As the dust settles around Netflix's (NFLX) disastrous Q3 earnings call, I want to cast aside the noise and make several key points completely clear.
Reed Hastings Continues To Be Reed Hastings
To argue that Netflix CEO Reed Hastings does not have a competent side ignores reality. As such, I never made that argument and do not intend to start now. Of course, he single-handedly - or so it seems - drove his company into the ground. On the "B" side, however, Hastings fooled the vast majority of the world into believing that Netflix deserved a triple-digit stock price just like companies with actual sustainable business models like Apple (AAPL), Amazon.com (AMZN) and Chipotle (CMG).
He fooled everybody largely with masterful spin. I do not need to reiterate the things I have said, repeatedly, in my Seeking Alpha articles on NFLX to support that point. It's all on the record. In short, Hastings has always said what needed to be said to get - and keep - people on his company's side. Then, all of a sudden, it all blew up in his face with the much-publicized price increase and the still birth of Qwikster.
That said, a vast majority of investors and consumers are missing two key, interrelated points.
- The price increase and Qwikster debacle represent little more than secondary diseases. Do not speak of either as causal. They're merely outcomes and manic responses to the overarching and inherent problem that made Netflix unsustainable ever since it went hardcore into streaming. There never was a way - subscriber exodus or not - that Netflix could keep up with billions in content obligations and international expansion costs using funds from subscriber growth and the alleged cost savings from decreasing DVD rentals.
- Hastings continues to spin and spin well. He wants your focus placed on the price increase and Qwikster misstep. Hastings wants to keep these two issues in the forefront and frame them for what they are - mistakes and bonehead moves, yes, but temporary headwinds that his company can overcome as they prepare to take advantage of the massive global opportunity in streaming digital content. Of course, he does not want you to focus on the core problems that existed in his business long before these two ephemeral errors occurred. He would much rather you focus on these fleeting problems because, in that vacuum, light exists at the end of the tunnel. He's buying time because no such light exists at the end of the real story of exponentially rising expenses and decreasing capital to pay for them as they come due.
Netflix Is The Next Webvan
On several occasions, I have made the comparison between Netflix and the now-defunct Webvan. I think it's even more apt than the Research in Motion (RIMM) to Palm associations. Consider what I wrote in this regard back in September:
The entire Netflix tale - namely too much, too fast market expansion and a sweeter than sweet deal for the CEO - reminds me of a dot-com debacle that Netflix's eventual demise could rival. That's the story of Webvan.
Like Netflix, Webvan provided a service that lots of people, particularly in the San Francisco Bay Area, loved. I still remember the famous green bins and Webvan trucks littering my neighborhood when I lived in "The City."
Given his ability to cash out options practically every week, I wonder if Hastings employment contract looks anything like that of former Webvan CEO George Sheehan's. As CNET noted back in 2001, the contract calls for Webvan to pay Sheehan $375,000 per year for the rest of his life. I presume he receives that yearly take to this day.
The SEC thinks the disclosure of churn and related subscriber metrics would benefit current and prospective Netflix investors. I agree. In addition to the things many of us have discussed for months, such as Netflix's treatment of content acquisition charges, I wonder if the SEC should be equally as concerned with CEOs who fail, yet set themselves up for life on the backs of shareholders.
While this, of course, brings up issues related to Netflix's aggressive options compensation program and its ill-advised stock buybacks, it also homes in on apropos business comparisons between Netflix and Webvan.
Like Webvan, Netflix is expanding too far, too fast. Of course, to ramp up the virtuous cycle of subscriber growth > more revenue > more content > more subscriber growth > more content, Hastings needs more subscribers. What better way to do it than to expand to apparently fresh, far-flung markets to find them.
Shortly before it folded, Webvan went through a period of contraction after an incredibly misguided and overly-aggressive expansion:
Although the company had pledged to find its way in the sluggish Internet economy, its demise was not unexpected. Webvan recently pulled out of the Atlanta and Dallas markets and drastically scaled back its Sacramento operations in an effort to conserve its dwindling cash reserves (emphasis added).
That's downright ominous. The above-referenced article from 2001 goes on to make a point that helps tell the story of Netflix's pending demise:
Like toy retailer Etoys, which went kaput after disappointing holiday sales last year, Webvan was a victim of the dot-com "get big fast" mantra, said David Kathman, a stock analyst at Morningstar in Chicago.
"Webvan and Etoys will be two lessons studied in business schools for years to come about the perils of setting expectations too high and locking yourself into those expectations," Kathman said. "If something goes wrong and you fall short, you're in much worse shape than if you held back and tried to grow modestly."
While I still believe Netflix will find a way to raise cash by divesting its DVD unit and/or doing a secondary stock offering (assuming either of these options remain even remotely possible), I also think the company will need to contract its operations. That might mean pulling out of some international markets to conserve cash and/or somehow restricting the scope and reach of DVD rentals.
As usual in the Netflix debate, investors and consumers - and, as an aside, the fact that Netflix interests both makes it all the more interesting - spend too much time focusing on all the wrong things. All that matters - and all that has ever mattered - are the rising content and international expansion costs up against a subscriber and revenue growth model that never had a chance.
While consumers might love streaming and it might just be the future, the numbers simply do not add up to allow Netflix to continue doing it. As I have argued all along, no reason exists for Netflix to exist in the space.
If you're going to be a glorified bootlegger of digital content, you need to have (A) deeper than deep pockets and (B) other synergistic, sustainable and meaningful revenue streams to support the costs associated with buying up content. Amazon.com and Google (GOOG) have both A and B. Netflix never has and likely never will have either.
The real opportunity, however, sits in the hands of the programmers and movie studios - possibly working in conjunction with cable and satellite operators - if they can ever break out of their old guard mold. While it's encouraging that the key members of the old guard decided not to sell Hulu, what they do next is what really matters. They can work to enhance and preserve traditional delivery methods while embracing new ones via platforms where they retain complete control of their digital content while bringing in massive subscription and advertising revenue.
In any event, however it plays out, expect that Netflix will no longer be part of the story. Don't count on the programmers and studios selling them content for much longer. Content owners must be wondering if they'll ever see the money Netflix has already obligated itself to pay.
As for me, I will truly miss seeing those red envelopes in my building's outgoing mail slot just as I missed seeing Webvan trucks and green grocery bins beautifully littering the streets and stoops of San Francisco when I lived there.