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JakilaTheHun (99.93)

Netflix's Management Has Learned the Wrong Lesson

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September 19, 2011 – Comments (7) | RELATED TICKERS: NFLX , AMZN , DISH

I’m almost dumbfounded after reading about Netflix’s new plan to split its DVD and streaming services.  A few months back, Netflix decided to end its bundled streaming + DVD plans, charging for both services separately.   For most customers, the new scheme resulted in a 60% price increase.  At the time, my take was that Netflix was trying to divest its DVD segment and believed it could more easily do so by splitting the two segments.  My problem was that I viewed it as extremely unlikely that any potential buyer could get as much value out of NFLX’s DVD segment as Netflix itself would.

Now Netflix is completely splitting the two segments, rebranding the DVD business “Quikster,” and launching a separate website for the service.   By making this move, Netflix CEO Reed Hastings has suggested that it’s pertinent for Netflix to “evolve with the times” and not go the way of Borders, the now-bankrupt book retailer.  Yet, both as a Netflix customer and an investor, I can’t help but to feel that Hastings is learning the wrong lesson.

Netflix’s Value Proposition

Hastings views streaming as “the future”, as he should, but he seems to completely ignore the competitive advantages the company has in working towards that future.   No other major company in America can offer a streaming and a DVD-by-mail service under one roof.  Streaming may be the future, but unfortunately, only about 15% - 20% of content is now available via that channel.  As a consumer, this can be extraordinarily frustrating. 

Last year, when I re-activated my account with Netflix, I did so on the assumption that I could use the streaming service, but get an occasional DVD when something I wanted to watch wasn’t available online.   It worked out very well.  For the first few months, I watched a lot of the streaming content, before the selection started to wear thin.  At that point, I got into the TV series, “Curb Your Enthusiasm”, which was only available on DVD.  A few months later, I started shifting back to more streaming.  This pattern continued on till this past summer.  Essentially, my experience has been one of going back and forth between the two services; utilizing the DVD service to make up for the huge gaps in the streaming service.

As I said, no other company could offer this.  At the same time, I thought Netflix was crazy for offering the service for as cheap as it did.  It was $8.99 when I first signed up.  It was then raised to $9.99.  I would have been willing to pay $12 or $13 to continue the service as it was.  Netflix was valuable to me precisely because it was an all-in-one service.   If it had been streaming-only or DVD-only, I may have never signed on, but the ‘bundling of services’ made it valuable to me as a customer.

Instead of utilizing this major competitive advantage, Netflix seems to be determined to destroy it. 

The Wrong Lesson

Borders may have failed because it did not evolve with the times, but Barnes & Noble has survived.  It developed an online presence early on and unveiled its e-reader, the Nook, back in 2009.  The lesson isn’t that radical restructuring of B&N helped it through a rapidly changing environment; it was that B&N had to move with the times and more importantly, the customers.  If you can’t meet the needs of your customers, your business will fail.  It’s that simple.  Netflix’s shift towards separating its two main business segments is a classic case of ignoring the customers’ needs.

By lining itself up as a ‘streaming-only’ service, Netflix makes Hulu, Amazon, and Redbox look vastly more attractive in comparison.  Meanwhile, I question the continued economic viability of the DVD-by-mail service as a stand-alone unit.  DVD-by-mail makes sense for customers that are heavy users, but we’ve always known that Netflix hates those customers anyway.  Netflix’s throttling strategy was one of the company’s first major controversies and the practice was dropped after lawsuits and media pressure.  Yet, it made it abundantly clear that Netflix did not want high-volume DVD renters, as it was losing money servicing those customers.

Only problem is that in the age of streaming, low-volume DVD rental may not make much sense from the customers’ perspectives.   If I watch 3-4 movies per month, even if I have to pay $3 to stream each video, that can still be a better deal than Netflix’s DVD plans.   Of course, this service will still be of value to some customers, but its appeal will obviously weaken over the next five to ten years.   

The End Game:  Divestment

This once again brings me back to the idea that Netflix wants to divest its DVD segment.   It seems thoroughly obvious at this point.  Not only are the two segments priced separately now, but the two websites will be completely unaligned.  What other purpose could this serve, aside from making it simpler to sell off the DVD segment to an outside buyer? 

The idea is flawed, however, because the DVD segment has more value to Netflix than it does to any other company.   This means that Netflix is dependent upon finding a sucker that will overpay for the business.    If they are successful, then maybe things work OK, but I question the strategy all the same.

Netflix would have been much better off keeping its streaming and DVD plans aligned.   This was precisely what provided the company with a competitive advantage.   Hulu couldn’t offer it.  Amazon couldn’t offer it.  Dish Network couldn’t offer it.  Only Netflix could bridge the gap; and now the company is determined to blow up the bridge in order to “shift into the future.”   Unfortunately, the odds have been increased that it could be a future where Netflix is no longer “top critter”.

While I do not believe that Netflix will go the way of Borders or AOL’s dial-up service, I do believe the company’s massive growth phase might be over, and that it is shifting from a mass-consumed product into a more niche market.  The company will survive, but don’t be shocked to see the stock price continue to fall back towards the $100 mark. 

My Position

As for me personally, I began buying puts on Netflix in 2010, based on a similar thesis to the one outlined by Whitney Tilson at the end of last year.  Those puts were dead money until last week, when they went from being huge losers to going back into the black.  I continue to own long-dated puts on NFLX, but have no intention of increasing my position, or initiating a new one. In fact, in the short-run, I believe NFLX will bounce again based on better-than-expected earnings. 

7 Comments – Post Your Own

#1) On September 19, 2011 at 12:40 PM, davejh23 (< 20) wrote:

"By lining itself up as a ‘streaming-only’ service, Netflix makes Hulu, Amazon, and Redbox look vastly more attractive in comparison."

If Netflix already had a best-in-class streaming service, the split would make much more sense, but they don't.  Many cable providers have just as much free content as Netflix has available streaming content.  I agree that their massive growth phase is over.  As such, NFLX is not worthy of the sky high P/E multiple it currently carries.  If they lose more subscribers in coming quarters, this could easily fall from a P/E of nearly 40 to below 15.  Analysts are still predicting 70% earnings growth for next year.  If earnings are flat, this stock easily has 30-50%+ downside.  If earnings decline on a significant loss of subscribers, and they do sell the DVD arm, NFLX could fall 80%+ (90%+ from the recent peak)...I don't believe anyone is convinced that their streaming service will grow rapidly as they currently have an inferior product catalog and they face rapidly increasing and diverse competition in that area.  Current management doesn't seem to have a clue, so I wouldn't say that going "the way of Borders or AOL's dial-up service" is out of the question. 

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#2) On September 19, 2011 at 1:18 PM, FleaBagger (28.92) wrote:

I love how the guy in the article you link to about the "throttling strategy" has an anime in the backhround. And not a Miyazaki.

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#3) On September 19, 2011 at 1:55 PM, ikkyu2 (99.15) wrote:

Responded on my journal because the comment got too long.  Nice post.  Thought provoking.  Wrong, of course, as I argue in my entry :)

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#4) On September 19, 2011 at 2:31 PM, JakilaTheHun (99.93) wrote:

ikkyu,

I don't see how your blog goes against anything I've said.  Methinks you like to disagree for the sheer sake of disagreeing. 

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#5) On September 19, 2011 at 4:38 PM, JCappel (< 20) wrote:

I'm a brand new Motley Fool subscriber (joined last week), so help me understand why David and Tom liken NFLX to the next Dell of the 90's and it sits firmly on the buy now list, yet everything I'm reading in this blog from fellow members sounds like NFLX is positioned on the verge of taking a big drop.  Do I buy now (per Dave and Tom) or wait?

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#6) On September 20, 2011 at 6:46 PM, MKArch (99.75) wrote:

Jakila,

IMO the all you can eat streaming service is unsustainable and I wonder if Hastings isn't separating dvd so that he can salvage something when streaming implodes. It's become increasingly clear that the streaming service will never be able to afford any content other than tv re-runs and ancient movies all of which is going to be available on the cable tv everywhere services for no additional cost to their subs. Since you need a broadband connection to use NFLX streaming service just about all of their subs will also be a cable sub with access to the same content NFLX provides for free.

They already had a near 50% churn rate before they ticked their subs off with the price increase/ service cut. I went back over the last few years and compared the number of subs who leave the service in a quarter to the number of gross additions in the prior years quarter and the percentage averages almost 100%. In other words subs were hanging around for about a year before they walked before the recent fallout. In the upcoming quarters the year ago adds get to 5M-6M suggesting they were looking a loosing 5M-6M subs a quarter before the fallout.  That's going to make churn even worse.

That's tough to overcome even while they are in high growth mode with new additions. Look out below when they saturate which is not far off. Even allowing that many subs they've signed are repeats they've already signed up something like half of the addressable market of broadband households in the U.S. and Canada at least once.

It's no surprise to me that Hastings is rushing into Latin America and the Caribbean as he need to keep adding new subs to feed this ponzi scheme. Ditto it's no surprise to me that he is fighting tooth and nail with the SEC to keep from having to disclose churn metrics after 2011.

It's also become increasingly clear that the content providers have wised up and are pricing in sub growth into their deals with NFLX. I wonder if NFLX is able to protect themselves on the downside when the U.S. market matures but existing subs continue to walk away in droves? God help them and their shareholders if they can't ratchet content costs down when their sub count starts rapidly sliding backwards. I don't agree that this isn't another AOL story in fact IMO they'll be lucky if their still around like AOL a decade from now.

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#7) On September 29, 2011 at 11:58 AM, rfaramir (29.32) wrote:

"The idea is flawed, however, because the DVD segment has more value to Netflix than it does to any other company.   This means that Netflix is dependent upon finding a sucker that will overpay for the business."

Or worse. If the buyer can make better use of the DVD segment, then Netflix is toast! Streaming is commodity, everyone is doing it, everyone can do it, there will be no margin in it. The DVD delivery business is hard, but has only one weak competitor that I know of (Blockbuster Online, to which I subscribe, unhappily).

If Apple or Amazon or Microsoft XBox Live or Hulu or Google or anyone who streams buys this segment, they have a good chance of putting the two together better than Netflix did, combining them with synergies Netflix didn't discover, and do Netflix right. (Long AAPL)

Even if no one else makes a success of the DVD business, the streaming business won't make money, so they're toast if they sell.

(No position in NFLX) 

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