Lessons learned from Netflixed

I finished Netflixed by Gina Keating yesterday and highly recommend giving it a read for anyone who wants a really detailed history of the company from inception to ~2010. The book is as much a history of the movie / TV industry as it moved from in-store rental to DVDs to streaming as it is Netflix.

NFLX has been public since May 2002 so as you can imagine there are some amazingly bad on-the-record takes from Wall St. analysts and entertainment executives since the company became public traded. I will come forward too as saying I have been consistently wrong on NFLX. In 2010 I remember reading Whitney Tilson’s short thesis on the company and concluding the company was doomed; boy was I wrong.

This book makes very clear why predicting the movement of industries is impossible. Companies try different strategies, consumer behavior changes, technology changes, the cost of capital changes and the people behind capital / companies change (Blockbuster was originally a subsidiary of Viacom and then heavily influenced by Carl Icahn’s activist campaign – as you’ll read, both of these largely influenced why the company ultimately lost to Netflix). It was a reminder to me to be very wary of things like TAM estimates, EPS projections, stated competitive moats, analyst price targets and anything as a reason to buy or sell a financial security. At the end of the day, we’re all guessing, and, as Bill Belichick likes to say, the score is a function of the plays that happen on the field.

Conveniently forgotten in most modern accounts of NFLX – Blockbuster Total Access was winning the market for a long time

All that said, I do think there are some things I learned from this book that made me a better investor. Here we go:

  • Growth always comes at a cost . As an investor you need to be hyper aware of those costs. Netflix and Blockbuster Online both struggled with “whale” subscribers effectively costing more than minnow subscribers. Someone who goes through dozens of popular mail-order DVDs a month puts a larger strain on inventory and mailing costs then a new subscriber who gets a readily available DVD. Not all subscribers are worth the same to companies. Lowering price and offering perks may boost growth at the cost of expensive debt or angry franchisees. This is exactly what happened to Blockbuster Online with their Total Access program. Blockbuster Online for a year+ was eating Netflix’s lunch in new sub growth. The company’s Total Access program allowed subs to rent online and return in-store, and gave them free in-store rentals with no late fees. The program wasn’t profitable and NFLX correctly predicted the company would bleed cash as long as the program continued. Blockbuster in part due to Blockbuster Online was forced to continue amending and extending with lenders.
  • Even so, NFLX investors fled the stock as it seemed clear Blockbuster Online was going to win online rental. Reed Hastings even offered to buy Blockbuster’s subs at up to $300 per sub (a deal that would’ve solved Blockbuster’s debt problems and possibly allowed it to survive if timed right). The reality is Wall St. loves growth. If you don’t have an awareness though of what the unit economics are behind growth, you’re going to get burned when a 2008-9 comes along or an activist investor demands profitability and the strategy changes (both of which happened to Blockbuster).
  • Activist investors… maybe a reason to stay away from a stock. Carl Icahn’s returns are great and I have a ton of respect for him. All that said, he in hindsight should’ve allowed ex Blockbuster CEO John Antioco to run the business and never pushed for new CEO James Keyes. Based on the book, Keyes quickly did away with Blockbuster Online and tried to re-invest in the franchises, even though this strategy had failed Blockbuster every year it was pursued (notably he put a failed bid on Circuit City, believing that offering consumer electronics would help the stores). Many of Icahn’s actions were due to Blockbuster’s declining stock price. The stock price hid the fact that Blockbuster Online and the Total Access program were growing (albeit not profitable yet) and probably deserved more marketing spend (when Keyes pulled budget, growth immediately slowed). As an investor, it’s hard to see your companies burning cash and my instinct always is to look for areas to improve margins, but the reality is there are circumstances where it’s justified to keep spending money. Operators above all need to be heard out and given as much respect as the stock price, which is ephemeral and based on many factors not related to fundamentals.
  • Form 4s matter. Yep, we all know this to some degree. But I was shocked to read that after a terrible company retreat where Keyes laid out his new strategy for Blockbuster, the exec team was so upset they all sold the stock, bought Netflix and then resigned.
  • Be wary of predictions, no matter who is making the calls. Here are some things many smart people thought in the early and mid 2000s:
    • The DVD is an early technology that doesn’t have a clear standard (read this wiki entry on DIVX) and has a long way to go to compete with VHS. Also, DVD players and DVDs are too expensive.
    • The DVD rental / subscription market and streaming market are niche markets that won’t eclipse DVD sales for decades
    • Movie and TV show streaming is too complicated for most consumers. Very few people want to watch anything on a laptop or phone
    • Consumers need to have the choice to watch all newly released movies on a format that isn’t in theaters (yep, this was in 2005, and Disney CEO Bob Iger and Mark Cuban both said this) because theaters are dead to a large percentage of consumers. In 2005, a survey said only 22% of consumers wanted to see a movie in theaters versus at home. Yet, box office revenues have gone up nearly ever year since then…
    • DVD kiosks will never work. People won’t trust a machine that charges your credit card for $1. Yep, NFLX, Blockbuster and many others passed on Redbox.
    • [Larger Company X] will crush [Smaller Company Y]. Walmart, Amazon, Disney, the cable providers, Blockbuster and many others have tried to take market share from NFLX at various points in time. Walmart abandoned the market several times and eventually started partnering with Netflix. Blockbuster was the favorite in the DVD rental wars in the eyes of Wall St. for a long time.
  • Leverage matters perhaps more than we think. NFLX throughout the 2000s had no debt and enough cash to weather through Blockbuster Online taking market share. Blockbuster on the other hand was a notorious slow payer of debt to the studios and banks. They decided to pay a massive dividend to Viacom right before the spin off. Antioco and Keyes were forced to renegotiate covenants time and time again with lenders. We may think in this era of cheap capital that a fortress balance sheet doesn’t count for much, but this book does a good job of pointing out hitting a refinancing wall is a real risk and one that NFLX did not have to worry about.
  • Scuttlebutt is non-trivial to gain and matters a lot. Many NFLX fans have probably heard this story, but worth relaying here – Mario Cibelli and other NFLX bulls found out early on 1) that NFLX’s distribution centers were extremely well-run and hard to replicate and 2) Blockbuster was including a barcode on its rental envelopes that could be used to tell you what subscriber # you were (so the newest subscriber number represented total subscribers). Both (1) and (2) required digging (visiting the distribution centers and asking questions, looking into barcode and comparing against other envelopes) and tipped the scales in favor of Netflix. (2) ended up being vitally important for Netflix, as the management team was constantly making projections on how much cash Blockbuster was burning and how much of the market they were winning based on the bar codes.
  • If you’re following a company, follow the competition and be conservative with that term. I don’t think it would’ve been possible to have an objective opinion on Netflix stock without following Blockbuster Online. Every company in 2021 claims they are its own unique product segment. We know that’s not true. I want to be better with following earnings for companies I don’t own that I know will impact companies I do.

Overall, Netflixed is a fantastic read and I will keep it in mind as I think about what books will be written about the companies I own. There is a whole lot going on outside of quarterly earnings and a thorough reading of SEC filings is only the beginnings of knowing a company and their industry. The biggest drawback of financials is that they represent snapshots in time and growth described in filings usually is sequential quarter / year-over-year and not forward looking. At most points in time in the 2000s, it would not have benefitted you to index on Netflix’s subscriber growth (especially when it was slowing down) as it wasn’t at all predictive of the future.

As always, investing is hard and it’s funny how being a decade removed from events really sets them in perspective.