And the Winner Is – Netflix!!

by Adam Hartung | Jan 29, 2013 | Current Affairs, Disruptions, In the Rapids, Innovation, Leadership, Television, Web/Tech

Last week's earning's announcements gave us some big news.  Looking around the tech industry, a number of companies reported about as expected, and their stocks didn't move a lot.  Apple had robust sales and earnings, but missed analyst targets and fell out of bed!  But without a doubt, the big winner was Netflix, which beat expectations and had an enormous ~50% jump in valuation!

My what a difference 18 months makes (see chart.)  For anyone who thinks the stock market is efficient the value of Netflix should make one wonder.  In July, 2011 the stock ended a meteoric run-up to $300/share, only to fall 80% to $60/share by year's end.  After whipsawing between $50 and $130, but spending most of 2012 near the lower number, the stock is now up 3-fold to $160!  Nothing scares investors more than volatility – and this kind of volatility would scare away almost anyone but a day trader!

Yet, through all of this I have been – and I remain – bullish on Netflix.  During its run-up in 2010 I wrote "Why You Should Love Netflix," then when the stock crashed in late 2011 I wrote "The Case for Buying Netflix" and last January I predicted Netflix to be "the turnaround story of 2012."  It would be logical to ask why I would remain bullish through all the ups and downs of this cycle – especially since Netflix is still only about half of its value at its high-point.

Simply put, Netflix has 2 things going for it that portend a successful future:

1. Netflix is in a very, very fast growing market.  Streaming entertainment.  People have what appears to be an insatiable desire for entertainment, and the market not only has grown at a breathtaking rate, but it will continue to grow extremely fast for several more quarters.  It is unclear where the growth rate may tap out for content delivery – putting Netflix in a market that offers enormous growth for all participants.
2. Netflix leadership has shown a penchant for having the right strategy to remain a market leader – even when harshly criticized for taking fast action to deal with market shifts.  Specifically, choosing to rapidly cannibalize its own DVD business by aggressively promoting streaming – even at lower margins – meant Netflix chose growth over defensiveness.

In 2011 CEO Reed Hastings was given "CEO of the Year 2010" honors by Fortune magazine.  But in 2011, as he split Netflix into 2 businesses – DVD and streaming – and allowed them to price independently and compete with each other for customer business he was trounced as the "dunce" of tech CEOs. 

His actions led to a price increase of 60% for anyone who decided to buy both Netflix products, and many customers chose to drop one.  Analysts predicted this to be the end of Netflix. 

But in retrospect we can see the brilliance of this decision.  CEO Hastings actually did what textbooks tell us to do – he began milking the installed, but outdated, DVD business.  He did not kill it, but he began pulling profits and cash out of it to pay for building the faster growing, but lower margin, streaming business.  This allowed Netflix to actually grow revenue, and grow profits, while making the market transition from one platform (DVD) to another (streaming.)

Almost no company pulls off this kind of transition.  Most companies try to defend and extend the company's "core" product far too long, missing the market transition.  But now Netflix is adding around 2 million new streaming customers/quarter, while losing 400,000 DVD subscribers.  And with the price changes, this has allowed the company to add content and expand internationally — and increase profits!!

Marketwatch headlined that "Naysayers Must Feel Foolish."  But truthfully, they were just looking at the wrong numbers.  They were fixated on the shrinking installed base of DVD subscribers.  But by pushing these customers to make a fast decision, Netflix was able to convert most of them to its new streaming business before they went out and bought the service from a competitor. 

Aggressive cannibalization actually was the BEST strategy given how fast tablet and smartphone sales were growing and driving up demand for streaming entertainment.  Capturing the growth market was far, far more valuable than trying to defend the business destined for obsolescence. 

Netflix simply did its planning looking out the windshield, at what the market was going to look like in 3 years, rather than trying to protect what it saw in the rear view mirror.  The market was going to change – really fast.  Faster than most people expected.  Competitors like Hulu and Amazon and even Comcast wanted to grab those customers.  The Netflix goal had to be to go headlong into the cold, but fast moving, water of the new streaming market as aggressively as possible.  Or it would end up like Blockbuster that tried renting DVDs from its stores too long – and wound up in bankruptcy court.

There are people who still doubt that Netflix can compete against other streaming players.  And this has been the knock on Netflix since 2005.  That Amazon, Walmart or Comcast would crush the smaller company.  But what these analysts missed was that Amazon and Walmart are in a war for the future of retail – not entertainment – and their efforts in streaming were more to protect a flank in their retail strategy, not win in streaming entertainment.  Likewise, Comcast and its brethren are out to defend cable TV, not really win at anytime, anywhere streaming entertainment.  Their defensive behavior would never allow them to lead in a fast-growing new marketplace.  Thus the market was left for Netflix to capture – if it had the courage to rapidly cannibalize its base and commit to the new marketplace.

Hulu and Redbox are also competitors.  And they very likely will do very well for several years.  Because the market is growing very fast and can support multiple players.  But Netflix benefits from being first, and being biggest.  It has the most cash flow to invest in additional growth.  It has the largest subscriber base to attract content providers earlier, and offer them the most money.  By maintaining its #1 position – even by cannibalizing itself to do so – Netflix is able to keep the other competitors at bay; reinforcing its leadership position.

There are some good lessons here for everyone:

1. Think long-term, not short-term.  A king can become a goat only to become a king again if he haa the right strategy.  You probably aren't as good as the press says when they like you, nor as bad as they say when hated.  Don't let yourself be goaded into giving up the long-term win for short-term benefits.
2. Growth covers a multitude of sins!  The way Netflix launched its 2-division campaign in 2011 was a disaster.  But when a market is growing at 100%+ you can rapidly recover.  Netflix grew its streaming user base by more than 50% last year – and that fixes a lot of mistakes. Anytime you have a choice, go for the fast growing market!!
3. Follow the trend!  Never fight the trend!  Tablet sales were growing at an amazing clip, while DVD players had no sales gains.  With tablet and smartphone sales eclipsing DVD player sales, the smart move was to go where the trend was headed.  Being first on the trend has high payoff.  Moving slowly is death.  Kodak failed to aggressively convert film camera customers to its own digital cameras, and it filed bankruptcy in 2012.
4. Dont' forget to be profitable!  Even if it means raising prices on dated solutions that will eventually become obsolete – to customer howls.  You must maximize the profits of an outdated product line as fast as possible. Don't try to defend and extend it.  Those tactics use up cash and resources rather than contributing to future success.
5. Cannibalizing your installed base is smart when markets shift.  Regardless the margin concerns.  Newspapers said they could not replace "print ad dollars" with "on-line ad dimes" so many went bankrupt defending the paper as the market shifted.  Move fast. Force the cannibalization early so you can convert existing customers to your solution, and keep them, before they go to an emerging competitor.
6. When you need to move into a new market set up a new division to attack it.  And give them permission to do whatever it takes.  Even if their actions aggravate existing customers and industry participants.  Push them to learn fast, and grow fast – and even to attack old sacred cows (like bundled pricing.)

There were a lot of people who thought my call that Netflix would be the turnaround tech story of 2012 was simply bizarre.  But they didn't realize the implications of the massive trend to tablets and smartphones.  The impact is far-reaching – affecting not only computer companies but television, content delivery and content creation.  Netflix positioned itself to be a winner, and implemented the tactics to make that strategy work despite widespread skepticism. 

Hats off to Netflix leadership.  A rare breed.  That's why long-term investors should own the stock.