Reed Replies to Whitney – Shorting Netflix

December 20, 2010


A great investor and a wonderful human being, Whitney Tilson recentlyposted an article about why he is short Netflix (NFLX). Whitney, who is a major co-donor with me to charter public schools like KIPP, writes that he has lost money betting against Netflix, and that he is still short Netflix in a big way.

At Netflix we mostly focus on building our business and letting the numbers do the talking. But Whitney is such a big-hearted donor to causes that I care about that I am writing this open letter for him to try to get him to cover his short now. My desire is to increase his odds of making money next year so he can donate even more to the charter public schools that we both think are important to our country’s future. For the record, I think short sellers are a positive force in capitalism, and I acknowledge that CEOs are generally biased in their bullishness on their respective firms.

Whitney’s core short thesis in his article “Why We’re Short Netflix” is:

In particular, we think margins will be severely compressed and growth will slow over the next year.

This is the natural outcome of his view that:

We don’t believe that Netflix has a better business model, better management or a meaningful competitive advantage in the business of streaming movies and TV shows.

Whitney lays out a series of potential issues for us: Our CFO’s recent resignation; threats to the First Sale doctrine for DVDs; internet bandwidth costs potentially increasing; declining FCF conversion; market saturation; weak streaming content; paying more for streaming content; and increased competition hurting margins. He only has to be right on one or two of these issues in 2011 for him to make money on his short of Netflix.

Odds are he is wrong on all of them, in my view. Let’s take them one at a time.

As to the CFO issue, Barry McCarthy is a very accomplished executive who was working for a successful, younger CEO, so he correctly figured the chances of him becoming the CEO of Netflix were not high. In early 2004 he had the same feeling, and let us know that we should launch a search to replace him by the end of 2004. During that year we entered into a huge fight with Blockbuster (BBI), and Barry felt it would be low integrity to leave us in the midst of battle. So, he agreed to stay for a few more years.

By 2008, we had substantially exited from our hand-to-hand combat with Blockbuster, and he started talking with me about the need for him to someday soon go seek his future broader role. Two weeks ago, he informed me that it was time for him to move on. He was willing to stay for up to a year, like in 2004, if we wanted to do a search. After discussions with the board, we chose his longest-serving finance lieutenant, David Wells, as our next CFO, instead of doing an outside search, and announced the transition. We feel great about David Wells as our CFO, and there was no reason to ask Barry to stay further. Barry is a super-principled guy, and if there were any known major danger, he would never have left us. It is precisely because things look so good going forward that he allows himself to think about his own career ambitions. Some lucky firm will get him as CEO.

On the First Sale doctrine, which only applies to DVDs and provides our right to rent a DVD after its first sale, even Whitney acknowledges that any potential change would not happen for several more years. Given the rate of our streaming growth, by the time there was any change to the First Sale doctrine, we would be not very sensitive to DVD costs. This issue is not a material threat to 2011 results, and thus not a potential reason to be short Netflix now. Perhaps Whitney was just trying to be thorough.

Next in Whitney’s catalog is the issue of potentially increasing internet bandwidth costs, given the recent fracas between Level 3 (LVLT) and Comcast (CMCSA). The cost of sending or retrieving a gigabyte of data has fallen every year for at least 30 years. Advances in technology are making all the parts of data transmission cheaper and cheaper, roughly following Moore’s Law. The odds that the cost of moving a gigabyte of data materially increase in the next few years are extremely low. It is vastly more likely that the costs continue to fall as component prices fall. There is some chance that consumer ISP networks like Comcast will prevail in their battle to not only charge consumers of data, but also charge suppliers of data (e.g., Google (GOOG), Netflix, Apple (AAPL), etc.). This has been an ongoing battle for many years.

A valid concern over the long term is how much power the consumer ISP networks will have to charge data suppliers (i.e. content). In the case of ESPN3, however, it is the reverse: ESPN3 charges consumer ISP networks like Comcast for the privilege of transporting the ESPN3 data to the ISP’s consumers (in essence, Comcast and peers are forced to share some of the revenue of the $45 per month broadband package with ESPN3). We don’t have any plans to go the ESPN3 route, but the odds of material negative Netflix P&L impact from broadband pricing trends in 2011 are very low.

Moving to more interesting angles, Whitney documents our recent decreased FCF conversion due to us paying for content earlier than we had in the past. With this angle, Whitney does draw a little blood. Our new CFO David Wells and our content team are all over our need to get more consistent about pay-by-quarter for content going forward rather than pay-by-year, even if it means we’ll pay a little more. We will be working to improve the FCF conversion trend in 2011. On a long term basis, FCF should track net income reasonably closely, as it has in the past, with stock options as an offset against small buildups in PPE and prepaid content. Nearly all of our computing is through Amazon (AMZN) Web Services and CDNs, which are pure opex.

Next in the litany of Whitney threats is market saturation. In 2011, this is unlikely to affect us. Streaming is growing rapidly; it is propelling Hulu, YouTube, Netflix and others to huge growth rates. Streaming adoption will likely follow the classic S curve, and we’re still on the first part (acceleration) of the S curve. Since we expanded into streaming, Netflix net subscriber additions have been 1.9m in 2008, 2.9m in 2009, and over 7m this year (estimated). While saturation will happen eventually, given the recent huge acceleration of our business specifically, and streaming generally, saturation seems unlikely to hit in the short term.

The next issue is what Whitney calls our “weak content.” While Whitney may think “Family Guy” is weak content, our subscribers do not. Furthermore, our huge subscriber growth to date has been built on this “weak content,” so imagine how much upside we have as we improve our content, as we are always trying to do. I think what Whitney may be misunderstanding is that at $7.99 per month, consumers don’t expect to have everything under the sun. A variant of this misunderstanding is when DirecTV (DTV) advertises against Netflix, calling out some Netflix content weaknesses. When an $80 per month service is picking on an $8 per month service, the $8 per month service just gets more attention from consumers and grows even faster.

Moving on to the widely-discussed issue of increased content costs, it is true that we are paying more for any given piece of content than we were two years ago, and that in two years, we’ll pay more than we pay today. Part of our goal as a business is to make money for content producers and to become one of their largest and best revenue sources. Fortunately, our subscriber base is growing fast enough, and DVD shipments are growing slow enough, that we can afford to pay for the existing streaming content we have, and also get more content. We try not to comment on specific deals, like the Starz renewal, as that rarely helps us get deals done.

Investors sometimes see the content cost threat as an issue around our margins. But we have no intention of overspending relative to our margin structure, and there is no specific content that we “must have” at nearly any cost. In our domestic business we spend 65-70% of revenue on COGS (which is mostly content and postage). So if content costs rose faster than we expected, then in practice we’d have less content than otherwise, rather than less margin. This would ultimately show up in less subscriber growth than we wanted from a not-as-good-as-it-would-otherwise-be service; it would not likely show up as a sudden hit to margins. Management at Netflix largely controls margins, but not growth.

Turning to competition, there is a legitimate short thesis in the unknown of who enters directly against us and when. Some offerings like Hulu Plus have some content we do not, but we are making progress on that gap. In the near term, some of our subscribers will also subscribe to Hulu Plus, but very few will quit Netflix because we have lots of streaming content that Hulu Plus does not. For a competitive firm to materially hurt our growth, they have to have some positive differentiator (price, additional content, integration, etc.), and then they have to market their service effectively. This wild-card of major new competitor offering great content and marketing aggressively is the single best near-term short thesis, but no one knows if it will happen in 2011.

The core competitive barrier for direct competitors is brand/subscriber-evangelism. Our large subscriber base is very happy with Netflix, and tells their friends about Netflix. That means that the cost of acquiring the incremental 1m subscribers is lower for us than for a competitor, and thus our net additions are higher. There are also lots of other smaller competitive barriers, but the happy subscriber base is the big one.

Another competitive threat is TV Everywhere. If MVPDs (multichannel video programming distributors) are successful at getting their subscribers (which is practically everyone) to use TV Everywhere, which is free, instead of Netflix, for streaming video, then the market opportunity for supplemental services like Netflix and Hulu Plus will be much smaller. There is no additional profit for MVPDs in TV Everywhere, but they are motivated to slow the growth of supplemental services because of the fear that someday the combination of ESPN3, Netflix,, Hulu, YouTube, and others could be an effective MVPD substitute over the internet. The TV Everywhere threat will grow over time, but is unlikely to bite in 2011 in a short-satisfying manner.

An issue that Whitney did not bring up is potential Netflix international expansion that would shrink global margins in the short term. We announced in October that we were so pleased with our initial results in Canada, which, if trends continue, will mean we can get to breakeven there one year from launch, that we were likely going to invest heavily in further international expansion, and that if we did so, it would be to the tune of a $50m hit to global operating income in the back half of 2011. We think the international opportunities for us to build profitable businesses may be quite large, but the rapid expansion will lower global operating margins as long as there are additional markets in which we can wisely invest. Starting next year we’ll break out domestic versus international for investors so they can track our progress for themselves.

To wrap up, I have to agree with my friend Whitney that there are many risks ahead for Netflix, that our valuation is substantial, and that it is possible that one could make money shorting Netflix today. But shorting a market leading firm as it is driving a huge new market is a very gutsy call. On balance, I would rather have my co-philanthropists on the long side of this particular bet.

Whitney: Short or long, I look forward to dinner and drinks together in the New Year.

Respectfully, your ally and admirer,



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