Netflix : Viva la overvaluation!

Is Netflix taking over the world? One movie studio makes a multiyear deal to stream videos for dirt cheap back when no one was getting better than 3mb downsteam from their internet connection, and lives to regret it. Netflix now offers first run movies at $8 with an unlimited subscription. This current deal cuts out DVD sales and other revenue streams for the studios. There is little motivation for the studios to continue the deal in it's current form.

"The relationship between Netflix and the media companies will most likely change drastically, beginning next year when a deal between the company and Starz, the pay-TV channel, to stream movies from Sony and Disney expires.

The original deal from 2008, in which Netflix paid an estimated $25 million annually — a paltry sum, executives say, compared with the hundreds of millions of dollars cable and satellite companies pay Starz for the same movies — is now seen as a major coup for Netflix, and a major mistake by Starz. "(1)

Any major increase cost of content will hit NFLX bottom line hard. The current margins of streaming content is huge, but may not continue to be after the next deal. More importantly, it is diffuclt to see the company sustaining a P/E ratio of 69 with massive increases in costs.

The author will sell NFLX $280 strike Jan 12 calls at $12 and buy NFLX $280 strike Jun 11 calls $4.65

(1) "Time Warner Views Netflix as a Fading Star", Dec 13, 2010, New York Times

Fed Out of Bullets: QE2 will keep the status quo

Author: The upcoming announcement by the FOMC regarding QE2 will be a non-event. It will chart the course for allocation of huge sums of money toward a policy that will have little effect toward it's goal. It is estimated that the Federal Reserve will print US currency to buy assets to inject money into the financial system.

Regarding the planned purchase of treasury instruments: the only objective, and a noble one, should be to keep rates where they are, and not allow them to rise. At some point if they keep rigging the auctions too long, there will be a run. This is just prolonging the elevated pricing for the treasuries, but cant move the price any higher.

But I do see Fed continuing to buy hefty amounts of mortgage debt. The whole Fed strategy relies upon the mortgage market remaining steady and solvent. During the last few years a drop in long term mortgage rates has enabled a new refinancing binge that helps alleviate the overhang of underwater mortgages. Now that rates are near rock bottom, this trick has more risk of boomerang if the securities are deemed to be low quality at high prices. The implications are too horrendous if mortgage rates rise even a percentage point.

Prediction: Total of $500B USD purchase over six months, including $350B mortgage and $150B treasuries

Not enough to move the market, but enough to scary anyone away from shorting the market.

What does this mean?

1) USD should bounce
2) Emerging markets should correct mildly
3) Treasuries should hold steady for the foreseeable future (I think they will be successful in that)

For a retrospective look at what Helicopter Ben has hinted as options for QE2, refer to the following article from LA Times, July 22: "Federal Reserve gives us insight into Plan B"

"Fed Would Act if Needed, Chairman Says
Ben S. Bernanke, emphasized on Thursday that the central bank was prepared to take action if needed. (July 22)

In his testimony on Thursday, Ben Bernake warned of “unusual uncertainty” in the markets but said the Fed had no immediate plans to deploy additional tools of monetary stimulus.
“We are ready, and we will act, if the economy does not continue to improve, if we don’t see the kinds of improvements in the labor market that we hope for,” Mr. Bernanke told Representative Melvin L. Watt, Democrat of North Carolina, in the second of two days of hearings on monetary policy…."

"First, he said, the Fed could make clear to the markets that it planned to keep the federal funds rate, currently set at zero to 0.25 percent, for even longer than the “extended period” it has been projecting for months."

Author: uhhhh….this is called “do nothing and hope what we have already done eventually works”. Fed Funds rates are already at zero. I have read that the “real interest rate” with deflation counted in is currently 5%. But the nominal interest rate is already at the lower bound.

"Second, the Fed could lower the interest rate it pays on excess reserves — deposits banks hold at the Fed in excess of what they are required to — from its current level of 0.25 percent."

Author: uhhhh….are you kidding me? Is it really going to make that much of a difference to lower the excess reserves rate from .25% to 0%?

"Third, the Fed could expand its balance sheet, which already stands at $2.3 trillion, primarily by purchasing additional assets, whether in the form of additional government debts and mortgage bonds, or in the form of new assets, like municipal bonds."

Author: Ahhh… here we go…. More of the same thing done before…. Maybe something beyond mortgage bonds which can’t drop much lower than the current 5% yield. The Fed can start buying Greek bonds, Dubai debt, Spanish Banks, US auto loans, US credit card loans and everything else put on the market. I would hate to be a shareholder of one of the US Federal Reserve Banks right now. Forced buying does not make for very good return on investment prospects.

QE2 expectations are too big:Long USD

The USD is oversold. Reports are leaking that the Treasury bond broker dealers are telling Helicopter Ben that additional Fed purchases of Treasury debt may not be productive. Thus the Fed may buy mortgage debt or just reduce the size of the purchases. In any case, the markets have overestimated the interest of the Fed to push rates down further.

Sell UUP Jan 2011 $23 put at .93
Buy UUP Jan 2011 $22 put at .35

.58 upside with .42 downside with technical trends in your favor.

Technical Top - Time to benefit from hype

After this long bull run, it is time for the market to take a breather. The USD is at a historical support point, fiscal stimulus is peaking. It is enough to take a risk that the SPY (SSO) will not rise another 6% (12%) in the next three months.

The author has entered in the following position.

Sell SSO Jan 2011 $47 Call at $1.22
Buy SSO Jan 2011 $48 Call at $.98

Net credit .24 with $1 risk.

QE2? Be quiet. Long the 30Y bond

End of stimulus spending and heightened expectations of quantitative easing make treasury bond prices ripe for increases. Also housing is resuming price declines, pushing money to risk adverse areas of the market.

Sell Jan 2011 TLT $93 Put for $1.2
Buy Jan 2011 TLT $91 Put for .81

Net credit of .39 with a $2 risk.

Doubling down: Sallie Mae senior debt

With the sell off of Student Loan Corp from Citigroup to Discover, the market is finding undervalued assets in private student loans. Sallie Mae, as a third party involved in the deal, purchased a portfolio of $28B portfolio of FFELP, Federal backed student loans, from Student Loan Corp to service. This makes SLM, the 800 pound gorilla, even bigger in the FFELP marketplace. Sallie Mae will be able to use this leverage to support prices and manage supply in this market niche.

"While Sallie Mae will no longer originate FFELP loans, it will still be able to manage its existing $150 billion FFELP portfolio, which generated about $800 million in cash flow in the first quarter, according to analysts." (1)

Sallie Mae has bigger problems. The low interest rate environment hurts earnings because much of the their portfolio floats in a spread to treasuries. Thus the longer the Fed keeps interest rates low the lower the revenue base from the portfolio.

But the real concern is the outstanding debt and whether Sallie Mae will be able to continue to pay it's debt load. Bondholders like us want to know that regardless of the outcome with the company, we are paid what we are owed. A key analyst sees a margin of safety in the current value of the bonds, which are selling at 75cents on the USD.

"For bondholders, the key issue is not the viability of Sallie Mae's business model but the fact that its assets, conservatively valued, more than cover its $27 billion of unsecured borrowings, according to CreditSights. If the company did nothing to restructure, it would have enough value in its current book of business to service its debt, CreditSights analyst Adam Steer said in an interview." (1)

So assuming bonds will pay out at par there is a 25% margin of safety while accumulating a 8% return on investment. Excellent risk reward ratio to the author.

Long SLM again at $19.1 (NYSE: JSM)

(1) Reuters, July 2010

Maybe a weather man would be better

Everyone knows that the there is no better job than the weather man. Every morning this person checks the lastest satellite images for the latest weather trends without insight to cause and tells the public with the utmost confidence what the day will bring. What sets apart stock market analysts and weathermen is belief in an observable and discernable causality. We don't know what makes the weather. We do know what makes money.

Recent data from the US economy makes the weather man look rather insightful. The mixed influence of a worldwide slowdown and a stimulus has the economy giving strange signals. As recently as July, the technology bellweather, Intel, raised guidance for the year by 10% on high demand. Then just three weeks later the company recanted their upward guidance and stated they will achieve the lower end of their original guidance.

Then on the premise of an upside surprise on the August ISM manufacturing index, the market bounced and gained 5% on renewed optimism. A few days later, when the much larger services sector index underperformed showing only slight growth in the August and the July factory orders index came in below expectations, the market showed no reaction.

It is impossible to tell what is driving the economy right now, or if it is growing or falling off. Many analysts can point to many different data points, but they should defer to a professional who is comfortable with extreme uncertainty. The safest person to ask the direction of the market is to ask the weatherman.