- Most leaders optimize their core business
- This does not prepare the business for market shifts
- Motorola was a leader with Razr, but was killed when competitors matched their features and the market shifted to smart phones
- Netflix's leader is moving Netflix to capture the next big market (video downloads)
- Reed Hastings is doing a great job, and should be emulated
- Netflix is a great growth story, and a stock worth adding to your portfolio
"Reed Hastings: Leader of the Pack" is how Fortune magazine headlined its article making the Netflix CEO its BusinessPerson of the Year for 2010. At least part of Fortune's exuberance is tied to Netflix's dramatic valuation increase, up 200% in just the last year. Not bad for a stock called a "worthless piece of crap" in 2005 by a Wedbush Securities stock analyst. At the time, popular wisdom was that Blockbuster, WalMart and Amazon would drive Netflix into obscurity. One of these is now gone (Blockbuster) the other stalled (WalMart revenues unmoved in 2010) and the other well into digital delivery of books for its proprietary Kindle eReader.
But is this an honor, or a curse? It was 2004 when Ed Zander was given the same notice as the head of Motorola. After launching the Razr he was lauded as Motorola's stock jumped in price. But it didn't take long for the bloom to fall off that rose. Razr profits went negative as prices were cut to drive share increases, and a lack of new products drove Motorola into competitive obscurity. A joint venture with Apple to create Rokr gave Motorola no new sales, but opened Apple's eyes to the future of smartphone technology and paved the way for iPhone. Mr. Zander soon ran out of Chicago and back to Silicon Valley, unemployed, with his tale between his legs.
Netflix is a far different story from Motorola, and although its valuation is high looks like a company you should have in your portfolio.
Ed Zander simply took Motorola further out the cell phone curve that Motorola had once pioneered. He brought out the next version of something that had long been "core" to Motorola. It was easy for competitors to match the "features and functions" of Razr, and led to a price war. Mr. Zander failed because he did not recognize that launching smartphones would change the game, and while it would cannibalize existing cell phone sales it would pave the way for a much more profitable, and longer term greater growth, marketplace.
Looking at classic "S Curve" theory, Mr. Zander and Motorola kept pushing the wave of cell phones, but growth was plateauing as the technology was doing less to bring in new users (in the developed world):
Meanwhile, Research in Motion (RIM) was pioneering a new market for smartphones, which was growing at a faster clip. Apple, and later Google (with Android) added fuel to that market, causing it to explode. The "old" market for cell phones fell into a price war as the growth, and profits, moved to the newer technology and product sets:
The Motorola story is remarkably common. Companies develop leaders who understand one market, and have the skills to continue optimizing and exploiting that market. But these leaders rarely understand, prepare for and implement change created by a market shift. Inability to see these changes brought down Silicon Graphics and Sun Microsystems in 2010, and are pressuring Microsoft today as users are rapidly moving from laptops to mobile devices and cloud computing. It explains how Sony lost the top spot in music, which it dominated as a CD recording company and consumer electronics giant with Walkman, to Apple when the market moved people from physical CDs to MP3 files and Apple's iPod.
Which brings us back to what makes Netflix a great company, and Mr. Hastings a remarkable leader. Netflix pioneered the "ship to your home" DVD rental business. This helped eliminate the need for brick-and-mortar stores (along with other market trends such as the very inexpensive "Red Box" video kiosk and low-cost purchase options from the web.) Market shifts doomed Blockbuster, which remained locked-in to its traditional retail model, made obsolete by competitors that were cheaper and easier with which to do business.
But Netflix did not remain fixated on competing for DVD rentals and sales – on "protecting its core" business. Looking into the future, the organization could see that digital movie rentals are destined to be dramatically greater than physical DVDs. Although Hulu was a small competitor, and YouTube could be scoffed at as a Gen Y plaything, Netflix studied these "fringe" competitors and developed a superb solution that was the best of all worlds. Without abandoning its traditional business, Netflix calmly moved forward with its digital download business — which is cheaper than the traditional business and will not only cannibalize historical sales but make the traditional business completely obsolete!
Although text books talk about "jumping the curve" from one product line to another, it rarely happens. Devotion to the core business, and managing the processes which once led to success, keeps few companies from making the move. When it happens, like when IBM moved from mainframes to services, or Apple's more recent shift from Mac-centric to iPod/iPhone/iPad, we are fascinated. Or Google's move from search/ad placement company to software supplier. While any company can do it, few do. So it's no wonder that MediaPost.com headlines the Netflix transition story "Netflix Streams Its Way to Success."
Is Netflix worth its premium? Was Apple worth its premium earlier this decade? Was Google worth its premium during the first 3 years after its Initial Public Offering? Most investors fear the high valuations, and shy away. Reality is that when a company pioneers a growth business, the value is far higher than analysts estimate. Today, many traditionalists would say to stay with Comcast and set-top TV box makers like TiVo. But Comcast is trying to buy NBC in order to move beyond its shrinking subscriber base, and "TiVo Widens Loss, Misses Street" is the Reuters' headline. Both are clearly fighting the problems of "technology A" (above.)
What we've long accepted as the traditional modes of delivering entertainment are well into the plateau, while Netflix is taking the lead with "technology B." Buying into the traditionalists story is, well, like buying General Motors. Hard to see any growth there, only an ongoing, slow demise.
On the other hand, we know that increasingly young people are abandoning traditional programing for 100% entertainment selection by download. Modern televisions are computer monitors, capable of immediately viewing downloaded movies from a tablet or USB drive – and soon a built-in wifi connection. The growth of movie (and other video) watching is going to keep exploding – just as the volume of videos on YouTube has exploded. But it will be via new distribution. And nobody today appears close to having the future scenarios, delivery capability and solutions of Netflix. 24×7 Wall Street says Netflix will be one of "The Next 7 American Monopolies." The last time somebody used that kind of language was talking about Microsoft in the 1980s! So, what do you think that makes Netflix worth in 2012, or 2015?
Netflix is a great story. And likely a great investment as it takes on the market leadership for entertainment distribution. But the bigger story is how this could be applied to your company. Don't fear revenue cannibalization, or market shift. Instead, learn from, and behave like, Mr. Hastings. Develop scenarios of the future to which you can lead your company. Study fringe competitors for ways to offer new solutions. Be proactive about delivering what the market wants, and as the shift leader you can be remarkably well positioned to capture extremely high value.
The great story is one thing. But are you saying Netflix worth ANY price? Surely you can’t be saying that. And if not ANY price, the what makes you conclude the the CURRENT price at 73x this year’s earnings is a buy?
Hi Brew57, I don’t care what tne price multiple is on this year’s earnings, or last year’s. I care about what the company can produce in sales, earnings and cash flow in 2012 and 2015. All smallish companies have very high early P/E multiples. If Netflix can take its subscriber base into the movie, television, indie movie, magazine, newspaper – and who knows what other digital subscriber product spaces – over the next 3 years how big can it be? Earnings have the opportunity to explode. That’s what makes Netflix a good investment – not what it’s P/E multiple is today. Thanks
The’ll do about $155m in earnings this year. Their current growth is around 25%. Perhaps 30%. may I ask – What kind of earnings are you estimating in 2012 and 2015 to justify paying $10b now for the business? Or if the stock was twice as high now, are you still a “buy”?
Hi Brew57, There are limits to how high any company should be priced. What I’m trying to characterize on this blog, and that we now see consistently, is a market that undervalues growth. And oftentimes overvalues the earnings of non-growth companies.
I am not a stock analyst, nor a financial advisor, so I don’t make earnings forecasts. What I can say is that companies that manage industry transitions well, make profits while undertaking transitions, and understand how to enter high growth markets are the kind of companies that over-perform on both sales and earnings. Netflix is the kind of company, and leadership, that is more likely to overperform than underperform. Their download platform positions them to supply movies, long format video, short format video (TV shows, traditional or independent, domestic or global), print subscriptions (magazines and newspaper content) and even software (including games or game modules.) I believe Netflix will overperform versus consensus estimates, and therefore see it as a company that would most likely be a good investment. I believe Netflix could well be another Apple, or Google, and therefore is very valuable.
At 70x earnings, are you aware how transitioning from a DVD distribution business to a streaming businesccncanand will negatively impact margins?
Are aware of how limited their streaming library is? Do you really believe the content owners will let Netflix walk away with a dominant high margin position?
If you are going for link bait withnthis recommendation, I suppose that is smart. But otherwise, I think it taints the credibilitynofmthis blog.
As they say Hindsight is always 20/20, but Cudos to Adam nonetheless for having picked a real winner. Although 2010 might have been to early to get in (2013 was perfect entry point). Would love to hear from Adam was other stock worth betting on?
Thanks for recognizing that I made this call over 6 years ago. I still like Netflix. It has pivoted again toward being a leader in original content creation, and this will serve it and investors well. Remain long on Netflix. I am also an investment fan of Facebook, which has multiple innovations that will drive revenue on its base platform – and on Snapchat and WhatsApp – for several years. Thirdly I like Tesla. In a decade people will wonder why they doubted that Tesla would be a leader in autos, battery production and home-based solar energy production. And lastly I would not count out the growth still in front of Amazon. As for smaller, emerging companies that are developing new unregulated markets I have not seen anything that looks to be the clear winner that Netflix was in 2010.