And the Winner Is – Netflix!!

by | 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.

The Case for Buying Netflix. Really.

by | Oct 4, 2011 | Current Affairs, Defend & Extend, Film, In the Rapids, Innovation, Leadership, Television, Transparency, Web/Tech


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.