Ted Nelson: But why do they put a guarantee on the box?
Tommy: Because they know all they sold ya was a guaranteed piece of sh**. That's all it is, isn't it? Hey, if you want me to take a dump in a box and mark it guaranteed, I will. I've got spare time. But for now, for your customer's sake, for your daughter's sake, ya might wanna think about buying a quality product from me.
-Tommy Boy, 1995
I found it interesting to discover that Whitney Tilson, who is notably long Netflix (NFLX) is also now shorting RIM (RIMM). These stocks are seemingly an odd couple, but if you take a closer look they make for an interesting comparison. So, here goes.
RIMM the Dinosaur
This is a company with a tangible book value of $6.6 billion and a market capitalization of roughly $6.7 billion that is facing some serious problems. Their BlackBerry has become a virtually obsolete product as far as the Western consumer is concerned, and as a result the company will be experiencing significant revenue and earnings declines in the quarters ahead. Yet, their global subscriber base is still growing, and they have some sticky customers in the more lucrative enterprise space who still value their core secure business communication value proposition. They also own valuable push messaging ip and physical network infrastructure.
As a response, management has decided to cut costs and refocus the business on the enterprise and less glamorous but cashflow generating international markets (Indonesia, MENA, South Africa, India, and Latin America) in which their brand continues to be a market leader in smartphones. Basically, they are happy to milk a cash cow and focus on the markets that are working for them instead of bothering to compete in what is now a highly unattractive Western market landscape dominated by two massive players.
Netflix the Wildcatter
This is a company with a $600 million book value and market capitalization of $5.7 billion that is moving away from their cash cow (they are actually trying to run it off faster) and instead focusing on the future. They are going after the global online video subscription market, and are now trying to rapidly expand internationally. They are pushing this expansion despite having yet been able to prove that the North American streaming business offers attractive rewards on investment. They have no real physical assets of note, and are thus entirely dependent on consumer perception of their brand to stay in business.
The brand valueis derived from low cost streaming access to high quality subscription video content. This content is licensed from content owners whose models are built around multi distribution channels. The online streaming distribution channel Netflix created was initially highly distinguishable from the old traditional competing pay-tv distribution channel because of the form of access, cost, and subscription portability.
Two of those three distinguishing traits have all but disappeared, leaving only cost as an advantage. The cost advantage is predicated on an infrastructure arbitrage that Netflix has been able to expose at the expense of the traditional competing distribution channel. The domestic sustainability of this arbitrage and the ability to continually expose it in international markets with much more monopolistically inclined telco/cable operators is questionable at best. Netflix management has concluded that this path must be followed as the alternative is extinction.
Their entire strategy is based on achieving massive economies of scale to spread their content and hosting costs across. This is despite the fact that content owners have traditionally gone out of their way to prevent the creation of such a player. Otherwise Amazon (AMZN) or YouTube would be the logical choice for such a role.
In pursuing their goal, Netflix retains limited balance sheet flexibility and thus is constrained relative to competitors with respect to content spend. Revenues and subscribers are growing but at a slower pace though earnings and cash generation are lagging as the company moves away from the higher margin DVD mail in business and incurs startup costs in international markets.
So, I ask, which stock would a value investor rather own?
The potential value trap priced like a value trap whose management team is seeking to focus on cash generation in less sexy niches or the growth story cutting edge digital distributor in a highly competitive and increasingly shifting landscape trading at 10x its book value. At these valuations I choose the former even if five years from now the whole thing might need to be liquidated.
Online streaming may look sexy, but underdeath all that shine all you are going to find is pretty crappy economics at these valuations. RIMM, on the other hand, comes off looking like an ugly duckling, but get past that rough exterior and you just might find yourself a nice little cash cow worth renting for a few years.
On a side note, while I think Netflix's quarterly earnings are no longer really worthy of individual articles as the course of the business has become quite predictable, I figured I'd point out a few things here that stood out to me.
1) Operationally, this was a better quarter than the last quarter which I think goes to show how much the dodo short squeeze dash for trash that swept through the market in January was the real driver behind Netflix's surge. Yes, this was the topic of my last Netflix note so I am biased, but I think there is no denying it at this point. Quarterly obsessions are what the market is all about, but they can often have very little to do with the stock price action.
2) Netflix management should come clean and stop treating everyone like morons. The Q2 guidance is soft because it is the exact mirror image of Q1 when it comes to free subs. I'm not even living in the States and Netflix still sent me three free trial offers in the Q4/Q1 period. If you are going to goose subs by aggressively going after free trial conversions, you should expect a sequential uptick in cancellations in the quarter when those free trials are not being offered. We don't need mathematical simulations to explain how this works.
3) Netflix continues to surprise on digital content cost management which is clearly an accounting phenomena.