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The History and the Future

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21

May 15, 2012 – Comments (4) | RELATED TICKERS: NFLX

Board: Netflix

Author: dvena

Hi Fellow Fools,

I get that a lot of folks don’t get NFLX as an investment. At first glance, many times it will appear black and white. I think this is more prevalent for those that bought NFLX shortly before the events of last year. Those that have been long time customers and/or investors may have a slightly different perspective. I would like to attempt to fill in the shades of gray. I wanted to provide a history of a Netflix customer from way back and a NFLX investor for nearly five years, because I believe a great deal of the lack of understanding of NFLX as an investment stems from a lack of history by some folks with the company.

For background, I was a Netflix customer long before I was a NFLX investor, although for the record, NFLX was the first of two investments when I first joined Stock Advisor in August of 2007 (MVL was the other). I came to Netflix years before that the same way that many did. If you are a young investor, keep in mind that at that time, Blockbuster was the only game in town. There were a few smaller chains, but if you want to rent a VHS (remember those?) or a DVD, if you were like the majority of folks, you probably went to Blockbuster. I was at the local Blockbuster store with a movie my teen daughter had misplaced, and was quite late. The amount that Blockbuster wanted to charge me in late fees was several times the cost of buying the movie new, far exceeding that value of replacing the movie – and I had the movie right there! I turned in my membership card that day, told them that I would never rent a movie there again and to this day have not.

Our first experiences with Netflix were probably typical. We did not have cable, so we started out with Netflix with the 5-movies out at a time plan. For about $27(?) per month we always had something to watch. We alternated between movies and TV series. Our first experiences with Netflix customer service were probably also typical, but also quite memorable. We received a DVD in the mail that was broken. I called customer service and explained that the DVD arrived that way, fully expecting them to require us to pay for the broken disk. The response I received was “I’m sorry that happened. We will send out the next disk on your list. If you would just put that back in the mail to us that would be great.” WHAT?!? I had never had such an easy customer service experience that I could recall. A further experience with Netflix customer service months later proved equally astonishing. We had lost a Netflix DVD in our care. We had looked everywhere and just could not find it. Finally, I called customer service, explained our situation and offered to pay for the missing movie. The rep checked our account history, and replied, “That won’t be necessary, sir. We will get another movie right out to you.” Again, WHAT?!? Finally, I received an email one day from Netflix, indicating that they had an outage on their website and even though we may not have been affected, they would be crediting our account for a day’s service. Again, I was amazed. This was customer service unlike anything I had experienced. This made me a very loyal and devoted Netflix customer. Later, these same experiences led me to be a NFLX investor.

Keep in mind that Netflix was written off for dead because they had very deep-pocketed competitors. No, I’m not talking about the current conversations about Amazon, Hulu and Apple. I am talking about the conversations about how Blockbuster and Wal-Mart were going to put Netflix out of business. Their business model had no moat and their competitors had very deep pockets and they would never be able to keep up this business profitably, as these deep pocketed competitors would drive them out of business. (Any of this sound familiar?)

The folks at NFLX have been ahead of the curve from the very beginning. They had outstanding customer service. They had a recommendation engine that actually suggested movies that I liked! They had a contest that paid $1M in prize money to anyone (or team) that could improve their recommendation engine by 10%. They added free streaming to their existing accounts before this was in itself a viable business model. They understood, better than anyone else that this was the future of in-home movie viewing. Streaming was the future and they wanted to get out in front of it. For those folks that ever watched streaming from any other provider at that time, you will recall that in the early days, NFLX did this better than anyone else. While many other providers have decreased NFLX’s lead in streaming technology, they have been doing it better and longer than anyone else. Netflix made agreements with various manufacturers to include Netflix access across a variety of devices – again, before this was fashionable. Reed Hastings has been a visionary from the very beginning.

Another area of misunderstanding with folks seems to be about the lack of “new” or recently released content in streaming. The story of NFLX has never been about the most recent content and I believe that is a sticking point with some folks. The story has been about The Long Tail. I have posted about this repeatedly going back for years. David Gardner first educated me (and others) about this subject early in my investing history with NFLX and this has always helped in my investing thesis. For those that are not familiar with this concept, and you are or are considering an investment with NFLX, I believe this article is a must read.

Netflix has made a good business out of what's unprofitable fare in movie theaters and video rental shops because it can aggregate dispersed audiences. It doesn't matter if the several thousand people who rent Doctor Who episodes each month are in one city or spread, one per town, across the country - the economics are the same to Netflix. It has, in short, broken the tyranny of physical space. What matters is not where customers are, or even how many of them are seeking a particular title, but only that some number of them exist, anywhere.

http://www.wired.com/wired/archive/12.10/tail.html

Go back on these boards, back to when the deal was first announced with Epix in August of 2008 to stream more movies. The investment community was astonished. Didn’t Netflix understand that paying nearly $1B for movies was going to bankrupt them? They could not support an obligation of that size. This was the beginning of the end of Netflix. However, many did not take the time to do the math. From a much earlier post:

Wall Street analysts estimated that Netflix would pay about $900 million over the course of five years to Epix. $900M / 5 = $180M +/- annually.

Ted Sarandos, the chief content officer for Netflix, said he was essentially taking the “huge pile of money” that Netflix paid in postage for DVDs by mail — about $600 million this year — “and starting to pay it to the studios and networks.”

NFLX feels it will save this much on postage. This would require reducing postage costs by approx 30% total over 5 years: $180M / $600M = 30%.


Snip

More subscribers means increased revenue. A larger percentage of the new subscribers will more likely stream due to the variety of streaming platforms - TV's, Blu-ray, gaming consoles, Roku, etc. Currently about 60% of current customers have watched via streaming. This lowers postage costs. This will not eliminate postage, but greatly reduce it.

Increased revenue + lower costs = higher profits


http://boards.fool.com/1081/epix-deal-28692200.aspx?sort=rec...

I also wanted to address the common misconception or comment that I hear that Netflix is “killing off” their DVD business. These statements are at the very least an exaggeration or at worst a falsehood. The folks at Netflix know that streaming is the future of their business. DVD’s will be around for a long time. Reed Hastings knows this, but he also knows that in the end, streaming will be the standard and DVD will be the dinosaur – not today, not tomorrow, but someday. This is why Netflix has been ahead of the curve from the beginning. This is why Netflix was giving away streaming before it was fashionable. This is why they have been preparing for this eventuality by attempting to accelerated the process. This is where Netflix made one of two mistakes – they attempted to separate the DVD from the streaming business. They neglected to understand that their customers liked having one place to go for both DVD’s and streaming. Many have assumed that this was so that they could spin off or sell off the DVD rental business. No proof has ever been offered and this assumption has been proffered about as so much fact. At the time, Reed Hastings explained that he wanted to two businesses to have their own teams to focus on growing each business.

The second mistake that Netflix made was regarding the price increase. They failed to see how the headlines would play out. Many of us on the NFLX board have opined that the price increase was not the issue, but how it was handled. I saw no issue with the increase and felt like I have always gotten more than my monies worth from my Netflix subscription. The issue was that they raised prices too much too quickly. This gave the media and the shorts fodder. The headlines read Netflix raises prices 60%. Never mind that this was only several dollars and only applied to one plan. The talking heads turned on NFLX and they were the news cycle. This cycle fed on itself. Netflix had not understood that when a company has such a rabid fan base, the backlash for any slight – real or perceived, would unleash a backlash that would be both swift and severe.

In my opinion and that is all this statement is, Netflix – for that one critical moment, failed to understand their customer base. Nothing more, nothing less. And for that moment, that was enough. To Reed Hastings credit, he acted quickly against the backlash and reversed course on the ill-fated Quickster fiasco. Yes, this was New Coke all over again. The public had spoken loud and clear and Netflix listened.

Another early lesson I learned that has helped me to understand NFLX better is that they manage margins. They will only commit to content that they know they can support from current earnings. There has been quite a lot said about how the content costs are not sustainable. I believe this to be a lack of understanding of NFLX model. Go back and read some of the earlier year’s posts (I sort by the number of rec’s to find the most useful posts). An important point is that Netflix has never revealed the substance of their contracts with content providers. Many surmised that NFLX would be required to pay based on the number of views - but no one knows except those privy to the contract! Everyone assumed that these costs would be prohibitive and that Netflix would be forced to cave in to the demands of content providers. When Starz came to the table with an offer that was unreasonable, Netflix declined. Why? Because Netflix knows what they can pay and still be profitable. So, while they are (and always have been) willing to pay for content, they are not willing to overpay for it. This is an important point. While this should have been reason for celebration and merriment, the talking heads decreed that this was the end (again?). That Netflix would not be able to acquire sufficient content to support their legion fans. But what they kept saying was newer content. Again, I say it has never been about newer content – it has always been about The Long Tail! I would also point out that shortly after this unsuccessful negotiation (or successful, depending on your outlook), Netflix revealed several new contracts with content providers to provide additional streaming content. This was widely overlooked or ignored by the talking heads. As for me and my family, we have always been able to find things to watch on Netflix. It is not, nor has it ever been the newest content (streaming or otherwise). What it is is a great opportunity to catch up on movies or shows we have missed, or that we have not seen for some time, or begin a new series from the start with a marathon weekend. It is knowing that there is always something we want to watch.

On a side note, why is it that the financial media decrees that Netflix will never be able to afford content – it will drive them bankrupt, but also decree that others with deeper pockets will come in and bury Netflix. Do you see the faulty logic in this? Why would someone else with deeper pockets want to come in and take business from Netflix if there is not money to be made? If Netflix, who has been doing this for years and has the history and the background – if Netflix cannot make money at this, why would any other company be interested? No company would want to move in on a business that could not be self-sustaining. That would be the business equivalent of suicide. The logic is faulty.

An area that gives Netflix a competitive edge – one that I do not believe is fully appreciated - is their knowledge base of their customers. They have the viewing records of over 21M customers, some of these customers for a decade or more (yours truly). With those records and knowledge of the viewing habits of those customers, does it not stand to reason that they know, better than anyone, what those customers want to watch? Would they not be able to deduce what content they should acquire, to most satisfy the viewing desires of the majority of these customers? The recommendation engine was great, but what about now? As has been pointed out before, they now have live data on these viewing habits. They know what you watched, for how long, whether you watched similar fare, what you turned off out of either boredom or disgust. They are going to focus on content that is the most in line with what their customers – their loyal customers watch. They allow you to quit your subscription in the summer months and come back later to find your queue intact. They allow you to start and stop your subscription at will. Some see this as a detriment. I see this as brilliant.

Look, I get that Netflix messed up. For that one critical moment, they were not evil, they were not greedy. They were disconnected. This happens in business from time to time. The sign of a great leader or a great business is not that they are perfect, but that they can admit a mistake, regroup and move on. NFLX now has streaming customers in 43 countries in Latin America. They are in Canada and have moved into Great Britain. They are willing to take a short term hit, by being unprofitable for a time, to grow in these international areas. They are building a foreign subscriber base. They are taking what they have learned over years of analyzing viewing data and taking it world-wide. They have learned lessons that will help them grow in the future that they will not have to make again. They are leveraging their knowledge base. This is what they do and this is why I believe they will be successful.

I hope this provides some shades of gray for those among you that are new to NFLX or are considering a position.

Danny
MELI Ticker Guide
ATW Ticker Guide
Netflix subscriber and NFLX investor from way back.

4 Comments – Post Your Own

#1) On May 15, 2012 at 10:53 AM, Mega (99.96) wrote:

"Another early lesson I learned that has helped me to understand NFLX better is that they manage margins. They will only commit to content that they know they can support from current earnings."

Margins have fallen off a cliff the last 2 quarters and are now negative.

But hey, it's OK. They're "managed".

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#2) On May 15, 2012 at 5:13 PM, TMFLifeIsGood (71.25) wrote:

This statement taken in a vacuum is misleading. 

A common "margin" that is used in business is Net Margin.  This is arrived at by dividing net profit by total revenue.  Netflix has typically run this at about 6% - 7%.  We all know what happened last year.  Over the course of the last few quarters, NFLX lost a bunch of customers in a short time, they turned unprofitable.  This resulted in negative margins.

Managing margins for NFLX is like turning a cruise ship - you can't turn it around on a dime.  As of this quarter NFLX has returned to increasing their subscriber count.  They have been adjusting their spend on content for several quarters now and their subscribers are returning.  All else being equal margins would likely be back to what they were pre-Qwickster.

Then we need to consider international expansion.  NFLX has made the strategic decision for additional expenditures in the short-term to grow the business in the long term.  By spending now, NFLX grows their subscriber base internationally, which in turn brings in additional continuous revenue streams.  Assuming that NFLX pays a flat rate for content (no one knows for sure) they improve their margins with each additional customer.  So by foregoing short-term profit (read being unprofitable for the next few quarters, which they announced), they increase their future profitability.  At some point, their margins for streaming will match, then exceed the margins for DVD's.  This is the part most detractors don't get.

So yes, the last few quarters, margins have fallen off a cliff.  And yes, NFLX will be unprofitable for the next couple of quarters due to international expansion.  Personally, I appreciate when management of a company I invest in is more concerned with the long-term than short-term results.

Danny
MELI Ticker Guide
ATW Ticker Guide

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#3) On May 15, 2012 at 6:40 PM, Mega (99.96) wrote:

Negative net margins only became the plan after the pricing fiasco.  So, is management really in control of margins?  They misestimated and committed to content that they can't support out of current earnings.  Of course, this is not a big deal if it's temporary.

"I get that a lot of folks don’t get NFLX as an investment."

"This is the part most detractors don't get."

When people disagree with you, it is a bit insulting to say that they simply don't understand.

I definitely "get" NFLX as an investment.  Specifically, as a short sale.

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#4) On May 15, 2012 at 6:55 PM, Mega (99.96) wrote:

Another way of putting it is that you can't have complete control over growth and margins at the same time.

NFLX ran into a big growth problem, so they decided to sacrifice margins for growth.  That is rarely a great investment condition.  As we will soon see when companies like AMZN and CRM crash in the next few years.

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