The Case for Buying Netflix. Really.


Reed Hastings, the CEO of Netflix, has long been considered a pretty good CEO.  In January, 2009 his approval ranking, from Glassdoor, was an astounding 93%.  In January, 2010 he was still on the top 25 list, with a 75% approval rating. And it's not surprising, given that he had happy employees, happy customers, and with Netflix's successful trashing of Blockbuster the company's stock had risen dramaticall,y leading to very happy investors.

But that was before Mr. Hastings made a series of changes in July and September.  First Netflix raised the price on DVD rentals, and on packages that had DVD rentals and streaming download, by about $$6/month.  Not a big increase in dollar terms, but it was a 60% jump, and it caught a lot of media attention (New York Times article).  Many customers were seriously upset, and in September Netflix let investors know it had lost about 4% of its streaming subscribers, and possibly as many as 5% of its DVD subscribers (Daily Mail). 

No investor wants that kind of customer news from a growth company, and the stock price went into a nosedive.  The decline was augmented when the CEO announced Netflix was splitting into 2 companies.  Netflix would focus on streaming video, and Quikster would focus on DVDs. Nobody understood the price changes – or why the company split – and investors quickly concluded Netflix was a company out of control and likely to flame out, ruined by its own tactics in competition with Amazon, et.al.

Neflix Price chart 10-3-2011 Yahoo (Source: Yahoo Finance 3 October, 2011)

This has to be about the worst company communication disaster by a market leader in a very, very long time.  TVWeek.com said Netflix, and Reed Hastings, exhibited the most self-destructive behavior in 2011 – beyond even the Charlie Sheen fiasco! With everything going its way, why, oh why, did the company raise prices and split?  Not even the vaunted New York Times could figure it out.

But let's take a moment to compare Netflix with another company having recent valuation troubles – Kodak. 

Kodak invented home photography, leading it to tremendous wealth as amature film sales soared for seveal decades.  But last week Kodak announced it was about out of cash, and was reaching into its revolving credit line for some $160million to pay bills.  This latest financial machination reinforced to investors that film sales aren't what they used to be, and Kodak is in big trouble – possibly facing bankruptcy.  Kodak's stock is down some 80% this year, from $6 to $1 – and quite a decline from the near $80 price it had in the late 1990s.

Kodak stock price chart 10-3-2011 Yahoo
(Source: Yahoo Finance 10-3-2011)

Why Kodak declined was well described in Forbes.  Despite its cash flow and company strengths, Kodak never succeeded beyond its original camera film business.  Heck, Kodak invented digital photography, but licensed the technology to others as it rabidly pursued defending film sales.  Because Kodak couldn't adapt to the market shift, it now is probably going to fail.

And that is why it is worth revisiting Netflix.  Although things were poorly explained, and certainly customers were not handled well, last quarter's events are the right move for investors in the shifting at-home video entertainment business:

  1. DVD sales are going the direction of CD's and audio cassettes.  Meaning down.  It is important Netflix reap the maximum value out of its strong DVD position in order to fund growth in new markets.  For the market leader to raise prices in low growth markets in order to maximize value is a classic strategic step.  Netflix should be lauded for taking action to maximize value, rather than trying to defend and extend a business that will most likely disappear faster than any of us anticipate – especially as smart TVs come along.
  2. It is in Netflix's best interest to promote customer transition to streaming.  Netflix is the current leader in streaming, and the profits are better there.  Raising DVD prices helps promote customer shifting to the new technology, and is good for Netflix as long as customers don't change to a competitor.
  3. Although Netflix is currently the leader in streaming it has serious competition from Hulu, Amazon, Apple and others.  It needs to build up its customer base rapidly, before people go to competitors, and it needs to fund its streaming business in order to obtain more content.  Not only to negotiate with more movie and TV suppliers, but to keep funding its exclusive content like the new Lillyhammer series (more at GigaOm.com).  Content is critical to maintaining leadership, and that requires both customers and cash.
  4. Netflix cannot afford to muddy up its streaming strategy by trying to defend, and protect, its DVD business.  Splitting the two businesses allows leaders of each to undertake strategies to maximize sales and profits.  Quikster will be able to fight Wal-Mart and Redbox as hard as possible, and Netflix can focus attention on growing streaming.  Again, this is a great strategic move to make sure Netflix transitions from its old DVD business into streaming, and doesn't end up like an accelerated Kodak story.

Historically, companies that don't shift with markets end up in big trouble.  AB Dick and Multigraphics owned small offset printing, but were crushed when Xerox brought out xerography.  Then, afater inventing desktop publishing at Xerox PARC, Xerox was crushed by the market shift from copiers to desktop printers – a shift Xerox created. Pan Am, now receiving attention due to the much hyped TV series launch, failed when it could not make the shift to deregulation.  Digital Equipment could not make the shift to PCs.  Kodak missed the shift from film to digital.  Most failed companies are the result of management's inability to transition with a market shift.  Trying to defend and extend the old marketplace is guaranteed to fail.

Today markets shift incredibly fast.  The actions at Netflix were explained poorly, and perhaps taken so fast and early that leadership's intentions were hard for anyone to understand.  The resulting market cap decline is an unmitigated disaster, and the CEO should be ashamed of his performance.  Yet, the actions taken were necessary – and probably the smartest moves Netflix could take to position itself for long-term success. 

Perhaps Netflix will fall further.  Short-term price predictions are a suckers game.  But for long-term investors, now that the value has cratered, give Netflix strong consideration.  It is still the leader in DVD and streaming.  It has an enormous customer base, and looks like the exodus has stopped.  It is now well organized to compete effectively, and seek maximum future growth and value.  With a better PR firm, good advertising and ongoing content enhancements Netflix has the opportunity to pull out of this communication nightmare and produce stellar returns.

 

 

 

 

Overcoming metrics to grow – Motorola, Xerox, Kodak, Six Sigman, TQM, Lean

Do all good ideas originate outside the organization?  Of course not.  Motorola understood all the critical technologies for smart phones, and taught Apple how to use them in a joint development project that created the ROKR.  That's just one example of a company that had the idea for growth, but didn't move forward effectively.  In this case Apple captured the value of new technology and a market shift.

On the Harvard Business Review blog site one of consulting firm Innosight's leaders, Mark Johnson, covers two stories of companies that had all the technology and capability to lead their markets, but got Locked-in to old practices.  In "Have You Already Killed Your Next Big Thing" Mr. Johnson talks about Xerox and Kodak – two stories profiled in my 2008 book "Create Marketplace Disruption."  Both companies developed the technology that replaced their early products (Xerox developed desktop publishing and Kodak developed the amateur digital camera.)  But Lock-in kept them doing what they did rather than exploiting their own innovation.

One of the causes is a fascination with metrics.  Again on the Harvard Business Review blog site Roger Martin, Dean of the Rotman School of Management at the University of Toronto, tells us in "Why Good Spreadsheets Make Bad Strategies" that you can't measure everything.  And often the most important information about markets and what you must do to succeed is beyond measuring – at least in the short term. 

Measurements are good control tools.  Measurements can help force a focus on short term improvements.  But measurements, and the concomitant focus, reduces an organization's ability to look laterally.  They lose sight of information from lost customers, from small customers, from fringe customers and fringe competitors.  Measurement often leads to obsession, and a deepening of Defend & Extend behavior.  It's not accidental that doctors often find anorexia patients measure everything in (liquids and solids) and everything out (liquids and solids). 

Measurements are created when a business is doing well.  In the Rapids.  Like Kodak during the 1960s and Xerox in the 1970s.  Measurements are structural Lock-ins that help "institutionalize" the behavior which makes the Success Formula operate most effectively.  And they help growth.  But they do nothing for recognizing a market shift, and when new technology comes along, they stand in the way.  That's why a powerful Six Sigma or Total Quality Management (TQM) or Lean Manufacturing project can help reduce costs short term, but become an enormous barrier to innovation over time when markets shift.  These institutionalized efforts keep people doing what they measure, even if it doesn't really add much incremental value any longer.

To overcome measurement Lock-ins we all have to use scenario planning.  Scenarios can help us see that in a future marketplace, a changed marketplace, measuring what we've been doing won't aid success.  And because we don't yet know what the future market will really look like, we can't just swap out existing metrics for something different.  As we proceed to do new things, in White Space, it's about learning what the right metrics are – about getting into the growth Rapids – before we tie ourselves up in metrics.

Note:  To all readers of my Forbes article last week – there has been an update.  The very professional and polite leadership at Tribune Corporation took the time to educate me about the LBO transition.  As a result I learned that what I previously read, and reported in my column as well as on this blog, as being an investment of employee retirement funds into the LBO was inaccurate.  Although Tribune is in hard times right now, the very good news is that the employee retirement funds were NOT wiped out by the bankruptcy.  The Forbes article has been corrected, and I am thankful to the Tribune Corporation for helping me report accurately on that issue.