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Inflation is running at a reported 5.1% in China, a figure most believe is on the low side. Nonetheless, China has been loath to hike rates out of fear of more "hot money" flowing in. Something had to give, and it did. The markets forced China's hand.

Please consider China Increases Rates to Counter Highest Inflation in Two Years

China raised interest rates for the second time since mid-October to counter the fastest inflation in more than two years and more moves may follow.

The benchmark one-year lending rate will rise by 25 basis points to 5.81 percent and the one-year deposit rate will climb by the same amount to 2.75 percent, effective today, the People’s Bank of China said in a one-sentence statement on its website late yesterday.

Premier Wen Jiabao is seeking to slow gains in property values and consumer prices that are making it harder for families to buy homes and pay for food. Bank lending and a wider-than-forecast November trade surplus have pumped more cash into an economy already awash with money.

China is tightening after a record expansion of credit to counter the effects of the world financial crisis. The broadest measure of money supply, M2, has surged by 55 percent over the past two years and outstanding yuan-denominated loans have climbed 60 percent to 47.4 trillion.

Residence-related costs, including charges for water, electricity and rent, jumped 5.8 percent last month from a year earlier, the most in more than two years, and consumer goods prices rose 5.9 percent, the biggest gain since August 2008, according to statistics bureau data.

Policy makers are concerned that raising interest rates could “encourage hot money inflows,” Paul Cavey, a Hong Kong- based economist at Macquarie Securities Ltd. said. “Raising interest rates has far more implications” than ordering lenders to set aside more of their deposits as reserves, as it may affect the ability of local governments and companies to pay their debts.

State Council researcher Ba Shusong told state television yesterday that the government will step up regulation of capital inflows, without specifying measures that will be taken.

The Ministry of Commerce is stepping up supervision of foreign investment in real estate to crack down on speculation after a 48 percent jump in overseas fund inflows to the industry in the first 11 months of the year, spokesman Yao Jian said on Dec. 15. Policy makers may also allow faster gains in the yuan to help curb inflation from higher prices of imported commodities, according to analysts’ forecasts.

China Overheating

China was number 5 on my list of Ten Economic and Investment Themes for 2011

5. China Overheats, Multiple Rate Hikes Coming

China, everyone's favorite promised land, has a hard landing. China will grow at perhaps 5-6% but that is nowhere near as much as China wants, or the world expects. Tightening in China will crack its property bubble and more importantly pressure commodities. The longer China holds off in tightening, the harder the landing.

Capital Controls Coming

Initially, rate hikes will encourage more "hot money" inflows into China. In hopes of preventing those inflows, China has announced more capital controls. It will be interesting to see precisely what those controls will look like.

Currency Sterilization Needed

One thing China should do is sterilize speculative hot money and balance of trade inflows via domestic government bond issuance, hoping to curb money supply growth.

However, it is not as simple as that, because in a fractional-reserve credit system, a net increase in lending itself increases money supply.

Clearly the Chinese central bank is behind the curve. Will China simply restrict lending? Would it even work?

I do not know about the former, but the latter would eventually force a hard landing if China gets serious enough. Actually, there are so many problems that I think a hard landing is coming regardless, and the longer China dallies, the harder it will be.

In the meantime, these paltry rate hikes by China of .25 points each pale in comparison to increases in reported consumer price increases.

Enormous Property Bubbles Including Vacant Cities

It is not "consumer price inflation" that is the big problem. Asset inflation, especially property speculation is rampant.

In case you missed it please consider The ghost towns of China: Amazing satellite images show cities meant to be home to millions lying deserted

Speculation will continue until China gets serious or until the pool of greater fools buying property at absurd prices dries up.

China’s Army of Graduates Struggles for Jobs

Exacerbating China's myriad of problems, an Army of Graduates Struggles for Jobs

In 1998, when Jiang Zemin, then the president, announced plans to bolster higher education, Chinese universities and colleges produced 830,000 graduates a year. Last May, that number was more than six million and rising.

It is a remarkable achievement, yet for a government fixated on stability such figures are also a cause for concern. The economy, despite its robust growth, does not generate enough good professional jobs to absorb the influx of highly educated young adults. And many of them bear the inflated expectations of their parents, who emptied their bank accounts to buy them the good life that a higher education is presumed to guarantee.

“College essentially provided them with nothing,” said Zhang Ming, a political scientist and vocal critic of China’s education system. “For many young graduates, it’s all about survival. If there was ever an economic crisis, they could be a source of instability.”

In a kind of cruel reversal, China’s old migrant class — uneducated villagers who flocked to factory towns to make goods for export — are now in high demand, with spot labor shortages and tighter government oversight driving up blue-collar wages.

But the supply of those trained in accounting, finance and computer programming now seems limitless, and their value has plunged. Between 2003 and 2009, the average starting salary for migrant laborers grew by nearly 80 percent; during the same period, starting pay for college graduates stayed the same, although their wages actually decreased if inflation is taken into account.

Chinese sociologists have come up with a new term for educated young people who move in search of work like Ms. Liu: the ant tribe. It is a reference to their immense numbers — at least 100,000 in Beijing alone — and to the fact that they often settle into crowded neighborhoods, toiling for wages that would give even low-paid factory workers pause.

“Like ants, they gather in colonies, sometimes underground in basements, and work long and hard,” said Zhou Xiaozheng, a sociology professor at Renmin University in Beijing.

Odds for social unrest will mount if China's growth slows. Yet, because of short-term overheating concerns on top of long-term peak oil issues there is no way China can keep growing at the current pace.

Eight Problems Facing China

Hot money inflows

Huge property bubble

Massive increases in money supply, much of it property speculation and building of unneeded capacity

Currency manipulation charges from the US and potential trade wars

Unsterilized trade imbalances fuel inflation

Slowing Europe

Dearth of Jobs for new graduates

Potential social unrest

Case For Hard Landing

Risks are enormously skewed to the downside, so much so that the odds China avoids a hard landing are not good. China is far more exposed to a slowdown in Europe than the US and the popping of China's property bubble will extract a huge toll.

Those plowing into commodities, foreign currencies, and equities (especially foreign equities), fail to consider those risks.

Moreover, given that much of China's growth is overheating and malinvestment, it is not even clear the Renminbi is undervalued.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

In what is rapidly becoming a mockery of the investing process, after Netflix recently advised shorts to cover during their investor call, the firm's desperation has hit a new all time low. Today NFLX CEO, Reed Hasting, has responded directly to ongoing attacks by Whitney Tilson that his company is due for a major correction, by posting in financial website Seeking Alpha. Hastings' stunning conclusion: " Whitney lays out a series of potential issues for us: Our CFO’s
recent resignation; threats to the First Sale doctrine for DVDs;
Internet bandwidth costs potentially increasing; declining FCF
conversion; market saturation; weak streaming content; paying more for
streaming content; and increased competition hurting margins. He only
has to be right on one or two of these issues in 2011 for him to make
money on his short of Netflix. Odds are he is wrong on all of them, in my view. Let’s take them one at a time." And while Tilson has indeed suffered major losses so far on this short, we are very confident that his perseverance will pay off. As we noted previously, the major concern facing Netflix is not so much margins (which is a major concern), but cash flow generation. As such, we continue to view the probability of a follow on offering by the company to be very high, as the firm already issued high yield bonds recently and has very little dry powder left under the "indebtedness incurrence" basket. In the meantime, we can all enjoy the spectacle that is NFLX' defense of its ludicrous 100x+ fwd P/E position.

From Seeking Alpha:

Netflix CEO Reed Hastings Responds to Whitney Tilson: Cover Your Short Position. Now.

A great investor and a wonderful human being, Whitney Tilson recently posted an article about why he is short Netflix (NFLX).
Whitney, who is a major co-donor with me to charter public schools like
KIPP, writes that he has lost money betting against Netflix, and that
he is still short Netflix in a big way.

At Netflix we mostly
focus on building our business and letting the numbers do the talking.
But Whitney is such a big-hearted donor to causes that I care about that
I am writing this open letter for him to try to get him to cover his
short now. My desire is to increase his odds of making money next year
so he can donate even more to the charter public schools that we both
think are important to our country’s future. For the record, I think
short sellers are a positive force in capitalism, and I acknowledge that
CEOs are generally biased in their bullishness on their respective
firms.

Whitney’s core short thesis in his article “Why We’re Short Netflix” is:

In particular, we think margins will be severely compressed and growth will slow over the next year.

This is the natural outcome of his view that:

We
don’t believe that Netflix has a better business model, better
management or a meaningful competitive advantage in the business of
streaming movies and TV shows.

Whitney
lays out a series of potential issues for us: Our CFO’s recent
resignation; threats to the First Sale doctrine for DVDs; internet
bandwidth costs potentially increasing; declining FCF conversion; market
saturation; weak streaming content; paying more for streaming content;
and increased competition hurting margins. He only has to be right on
one or two of these issues in 2011 for him to make money on his short of
Netflix.

Odds are he is wrong on all of them, in my view. Let’s take them one at a time.

As
to the CFO issue, Barry McCarthy is a very accomplished executive who
was working for a successful, younger CEO, so he correctly figured the
chances of him becoming the CEO of Netflix were not high. In early 2004
he had the same feeling, and let us know that we should launch a search
to replace him by the end of 2004. During that year we entered into a
huge fight with Blockbuster (BBI), and Barry felt it would be low integrity to leave us in the midst of battle. So, he agreed to stay for a few more years.

By
2008, we had substantially exited from our hand-to-hand combat with
Blockbuster, and he started talking with me about the need for him to someday
soon go seek his future broader role. Two weeks ago, he informed me
that it was time for him to move on. He was willing to stay for up to a
year, like in 2004, if we wanted to do a search. After discussions
with the board, we chose his longest-serving finance lieutenant, David
Wells, as our next CFO, instead of doing an outside search, and
announced the transition. We feel great about David Wells as our CFO,
and there was no reason to ask Barry to stay further. Barry is a
super-principled guy, and if there were any known major danger, he would
never have left us. It is precisely because things look so good going
forward that he allows himself to think about his own career ambitions.
Some lucky firm will get him as CEO.

On the First
Sale doctrine, which only applies to DVDs and provides our right to rent
a DVD after its first sale, even Whitney acknowledges that any
potential change would not happen for several more years. Given the
rate of our streaming growth, by the time there was any change to the
First Sale doctrine, we would be not very sensitive to DVD costs. This
issue is not a material threat to 2011 results, and thus not a potential
reason to be short Netflix now. Perhaps Whitney was just trying to be
thorough.

Next in Whitney’s catalog is the issue of
potentially increasing internet bandwidth costs, given the recent fracas
between Level 3 (LVLT) and Comcast (CMCSA).
The cost of sending or retrieving a gigabyte of data has fallen every
year for at least 30 years. Advances in technology are making all the
parts of data transmission cheaper and cheaper, roughly following
Moore’s Law. The odds that the cost of moving a gigabyte of data
materially increase in the next few years are extremely low.
It is vastly more likely that the costs continue to fall as component
prices fall. There is some chance that consumer ISP networks like
Comcast will prevail in their battle to not only charge consumers of
data, but also charge suppliers of data (e.g., Google (GOOG), Netflix, Apple (AAPL), etc.). This has been an ongoing battle for many years.

A
valid concern over the long term is how much power the consumer ISP
networks will have to charge data suppliers (i.e. content). In the case
of ESPN3, however, it is the reverse: ESPN3 charges consumer ISP
networks like Comcast for the privilege of transporting the ESPN3 data
to the ISP’s consumers (in essence, Comcast and peers are forced to
share some of the revenue of the $45 per month broadband package with
ESPN3). We don’t have any plans to go the ESPN3 route, but the odds of
material negative Netflix P&L impact from broadband pricing trends
in 2011 are very low.

Moving to more interesting
angles, Whitney documents our recent decreased FCF conversion due to us
paying for content earlier than we had in the past. With this angle,
Whitney does draw a little blood. Our new CFO David Wells and our
content team are all over our need to get more consistent about
pay-by-quarter for content going forward rather than pay-by-year, even
if it means we’ll pay a little more. We will be working to improve the
FCF conversion trend in 2011. On a long term basis, FCF should track
net income reasonably closely, as it has in the past, with stock options
as an offset against small buildups in PPE and prepaid content. Nearly
all of our computing is through Amazon (AMZN) Web Services and CDNs, which are pure opex.

Next
in the litany of Whitney threats is market saturation. In 2011, this is
unlikely to affect us. Streaming is growing rapidly; it is propelling
Hulu, YouTube, Netflix and others to huge growth rates. Streaming
adoption will likely follow the classic S curve, and we’re still on the
first part (acceleration) of the S curve. Since we expanded into streaming, Netflix
net subscriber additions have been 1.9m in 2008, 2.9m in 2009, and over
7m this year (estimated). While saturation will happen eventually,
given the recent huge acceleration of our business specifically, and
streaming generally, saturation seems unlikely to hit in the short term.

The next issue is what Whitney calls our “weak
content.” While Whitney may think “Family Guy” is weak content, our
subscribers do not. Furthermore, our huge subscriber growth to date has
been built on this “weak content,” so imagine how much upside we have as
we improve our content, as we are always trying to do. I think what
Whitney may be misunderstanding is that at $7.99 per month, consumers
don’t expect to have everything under the sun. A variant of this
misunderstanding is when DirecTV (DTV)
advertises against Netflix, calling out some Netflix content
weaknesses. When an $80 per month service is picking on an $8 per month
service, the $8 per month service just gets more attention from
consumers and grows even faster.

Moving on to the
widely-discussed issue of increased content costs, it is true that we
are paying more for any given piece of content than we were two years
ago, and that in two years, we’ll pay more than we pay today. Part of
our goal as a business is to make money for content producers and to
become one of their largest and best revenue sources. Fortunately, our
subscriber base is growing fast enough, and DVD shipments are growing
slow enough, that we can afford to pay for the existing streaming
content we have, and also get more content. We try not to comment on
specific deals, like the Starz renewal, as that rarely helps us get
deals done.

Investors sometimes see the content
cost threat as an issue around our margins. But we have no intention of
overspending relative to our margin structure, and there is no specific
content that we “must have” at nearly any cost. In our domestic business
we spend 65-70% of revenue on COGS (which is mostly content and
postage). So if content costs rose faster than we expected, then in
practice we’d have less content than otherwise, rather than less margin.
This would ultimately show up in less subscriber growth than we
wanted from a not-as-good-as-it-would-otherwise-be service; it would not
likely show up as a sudden hit to margins. Management at Netflix
largely controls margins, but not growth.

Turning
to competition, there is a legitimate short thesis in the unknown of who
enters directly against us and when. Some offerings like Hulu Plus have
some content we do not, but we are making progress on that gap. In the
near term, some of our subscribers will also subscribe to Hulu Plus, but
very few will quit Netflix because we have lots of streaming content
that Hulu Plus does not. For a competitive firm to materially hurt our
growth, they have to have some positive differentiator (price,
additional content, integration, etc.), and then they have to market
their service effectively. This wild-card of major new competitor
offering great content and marketing aggressively is the single best
near-term short thesis, but no one knows if it will happen in 2011.

The
core competitive barrier for direct competitors is
brand/subscriber-evangelism. Our large subscriber base is very happy
with Netflix, and tells their friends about Netflix. That means that the
cost of acquiring the incremental 1m subscribers is lower for us than
for a competitor, and thus our net additions are higher. There are also
lots of other smaller competitive barriers, but the happy subscriber
base is the big one.

Another competitive threat is TV Everywhere. If MVPDs (multichannel video programming distributors) are
successful at getting their subscribers (which is practically everyone)
to use TV Everywhere, which is free, instead of Netflix, for streaming
video, then the market opportunity for supplemental services like
Netflix and Hulu Plus will be much smaller. There is no additional
profit for MVPDs in TV Everywhere, but they are motivated to slow the
growth of supplemental services because of the fear that someday the
combination of ESPN3, Netflix, CNN.com, Hulu, YouTube, and others could
be an effective MVPD substitute over the internet. The TV Everywhere
threat will grow over time, but is unlikely to bite in 2011 in a
short-satisfying manner.

An issue that Whitney did
not bring up is potential Netflix international expansion that would
shrink global margins in the short term. We announced in October that we
were so pleased with our initial results in Canada, which, if trends
continue, will mean we can get to breakeven there one year from launch,
that we were likely going to invest heavily in further international
expansion, and that if we did so, it would be to the tune of a $50m hit
to global operating income in the back half of 2011. We think the
international opportunities for us to build profitable businesses may be
quite large, but the rapid expansion will lower global operating
margins as long as there are additional markets in which we can wisely
invest. Starting next year we’ll break out domestic versus international
for investors so they can track our progress for themselves.

To
wrap up, I have to agree with my friend Whitney that there are many
risks ahead for Netflix, that our valuation is substantial, and that it
is possible that one could make money shorting Netflix today. But
shorting a market leading firm as it is driving a huge new market is a
very gutsy call. On balance, I would rather have my co-philanthropists
on the long side of this particular bet.

Whitney: Short or long, I look forward to dinner and drinks together in the New Year.

Respectfully, your ally and admirer,

-Reed

Disclaimer:
The foregoing comments contain certain forward-looking statements
within the meaning of the federal securities laws, including statements
regarding threats to the First Sale doctrine for DVDs, internet
bandwidth costs potentially increasing, declining FCF conversion, market
saturation, weak streaming content, paying more for streaming content,
and increased competition hurting. These statements are subject to risks
and uncertainties that could cause actual results and events to differ.
A detailed discussion of these and other risks and uncertainties that
could cause actual results and events to differ materially from such
forward-looking statements is included in our filings with the
Securities and Exchange Commission, including our Annual Report on Form
10-K filed with the Securities and Exchange Commission on February 22,
2010. We undertake no obligation to update forward-looking statements to
reflect events or circumstances occurring after the date these comments
are posted.

Disclosure: I am long NFLX

Additional disclosure: I am CEO of Netflix

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Tuesday, December 28, 2010

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