A lesson in technology and Internet investing from Netflix (NFLX)

Oct.15.04 | About: Netflix, Inc. (NFLX)

Netflix shocked investors this evening.  It announced that it expects Amazon to enter the online DVD rental market. Netflix therefore plans to delay its entry into the UK market, cut its monthly service fee from $22 to $18, and no longer expects to be profitable in 2005.  Investors dumped Netflix’ stock after this announcement, causing it to fall by 37%.

I think investors were wrong to own Netflix' stock before this announcement, and I think they’re wrong to dump it now.  The reasons are fundamental to technology and Internet investing.


Here’s why investors were wrong to own Netflix stock before now

The movie rental market is undergoing fundamental structural change that will lead to the fall of the movie rental store.  Technology advances will result in significant price declines in movie distribution and new market leaders.

But the price declines are much more certain than who the leaders will be.  I’m absolutely sure that Blockbuster won’t be able to charge $4-6 for a three day movie rental when Neflix and Walmart are offering unlimited monthly rentals with no late-fees, when disposable DVDs are sold in vending machines, and when video-on-demand becomes widely available.  But I’m far less sure that Netflix will be the ultimate winner.

So the right way to play the turmoil in the movie rental business as an investor was on the short side. Blockbuster (BBI), Hollywood Entertainment (HLYW) and Movie Gallery (MOVI) were shorts.  (I had a short position in one of these three stocks almost constantly from early 2003 to mid-2004, as I discussed here.  Now I don’t, but that could change.) 

The wrong way to play this was on the long side (to buy Netflix stock), because it’s just too early to see who the winners will be.

Fred Hickey makes this mistake almost every month in his Hi-Tech Strategist newsletter by owning 3Com stock.  Like the movie rental market, the data networking market is also undergoing structural change.  New competitors with different business models and cost structures are entering the market.  Dell is pushing into low-end data networking products and positioning itself as a one-stop IT shop for companies, and Chinese networking vendor Huawei has formed a joint-venture with 3Com to produce and market Layer 3 switches in the U.S. and Europe.  Huawei has fundmantally lower costs than its U.S competitors, because it pays less for manufacturing and R&D and nothing for intellectual property.  The entry of Dell and Huawei are both highly deflationary for the networking market.

But Hickey played this the wrong way as an investor: he went long 3Com stock (and he still owns it).  He did that before it was clear that 3Com could manage the JV, could make money from selling cheap switches, and could survive Dell’s assault at the low-end.  Well, sure enough prices are under pressure, but 3Com’s stock has tumbled. 

What should he have done?  Played it on the short side.  He should have shorted Extreme Networks and Foundry.  (I shorted both, and still hold an open short position in Extreme at the time of writing.)

That’s why investors were wrong to own Netflix’ stock before this announcement: don't go long the stocks of companies whose markets are in turmoil and whose pricing is in free-fall.  Find shorts instead.

But now investors are dumping their Netflix stock because Netflix is cutting prices and delaying profitability. 

Here’s why investors are wrong to dump Netflix stock now

Aggressive price-cutting is the right strategy for market-leading Internet companies.

There are two reasons for this.  First, the most fundamental costs of Internet businesses – technology costs - tend to decline sharply over time (in real, hedonically adjusted terms, Mr Gross).  So the most competitive companies should aim for constant price cuts.

Second, Internet businesses tend to exhibit significant returns to scale, networking effects and brand value.  That means that first-movers have a huge advantage, and Internet markets tend to be monopolies or duopolies.  (Think eBay in auctions, Amazon in diversified retailing, Yahoo! and Microsoft in web email, and AOL in instant messaging.)  In markets where first-mover advantage is so significant, taking short-term profits at the expense of long-term growth is a mistake.

Here’s a company that got this badly wrong: E*Trade (NYSE:ET), under its previous CEO Christos Costsakos.  E*Trade initially had first-mover and brand-leader advantage in the online brokerage business.  But it used those advantages to maintain pricing to maximize short-term profitability.  As a result, Ameritrade and Datek undercut E*Trade’s pricing for years ($8 per trade versus $15) and together added over 1.5 million accounts.  Ameritrade and Datek subsequently merged, showing they understood the importance of scale in a technology-enabled business.

Now E*Trade has regained momentum through aggressive differential pricing: it undercuts Ameritrade for active traders, is the only brokerage to offer mutual fund fee rebates, is the new low-price leader in index funds (significantly below Vanguard), and will probably cut the price of ETF trades.  I own E*Trade stock because it's the got the right strategy (offer a suite of banking and brokerage products to maximize revenue and stickiness per customer, and aggressively cut pricing) and the right cost structure (no heavy branch network).

But think of this: what would E*Trade look like today if Costsakos had kept E*Trade’s pricing below Ameritrade’s and Datek’s between 1997 and 2001?  My guess: E*Trade would have  4 million brokerage customers today instead of 2 million, and the company would be vastly more profitable.

In this light, Amazon’s decision to keep cutting prices and offering free shipping is correct, and wrongly disliked by investors and sell-side analysts.  Amazon’s logistics, brand recognition and scale give it huge first-mover advantage.  It needs to maintain its price leadership to reap much greater economies of scale and profits in the future.

And Netflix' decision to postpone its entry to the British and Canadian markets is also correct.  It shows that CEO Reed Hastings understands the underlying dynamics of his market.  Netflix has no first-mover advantage outside the U.S, while Amazon has stronger brand and a pre-built distribution infrastructure.  So Netflix will never succeed there.  Hastings is right to conserve his capital to get economies of scale in the U.S.

So here’s the wider message from Netflix:

Companies that price aggressively to maintain first-mover advantage in natural-monopoly markets make great long-term investments.  But when the price war erupts for the first time, don't go long the potential winners.  Go short the losers instead.

Related links:
I first wrote about the movie rental business in The Fall of the Movie Rental Store.  Then, when Disney announced Moviebeam, I wrote Three Developments in the Movie Rental Business. 

Similar analysis was applied to the online brokerage stocks in Winners and Losers in the E-Finance War and Three Developments in the Online Brokerage Market.

This article discusses stocks that I am long (ET) and short (NASDAQ:EXTR).  Please see the Important Disclosures.

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