Amen of the Week:
“When there’s an ache, you want to be like aspirin, not vitamins. Aspirin solves a very particular problem someone has, whereas vitamins are a general ‘nice to have’ market. [The Netflix idea] was certainly aspirin.”
- Reed Hastings, Netflix founder and CEO
Fortune Magazine, “How Netflix Got Started” January 28, 2009
Few professional short-sellers can raise their hands and proclaim, “I have never been short Netflix.” Back in the mid-2000’s when I co-managed a hedge fund, I too had bet against the company. Briefly. The thesis for Netflix’s imminent failure was “elegant” in the words of my best analyst. Although the company had enjoyed success creating a DVD-by-mail business catering to the “long tail” of movie buffs with eclectic tastes, it was doubtful such artful connoisseurs existed in sufficient mass outside of cities like San Francisco where its early customers were clustered.
Yet, even if the market did prove to be much larger, Netflix was sure to lose out to the big, bad Blockbuster, who had just announced (in 2004) that it would be launching its own DVD-by-mail service. And Blockbuster wasn’t messing around. It planned to invest $500 million (an amount almost equal to Netflix’s sales that year) to roll out its competing service.
Besides, even without the Blockbuster threat, Netflix’s business model of mailing DVD’s was clearly not sustainable. Even back in the olden days of 2005 everyone knew that DVD’s would go the way of VHS as content would eventually go digital. But the cherry on top - what really got short-sellers like me excited - was that Netflix’s best customers were its least profitable. Its absolute best customers were likely even unprofitable. Despite these obvious negatives, the stock was trading at an “expensive” valuation.
Who among you would not have been tempted to short this stock? Thankfully, I had the good fortune to attend a meeting in New York where Netflix management spoke to a room full of analysts. I remember looking around the room at my peers and smiling to myself, thinking, “I wonder if these guys have any idea that more than half the folks in this room are short their stock?” Then the CFO opened his remarks with, “Welcome shareholders, potential shareholders, and of course, short-sellers.” He proceeded to speak candidly about their business, addressing the formidable threats they faced. Rather than ducking the tough questions from short-sellers, he took them head-on – and did not even seem bothered by them. This was not how management teams typically dealt with short-sellers. They almost seemed to be encouraging the shorts to share their critical concerns. I was suddenly struck by something that I had never before experienced in my hundreds of such meetings: Could these guys be here to learn from their critics?
After the meeting, I made a point to spend more time studying the people behind this company rather than myopically focusing on the business model. Who was this Reed Hastings guy? I learned that prior to his Netflix days he had proven himself to be not only a successful engineer-turned-entrepreneur, but a leader with a zen-like self-awareness and intense focus on identifying mistakes rather than covering them up or making excuses. I concluded that I could not risk betting against this guy. Thankfully my Netflix short-sale was short-lived. The stock is up over 17-fold since 2004.
In retrospect, I wish my reasoning had extended from “I cannot bet against this guy” to “I need to invest in this guy.” But I just couldn’t believe that Netflix had a sustainable future given the inevitable demise of physical DVD's (its core business!). Then, the unthinkable happened. Hastings led the company through a complete change of its business model – from the physical to the digital. One of the classic “red flags” for a short-seller is a company that begins to change its business model. Hastings faced mega competitors like Time Warner and Charter as he charged into the digital world. How, then, did Netflix escape the demise that so many smart investors foresaw? It was not a grand business plan but a grand entrepreneur - one who built a tight culture of truth seekers who experimented relentlessly, studied and learned scientifically, and executed forcefully to deliver what customers wanted.
Netflix shouldn’t exist. But it does – in spite of Blockbuster, in spite of the death of DVDs, in spite of all the competitors who should have crushed it. Netflix exists because of Reed Hastings. This is a reminder of why some founder-run businesses have such an inherent advantage. It is also a reminder of how innovators and their innovations will continue to improve our lives. As long as guys like Hastings choose to stay in (or come to) the US, I will remain bullish on our long-term prospects.
Yours in the Field,
Frank Byrd, CFA
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