's Marks again (emphasis his):
"Is it prudent to lend money to a company that goes through it at such a prodigious rate? Will Amazon or Google be able to loosen Netflix's hold on its customers? Is it wise to buy bonds based on a technology position that could be overtaken? Positive investor sentiment has taken the company's equity value to $70 billion; what would happen to the bond price if worries about rising competition took a bite out of that one day? Should you take these risks to make less than 4% per year?
"In Oaktree's view, this isn't a solid debt investment; it's an equity-linked digital content investment totally lacking in upside potential, and it's not for us," Marks continued. "The fact that deals like this can get done easily should tell you something about today's market climate."