It's hard to imagine how I haven't purchased a stock in over two years — certainly not a good way to succeed in investing :( One of my New Year's resolutions is to focus more on investing and work much harder. In any case, I have been researching Netflix (NFLX) lately and it keeps getting more interesting by the minute. I remember an anonymous reader said in my prior post he/she thought Netflix was worth around $50 to $60 per share and he/she would buy it around $40. Well, the stock did decline to $62, before skyrocketing recently. There was also a roughly 10% dilutive capital raise in the last few months so the stock price is close to the range of the anonymous poster. It's still a high risk stock—it can easily go bankrupt within 10 years—but some of its qualities seem attractive.
I took a preliminary look at its business model and competitive environment in this post about two months ago, and thought I would write up its background and the transformation it is undergoing, or at least my understanding of it. I was actually writing a post analyzing its financials but the business change was important and I ended up writing quite a bit about it. I'll save my thoughts about its financials for a future post.
The Game Has Changed
Netflix is kind of complicated to analyze and I suspect value investors won't look at it for another 4 or 5 years. The reason isn't because Netflix is a complicated operation—it isn't and is easier to understand than something like Berkshire Hathaway or Disney—and neither is it due to the lack of multi-year historical data. Netflix has almost 10 years of financial statements and this should be enough of a record for most investors. Contrary to some people's view, I also don't think Netflix operates in a technology industry with rapidly changing products. If anything, the product Netflix deals with (video media) doesn't really change much and isn't based on hits, fads, or trends (note: I'm talking about video as a whole and not necessarily about individual content).
Instead, the complication with Netflix is that its historical financials are almost useless! Netflix has embarked on a radical change to its business—I support the change and think it is required since its DVD business may dissapear within 5 years—and, hence, its current performance and future outcome cannot be discerned from the past. Drawing the line is quite subjective but I would say its financial statements prior to 2010 are not reflective of its future business.
In particular, the business model of Netflix is changing and its financial performance will be quite different in the future. Anyone investing in Netflix right now is essentially investing in a restructuring. However, unlike classic restructuring carried out at the last minute when the company is failing, Netflix is profitable and is trying to create a new market.
Once Upon a Time in America
For those who are not familiar, Netflix had one line of business for the last 10 years or so: DVD rentals by mail. With a Netflix subscription, customers can choose movies or tv shows or other special video content on DVD and rent them by mail. According to some, the collapse of DVD rental powerhouses, Hollywood Video (later on owned by Movie Gallery) and Blockbuster Video, were due to the ascent of Netflix. Whereas Netflix offered rentals by mail only, the other three mostly owned physical locations.
(On a side note, Hollywood Video was founded in 1988, while Movie Gallery and Blockbuster started in 1985. Given how all of them went bankrupt in 2010, and how other rental stores probably started a little before that, it means that the video rental industry had a lifespan of around 30 years. Unless you are investing in megacaps, it's probably a good rule-of-thumb to assume that companies last 20 to 30 years.)
Netflix became dominant in DVD rentals by capitalizing on the Long Tail, as Amazon had done with books initially. For those not familiar with the notion of the Long Tail, it can be described as:
The term Long Tail has gained popularity in recent times as describing the retailing strategy of selling a large number of unique items with relatively small quantities sold of each – usually in addition to selling fewer popular items in large quantities. The Long Tail was popularized by Chris Anderson in an October 2004 Wired magazine article, in which he mentioned Amazon.com and Netflix as examples of businesses applying this strategy. Anderson elaborated the concept in his book The Long Tail: Why the Future of Business Is Selling Less of More.Basically, the Long Tail strategy involves catering to a large audience of niche tastes, rather than to the volume-heavy popular audience. Chris Anderson characterized companies such as Amazon and Netflix as capitalizing on the Long Tail. The following images—horrible colour scheme :(—from his writing at Wired and the Long Tail blog illustrates the Long Tail:
The distribution and inventory costs of businesses successfully applying this strategy allow them to realize significant profit out of selling small volumes of hard-to-find items to many customers instead of only selling large volumes of a reduced number of popular items. The total sales of this large number of "non-hit items" is called the Long Tail.
(source: "The Long Tail," Chris Anderson, Wired. October 2004.)
(source: "The real meaning of 80/20," Chris Anderson, The Long Tail. March 16, 2005.)
Similar to what Amazon did with bookstores in the late 90's and early 2000's, Netflix offered a far larger library catalogue than bricks&mortars stores like Blockbuster Video. If you walked into a Blockbuster video store, you had access to around 3,000 DVDs, whereas Netflix subscribers could order from a colleciton of 25,000 DVDs. Customers who wanted instant videos and couldn't wait 2 or 3 days for a rental to be delivered through the mail, or wanted the popular hits, used Blockbuster. But those who wanted obscure movies or TV shows (these can be expensive since there are many episodes over many seasons) found Netflix to be more useful. Netflix basically ended up with a large number of customers, possibly with low volume per customer, for a big selection.
Netflix's strong customer focus also enabled it to provide superior customer service. It was often ranked near the top of customer service surveys for retailers or media distribution companies. I think the low-cost, cancel-anytime, subscription model helped with customer satisfaction. Netflix had lower marketing costs due to strong word-of-mouth.
A very important point to note is that the cost of the DVD-by-mail business didn't vary much as the business scaled up. If you purchased a DVD, you could rent it as many times as possible (this is how the legal framework is in America and somewhat similar in many other places). Furthermore, once you built out the distribution centers, customer support, and the like, your costs didn't rise very much with each new customer.
A Fork in the Road
As the video rental business evolved, and mainstays like Hollywood Video and Blockbuster collapsed, Netflix came to the conclusion that video viewership was going to shift to online streaming. Netflix had always been interested in online streaming but Reed Hastings probably felt they had to capitalize on first-mover advantage and decided to go big.
The big thesis of Reed Hastings is that online streaming cost is declining precipitously (or conversely, connection speed is increasing), following an almost-Moore's-Law-like curve. His feeling is that streaming will not only be accepted by the mainstream, but that it will be cheaper. There are quite a number of people, including many Netflix bears, who think this isn't true or that costs can't continuously fall. I side with Hastings, and although ISPs will try to charge more for Internet connections, I think the value proposition will still favour online streaming.
I feel that re-architecting the company in the direction of online video streaming is the proper strategy. Netflix's numbers do seem to support the shift-to-online-streaming thesis. For instance, as of 3Q 2011, Netflix had around 21.5 million streaming subscriptions versus 13.9 million DVD subscriptions (do note that these numbers overlap since many customers have both). As recently as 2 years ago, Netflix had almost zero streaming customers. So the strategic shift is the right move. If Netflix didn't capture these streaming customers now, competitors may lock them up and Netflix will be stuck with a perpetually-declining DVD-by-mail business.
However, by pursuing online streaming, Netflix radically altered its business. There are some advantages to streaming but there are some big negatives as well. In particular,
- Netflix lost its Long Tail benefit,
- Has significantly weaker negotiating power against content producers (movie and television studios),
- Will face off against powerful MVPD (multi-video programming distribution i.e. cable/satellite/pay-TV) providers, and
- Face new, financially-strong, media-technology competitors like YouTube (owned by Google) and Amazon.
Some of the threats are over-blown and dependent on many 'ifs' and 'buts.' For instance, services like YouTube don't really compete directly against Netflix since they are advertising-supported. It's kind of like comparing HBO, a specialty subscription channel, to ABC, a free, ad-supported, channel. Yes, they compete for viewership time but someone that wants free television is not going to subscribe to HBO.
The first two items listed above are quite significant and important for investors to understand. I thought I would present my opinion on them.
Loss of the Long Tail & Bargaining Power
One of the reasons investors drove Netflix to a high valuation—Netflix had a market cap of around $15 billion at its peak—was because they probably thought it was going to expand its Long Tail advantage to online video streaming. And, become totally and utterly dominant like Amazon.
Unfortunately for Netflix and its shareholders, the online streaming business is actually worse—so far—for distributors. In fact, Netflix will lose its Long Tail advantage it had in the physical DVD rental market. Netflix will never monopolize the video streaming content! Potential investors need to factor this into their valuations. When this became evident, investors headed for the exit and marked down the valuation back down to around $4 billion.
Netflix owned the Long Tail content in physical DVD rentals because it could acquire the content on its own. As long as a physical DVD (and later on, Blue-ray) was available, it could buy it and rent it to as many customers as possible. As the company became more and more successful, and could purchase more DVDs, it ended up owning more and more, eventually owning almost anything available on DVD.
With online streaming, Netflix can neither buy content (it's way too expensive), nor can it procure content on its own. Instead, it has to sign licensing deals with the content owners. This killed off the Long Tail immediately for several reasons:
First of all, owning most of the content was difficult since there are numerous content owners and you had to sign licensing deals with all of them. Just getting all the content owners to agree is an arduous task. In fact, there are some content that is almost impossible to license since there are so many content rights holders and you can't even track them down — think about trying to sign a licensing deal for an art film from the 1950's with some studio that may not even exist now and who knows where the rights ended up.
Secondly, as Reed Hastings has detailed clearly in shareholder letters, and quoted in a prior post, the normal structure of the video business is to sign exclusive deals. This is different from the norm in the music industry but that's how television and the movie business has operated for 50+ years. If you think about television, you'll notice this. For example, a television show or movie acquired by, say, ABC, is not shown on CBS. So, a company like Netflix or YouTube was never going to own all the streaming rights to all the content; you would have to be as big as all the cable, satellite, movie theater, and pay-TV companies combined in order to exclusively acquire all the content. (Having said that, do note that pay-per-view or digital purchase is generally not exclusive. What I am describing in this post, and what Netflix is involved in, is fixed-subscription services that are comparable to cable/satellite television.)
Related to the prior point, content owners—these are companies like Disney, Dreamworks, Time Warner—earn most of their income from cable, satellite, pay TV, and similar distributors. The content producers are concerned about devaluing their content so they won't offer streaming rights that hurt their existing business or devalues the future worth of their content. So, strategically, the content owners are unlikely to give away all their content to one company. They also are likely to, and indeed have been, force online streaming to occur well after the lucrative television/theater release windows.
So, as Netflix becomes more of a streaming provider, won't have much bargaining power. In the grand scheme of things, although Netflix has a sizeable 22 million subscribers, its revenue isn't very large and it is small compared to the content producers or the existing MVPD competitors. This isn't likely to change any time soon.
One of the big complaints against Netflix streaming, by current as well as potential customers, is that it doesn't generally have new content. Customers also complain that Netflix doesn't have all the content. I don't think this situation is going to change and other online streaming providers (so far, YouTube, Hulu Plus, Amazon Prime, HBO Go, TV Everywhere) will have the same problem.
Given the radical changes to the business and the limited online streaming content, it's possible that Netflix may experience big changes in the nature of its customers. Netflix customers used to DVDs and the Long Tail content may eventually leave Netflix since its streaming business will never have anywhere near the same content (note that Netflix will still continue its DVD-by-mail business but it won't focus on it). On the other hand, those used to traditional television may view streaming as better than what they were used to on television (streaming content limitation is no different than on television and the instant-ON nature of streaming is a strong value proposition for television viewers). In addition, Netflix (and its competitors) may pick up totally new customers who may consume content on portable devices like tablets or Internet-connected cars. These are customers who may never have used the Long Tail aspect of DVDs, and wouldn't even be aware of the limited content.
If my theory that the make-up of the customers may change is correct, it'll be critical for Netflix, which has depended on customer service and a low fixed price to differentiate itself, to satisfy the new breed of customers. The new customers will likely behave quite differently from the traditional DVD-by-mail customers. Since the content will be limited, Netflix will have to provide superior streaming quality, better software design, new social networking features, and so forth. It's not clear that Netflix can pull this off.
The Story Doesn't Sound Good
One might be wondering if there is anything that Netflix actually gains from the new streaming model. I think Netflix loses a lot of its strengths by moving into the online streaming business. It was necessary in my eyes so it didn't have much choice — if not now, it would have faced a similar situation in 2 or 3 years!
My philosophy in life is that there is a good to any bad situation, and, conversely, there is always a bad side to any good circumstance. Such is the case in business as well.
Netflix's bargaining power is weaker in online streaming and it is almost starting from scratch since it is a new market. Yet, that same scenario also gives it an opportunity to gain first-mover advantage and potentially develop and expand a new market. Netflix had almost saturated its DVD-by-mail business and destroyed all its competition so it had limited growth opportunities. But not so in online streaming.
If Netflix can expand the video market without destroying content value, it'll satisfy the content producers, and direct more money towards content creation. For instance, one reason high-value shows like Mad Men or Sopranos get produced is because the premium cable/satellite providers created value for content producers. Before the emergence of premium cable in the 90's, such shows would never have been made. Similarly, many sporting events, particularly NFL and NBA, have very high production values because the distibutors created value for the content producers. Netflix isn't in sports but it sort of shows how more money directed towards the content producers is good. It'll be good for the ecosystem if the market can be expanded.
An example of how the market may be expanded is through international expansion. This is very costly and who knows if Netflix (or companies like it) will be successful but it is a big opportunity. Not every country has the Internet infrastructure but I remember Reed Hastings commenting once how Costa Rica (or some country like that) was laying fiber optic cables for Internet than building out traditional phone lines or laying cable for television. It was actually cheaper to build out the Internet infrastructure. Even people who couldn't afford regular television may be streaming content within a decade—similar to how many developing countries skipped to mobile phones without spending money building out landlines.
If Netflix remained as a DVD-by-mail business, international expansion would have been difficult to almost impossible. For instance, many developing and even some middle-of-the-pack developed countries don't have good, affordable, mail delivery systems (not to mention theft and damage). If Netflix can attract international customers, it will be able to potentially sign world-wide content deals—not only paying more to content producers, but pushing content to customers who didn't have access to it.
As Netflix becomes more and more of an online streaming company, it also becomes asset-light. Netflix already has high ROE (since it has few assets) and it'll have even higher ROE as it morphs into a streaming company. High ROE means that very little shareholder capital is required to acquire more customers. The downside is that there is almost no physical assets for the shareholder to fall back on if things deteriorate.
I'll cover more of the underlying business characteristics of Netflix when I look at its financials in a future post.
Tags: corporate strategy, investment evaluation, media, Netflix (NFLX)