Rule of 72, Apple (APPL) and Netflix (NFLX)

I just got back from a trip to Cornell University in Ithaca, New York (beautiful time of the year to visit.) This week’s blog is a hodgepodge of topics: Rule of 72 for young adults (inspired by throngs of enthusiastic Cornell students), should Apple pay a dividend, and Netflix’ third quarter financial announcement.

Rule of 72 for young adults: The rule of 72 and an overview of other basic financial information should be taught in every high school and university in the world. A short definition on how the rule of 72 works: it is 72 divided by the investment yield which equals the number of years required for the investment to double. With an investment yield of 6% your investment will double in 12 years (72 / 6 = 12). For example, if you invest $10,000 and the investment yield is 6% in 12 years you would have $20,000. Why is this vitally important for young adults to know? Here’s why: had I invested $10,000 at the age of 22 (I decided to buy a used car and not a new car) and the investment yield was 7% I would have $233,290 at the age of 67. If I postponed the decision to save or invest money until the age of 40 (leasing expensive cars, etc.), with the same investment of $10,000, by age 67 I will only have $66,182. If you understand how the rule of 72 (compounding) works you will be much more likely to start investing at a young age. Another hypothetical example, you are getting married at 22. Your parents give you up to $30,000 to spend on the wedding, or you could reduce the cost of the wedding and invest the difference. You decide to cut back the cost of the wedding and invest the difference. Let’s use the following example: the wedding cost $10,000 and you invested $20,000 with a yield of 7%. At the age of 67 you will have $466,580. The better you understand the rule of 72, the more likely you are to become an investor and not a consumer (and in debt). You will “get” why you should start investing at a young age and pay yourself first (this means you save a certain amount of money from every paycheck you receive). If all young people bought in to this way of thinking, it would go a long way toward helping the US become a nation of savers and not spenders (and increasingly in debt). Likewise it will also help the US become a net exporter (like China and Germany as examples) and not a net importer nation (forever increasing national debt).

Should Apple pay a dividend? Apple paid a dividend from June 15, 1987 to December 15, 1995. The lowest dividend payout was $.06 and the highest was $.12. If Apple were to have a 4% dividend yield (assuming the stock price was $300) it would require a $12 yearly dividend payout ($3.00 per quarter). Apple’s reported fourth quarter results (October 18, 2010) indicated profits of $4.31 billion and free cash flow of $5.7 billion. Apple has 914 million shares outstanding; to pay a $3 quarterly dividend it would require Apple to distribute $2.742 billion to shareholders each quarter. This is 48% of the quarter’s free cash flow number. The dividend payout ratio (dividends per share / earnings per share) would be ($3 / $4.64) 65%. Apple should have no problem paying a 4% dividend payout as they have approximately $50 billion dollars of cash or cash equivalent on-hand (Apple is in the top 5 non-financial companies in the world for amount of total cash or cash equivalent on-hand). A company can do the following with its cash or cash equivalent on-hand:

• Increase Research and Development (R&D), sales force, etc.
• Start or increase dividend payout
• Increase capital or infrastructure expenditures
• Buy companies
• Invest the cash
• Buy back shares to increase the price of the stock

(If you are interested, for a more detailed discussion, please see the following blog: http://paulsgang.blogspot.com/2010/09/investing-in-possible-buyout-companies.html)

In my opinion, Apple should again start paying a dividend. With a 4% dividend yield they can still accumulate cash (around $2.5 billion per quarter) and it may spur an increase in the number of people willing to buy the stock. What is your opinion? Please add a comment if you think Apple should or should not pay a dividend to their shareholders.

Netflix third quarter financial announcement: I had a record number of visits to Paul’s Gang from last week’s blog on Netflix and received plenty of positive feedback. Netflix announced their third quarter financial results October 20, 2010. What was good about the Netflix financial announcement was: over 2 million new subscribers for the quarter, 66% of subscribers using streaming video (subscribers will watch more content on streaming video than DVDs in the fourth quarter) and 31% revenue growth year over year. What was not so good was: there are over 1 million free (non-paying – trial customers) subscribers (the percentage of which has been increasing), gross margin decreased by 1.7% from the second quarter (number of free subscribers or increasing cost of content?) and overall free cash flow was only $7 million. Overall it was maybe an above average but not great financial announcement. Stock price did increase by over $19. What did you think of Netflix’ third quarter financial announcement? What do you think will be the high and low stock price in the fourth quarter?

Please chime in with comments about the rule of 72 for young adults, should Apple pay a dividend and Netflix’ third quarter financial announcement. What are your favorite financial and investment books, ideas for future blogs, etc.? Future blogs that I will be writing:

• Income generating bucket of money
• Investing in possible buyout companies
• Investing in Brazil
• Reviewing the classic financial book (written in the 1950’s): Common Stock and Uncommon Profit by Philip A. Fisher
• Using Philip A. Fisher’s stock picking methods to analyze stocks

© 2010 Paul Cusick

Netflix (NFLX)

In this week’s blog I evaluate Netflix Inc.: current and future business strategy, financials and what would be a reasonable buy price for the stock. To quickly summarize Netflix business, customers can view TV shows and movies by video streaming over the internet and playing on TVs, computers, smart devices (cell phones, game consoles), iPads and other devices. The customer can also get DVDs delivered by mail (depending on the product level/delivery method the customer selects upon subscribing). There are no late fees, no due dates or shipping fees with any of their delivery methods (this was one of the key factors that helped drive Blockbuster, one of their major competitors, to bankruptcy). Currently Netflix have over 12 million subscribers in the US.

Netflix built its company and reputation on mailing DVDs to households and a recommendation engine that suggested videos based on consumers’ viewing history. As Netflix expands beyond North America, this delivery method will not be available to international customers, although the streaming option will still suggest shows or movies based upon your preferences.

The long range plan of Netflix is to reduce the number of DVD subscribers (DVDs shipped per day number over 2 million) and enlarge the customer base that uses video streaming. Half of their cost of goods sold or COGS ($1.4 billion in 2009) goes to the cost of postage and handling of DVD shipments. They paid the United States Postal Service over $600 million per year just to ship DVDs. It costs $1 every time Netflix sends a DVD to a customer versus less than 5 cents to stream video content.

Another long term goal is to expand internationally with video streaming only. In September 2010 Netflix launched in Canada a video streaming delivery method, charging a flat fee of $7.99 (CD) per month, for which the customer can view as many TV shows or movies as they wish. It’s similar to a franchise business, such as McDonalds, which can continue to grow revenue and profits by expanding its business into new countries. Canada has a higher broadband penetration than the US with over 70 percent of households receiving the service. There are 13 million households in Canada, so the number of potential customers for Netflix’s streaming video delivery method would be 9.1 million households. More than 10% of households in the US subscribe to Netflix’s products (DVD and video streaming). If we assume that 10% of Canadian households will have become Netflix subscribers by January 1, 2014, the revenue generated would come to around $87 million. Netflix’s current net income is 7.25 percent (this includes the high-cost DVD delivery method which will not be part of international Netflix offerings). If we assume that revenue will be 1.5 times higher for the international business, the international net income would be about 11 per cent (this is a conservative estimate – it could be higher). The Canadian business would contribute $9.5 million to Netflix’s annual net income. Another example: if Netflix decides their next expansion target will be Great Britain, and there are 3 times the broadband equipped households in Great Britain as there are in Canada, the estimated net income would be approximately $29 million per year. Netflix’s current number of outstanding shares is 52.36 million. If Canada and Great Britain contributed $38.5 million in net income, it would add $.73 to the earnings per share (EPS). This estimate is low; I would think with the low cost of streaming video the net income could be 14.5 percent which would add at least $1 to Netflix’s EPS.

There are over 500 million households globally that have broadband and that number will continue to grow over the next 10 years. Netflix is well positioned for the future to expand the brand, revenue and profit by expanding globally.

Currently the market for internet streaming video has 3 segments: video-on-demand (user pays $5 for a movie), ad supported (you see ads before viewing the content) and subscription, like Netflix. Examples of VOD competitors would be Amazon, Apple and cable companies (i.e. Comcast). Ad supported competitors include Hulu and YouTube. Netflix is the primary provider in the subscription segment. Other competitors will enter the market as consumer demand for video streaming continues to grow. Netflix will have the following advantages over its competitors in the subscription segment:

· Video streaming technology that has the ability to scale streaming video worldwide

· Revenue stream that allows it to continue adding to its movie and video content

· Excellent consumer brand recognition (like Apple and Google)

· Superior user experience

· Personalized merchandizing and technology to enhance the user experience

· Advanced technology and operational efficiency

· Expanding number of supported devices

Netflix is not an inexpensive stock. It currently sells for around $150 with a 52 week high of $174.40 and a low of $45.94. It has a current price earnings (PE) of 61 and an estimate for next year of 40. Netflix can continue to grow their brand, revenue and profit margin by expanding to international markets. Since they can deliver video streaming to your home, office or mobile device, they could also deliver other content, for example, music, magazines, e-books, etc. By expanding their product offering, they could gain market share, increase the subscription price and charge more for the added features. Netflix has one of the best consumer brands in the US. It has very high consumer ratings for customer service, delivery, ease of use, movie and TV information, personalized information, etc. With their growing scale and revenue Netflix can continue to scale video streaming and buy content for the worldwide market. I think Netflix has a lot potential and can continue to grow revenue and profits by expanding globally; after the worldwide recession subsides, they should be able to raise their subscription prices. If the stock pulls back to between $110 and $120 I will put in a buy order.

The following are some of Paul’s Gang recommended financial and investment books. If you are interested, you can select the link and get a review of the books from the Amazon website:


The Ascent of Money: A Financial History of the World
The Big Short: Inside the Doomsday Machine
Common Stocks and Uncommon Profits and Other Writings (Wiley Investment Classics)
Die Broke: A Radical Four-Part Financial Plan
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
The Intelligent Investor: The Classic Text on Value Investing
The Millionaire Mind
One Up On Wall Street : How To Use What You Already Know To Make Money In The Market
Security Analysis: The Classic 1934 Edition

Please chime in with comments about NetFlix. What buy price would you look for? What are your favorite financial and investment books, ideas for future blogs, etc.? Future blogs that I will be writing:

Income generating bucket of money

Investing in possible buyout companies

Understanding the Rule of 72 and why it is important for young adults

Investing in Brazil

© 2010 Paul Cusick

Non Tradable (Non Traded), Non Exchange Traded or Private REITs

This week’s blog is about non tradable Real Estate Investment Trusts (REITs). These also go under the names: non exchange traded REIT and private REIT. My family inherited a non tradable REIT, Inland American Real Estate Trust, Inc. and that raised the question in my mind: is this a good investment for your income generating bucket of money (a relatively risk free source of income)?

The non tradable REITs have the same qualifications as exchange traded REITs (REIT blog: http://paulsgang.blogspot.com/2010/07/reits.html).

The following are the major qualifications of REITs:

• Pay dividends of at least 90% of the REIT’s taxable income
• Have shares of transferable certificates of interest
• Owned by 100 or more persons
• At least 75% of their total investment must be in real estate
• Have at least 95% of gross income from dividends, mortgage income or property income
• Derive at least 75% of gross income from mortgage interest or rents

The major difference between tradable and non tradable REITs is the first are traded on a stock exchange and the second are not. You can sell tradable REITs like any other stock which makes them liquid. You know the value of your investment at any time.

The first major problem with non tradable REITs is they are not traded on stock exchanges which make them illiquid. You can only sell non tradable REIT shares to the REIT company that you bought them from if they have a stock repurchase program, or on a secondary market. If a non tradable REIT has a stock repurchase program, it may impose restrictions that can make it barely more liquid than a REIT without a stock repurchase program. Such restrictions might include: you can only sell the shares after a number years of owning them, some non tradable REITs will only buy back a percentage of outstanding shares (for example 5%) and they can stop the stock repurchase plan at any time. During the current real estate financial crisis many of the largest non tradable REITs have suspended their repurchase programs. Inland American is one of the non tradable REITs that have done this. The only way you can sell your shares in on the secondary market.

The second problem is that non tradable REITs have high upfront cost (sales commission). The upfront cost can be as high as 15% (on the other hand the purchase cost of tradable REITs can be as little as $5 per trade). For example, if you purchase $100,000 of a non tradable REIT, your financial advisor just made $15,000 (it is very difficult to be unbiased when you are being paid a very high commission).
Inland American is the eighth largest retail real estate owner in the United States, located in 47 states with managed assets of $25.3 billion. Currently they pay a 5% dividend yield, reduced from a 6.2% dividend yield in January 2009. Inland American stopped their stock repurchase plan in March 2009. The Inland American shares were bought for $10 in 2005. After checking several non tradable REIT secondary market companies, the highest price they were willing to pay for the shares was $4. In 6 six years the investment has taken a 60% ‘haircut’ (loss) in the value of Inland American shares. The company that buys the shares on the secondary market would get a 12.5% dividend yield.

There are much better investments for your income generating bucket of money for example, short term (duration) bond funds, annuities (for example a gift annuity that includes a tax free portion), etc. An illiquid investment carries higher risks than a liquid one; this becomes exacerbated during times of financial problems/crises. The investment becomes much more difficult to unload, or you can only do so by losing a lot of money on it. The high upfront cost is another problem - it is hard to swallow paying somebody 15% for their ‘financial advice’ (how unbiased can you be when you are getting such a hefty commission?).

You should be very careful when you invest in non tradable REITs and - like all investments - you need to understand the advantages and disadvantages of the investment. In 6 six years the value of the Inland American investment dropped 60% for a 5% dividend yield. I question if my relative’s ‘financial advisor’ ever talked about the disadvantages of non tradable REITs, my assumption is he only talked about the 6.2% dividend yield.

The following are some of Paul’s Gang recommended financial and investment books. If you are interested, you can select the link and get a review of the books from the Amazon website:

The Ascent of Money: A Financial History of the World
The Big Short: Inside the Doomsday Machine
Common Stocks and Uncommon Profits and Other Writings (Wiley Investment Classics)
Die Broke: A Radical Four-Part Financial Plan
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
The Intelligent Investor: The Classic Text on Value Investing
The Millionaire Mind
One Up On Wall Street : How To Use What You Already Know To Make Money In The Market
Security Analysis: The Classic 1934 Edition

Please chime in with comments about non tradable REITs. What are your favorite financial and investment books, ideas for future blogs, etc.? Future blogs that I will be will be writing:

• Evaluating NetFlix stock
• Income generating bucket of money
• Investing in possible buyout companies

© 2010 Paul Cusick