Revisiting Reed Hastings Vs. Whitney Tilson: Was Tilson Right?

Sep. 6.11 | About: Netflix, Inc. (NFLX)

One of the most talked-about exchanges between financial professionals happened on Seeking Alpha from December 2010 to February 2011 as Whitney Tilson and Reed Hastings discussed the merit of shorting or owning Netflix (NASDAQ:NFLX) shares.

Whitney Tilson, a hedge fund manager, wrote "Why We're Short Netflix," which was published by Seeking Alpha on December 16, 2010, when Netflix was trading around $180. Tilson cited the possibility that shares could tumble due to Netflix's dependence on its streaming business, which, he asserted, would require continuously buying increasingly-expensive content (and decreasing margins) or maintaining a weak library (resulting in subscription cancellation). Either outcome, he said, could drive shares lower.

Reed Hastings, the CEO of Netflix, controversially replied directly to Tilson's article in "Cover Your Short Position Now", published on December 20, 2010 at Seeking Alpha. After opening with a few friendly and cordial statements about Tilson the person, he attacked the points of Tilson the money manager's article. Hastings intelligently rebutted most of Tilson's points, honestly noting some challenges that Netflix was facing and the policies and strategies that would be deployed to address them.

Tilson threw in the towel in February 2011 and explained his action in "Why We Covered Our Netflix Short." Netflix shares had rallied 25% since his December article and he decided to cover his position. It was a good short-term decision; shares rallied from around $220 when the article hit Seeking Alpha to over $300 in July. In the article, Tilson conceded that his fears about content costs of subscriber attrition were overblown, even noting that his firm conducted a survey of Netflix customers that revealed a higher-than-expected satisfaction rate. He closed the article by stating that he wasn't a buyer of Netflix at $222 and 75x trailing EPS, but he didn't think it was a good idea to be short any longer.

Both authors made statements that are very interesting when viewed via hindsight. Tilson wrote the following, which predicted higher costs and the potential for a price increase in the near future:

Given that content providers aren't about to slash their prices, Netflix has three choices, all of them unpleasant:

  1. It can have a weak library and maintain low prices, or

  2. It can license better content and pass the cost along to its customers, which would crimp growth, or

  3. It can license better content and eat the cost, which would hurt margins.

He also noted the potential difficulties for the renegotiation of Netflix's content deal with Starz; he wrote that "Netflix will either have to pay up or lose the Starz content when the contract expires." We now know that Netflix will be losing the Starz content in February when the contract expires.

Mr. Hastings honestly admitted the potential that Netflix would be faced with both of these problems and outlined the company's strategy to deal with issues. He said:

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.

He executed his plan; in the second paragraph, he suggests that the company would sacrifice content before margins, and that's exactly what happened when Netflix didn't sign a new contract with Starz. As he also suggested, the company (and the investment community) probably can't yet predict the effect on subscriber growth.

Before these concerns existed, the stock rallied; as previously noted, shares peaked over $300 in July due to continued business success and a favorable market environment. Since then, as these worrisome developments have occurred, Netflix has been a falling knife.

Shareholders were spooked by the announcement of a new pricing structure (hinted at in Tilson's article, though not in specific terms) that amounts to a price increase/service decrease for many customers. (Netflix split DVD and streaming plans, allowing consumers to choose one or the other, or pay an additional cost for both.) The internet was outraged, and many customers vowed to cancel their subscriptions. But posting a comment is not the same as actually cancelling, and now that Netflix's higher rates are going into effect, investors will soon find out if a meaningful number of customers are actually dumping Netflix. If many do, earnings are likely to be pressured; if commenters were bluffing, earnings will surge because Netflix will be collecting higher monthly fees.

Shares fell last week after the Starz announcement was made. Shares closed at $213 on September 2nd; they are still above Tilson's original short call, but now lower than when he wrote about covering his position. At this juncture, with new information available, is Tilson's short thesis or Reed's long thesis more likely to be correct? (It would be great to have two successful financial professionals, Tilson and Reed, provide opinions, but in their absence I'll provide mine.)

I believe that Tilson's original concerns have materialized, and shares are likelier to fall than rise. (Unfortunately for Tilson, his original call was ruined by the usual reason that a short sale fails - poor timing, not a bad thesis - which is why I am not personally shorting shares at this time.)

Netflix shares were driven higher by strong business execution over recent quarters, bright future prospects, and momentum. The latter two aspects have changed significantly since July.

The company's future prospects are less certain because of the price increase and content uncertainty. If subscribers absorb the increase, as bulls hope, the company will enjoy much higher revenue and income in coming quarters. Realistically, the price increase is only a few dollars per month, so the company may not lose many customers. Content uncertainty is probably a bigger concern to long-term business success. Starz content was important, though not necessary, to Netflix's portfolio; more importantly is the indication that all future content is going to be very expensive.

When combined, these two independently-moderately concerning issues are a greater threat to long-term stock performance. Continuously increasing prices and declining content quality and quantity will certainly make a Netflix subscription less attractive. The point at which a mass exodus occurs almost certainly hasn't been reached, but it may be inevitable.

However, Netflix could continue to execute better than I (and the sloth of bears) expect. The service is still very inexpensive compared to TV or most other monthly subscriptions (cell phone, gym membership, etc) and $16 per month (for both streaming and 1 DVD) is far from outrageous. An out-of-touch consumer may not even notice the change. Even a few additional price increases could probably be stomached before the service begins to seem no-longer inexpensive.

There is also a limit to the amount of money content providers can demand, and Netflix, as a very large distributor, may even develop pricing power in the future. Just as consumer goods companies will sell to Walmart on Walmart's terms, Starz and others may eventually become more likely to meet Netflix's demands if they discover that their other revenue streams and delivery methods (such as proprietary delivery systems, i.e. HBO GO) aren't as robust as expected.

Clearly, the current and future variables have the potential to drive the stock price much higher or much lower. I'm still on the sidelines, but if you believe in Hastings, shares are now almost $100 less than they were a few months ago. If you think that Tilson's concerns (and new developments) will pressure the stock price, shares still trade at a trailing PE of 50, so there might be much more room to fall.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.