What Do You Get When You Buy Netflix?

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Includes: AMZN, NFLX
by: Rob Fagen

Whether Netflix (NASDAQ:NFLX) is insanely overvalued or just beginning to climb a very steep cliff of share price appreciation is a very hot topic of late. Since the earnings call late in January, there have been untold numbers of bulls and bears trotting out their pet theories. There have even been some insightful analyses, like the one that Komodo did based on 'owner earnings'.

I don't have a deep quantitative argument here, but I can tell you exactly what I think I'm holding as a grossly overweighted segment of my retirement (maybe even early-retirement) fund. I was on the inside for seven years -- from 1 million members to 15 million. I saw a very large number of things being done right, and I saw a great many decisions being made. Here's the value bullets, in rough order of importance:

  1. Excellent Hiring Practices
  2. Management
  3. Relationships
  4. Expanding Markets

Let's take them one by one.

Excellent Hiring Practices

One of the most valuable things I took away from my tenure at Netflix was the opportunity to develop my ability to recognize and hire first class engineering talent. The same exact standards are upheld for every other area of the company from content acquisition to accounting to marketing. Take a look at the "Freedom & Responsibility Culture" deck for the details. In summary, Netflix only hires the best of the best, Netflix only hires people that know how to move the business forward and are focused like a laser on doing it, and Netflix aggressively (some might even say brutally) trims the ranks of those hires that aren't meeting the high standards of the rest of the team. Netflix provides a pretty soft cushion to help those ejected, Also, to answer the question before it's asked, I left Netflix to seek a startup opportunity, I wasn't asked to leave.

Because everyone is a rock star without an ego (well, mostly without egos...), an amazing amount of incredibly complex work gets done in a remarkably small amount of time with great agility and responsiveness to changing market conditions. Because everyone who is hiring is always hiring to raise the bar and bring in new and better talent (better even than themselves), the ability of the organization to handle greater and greater challenges is growing just as fast or faster than the complexity of those challenges.

Management

This leads into value point number two: management. The entire management team is incredibly cohesive and concerned with organizational alignment. However, the management team is smart enough to allow the teams themselves to be loosely coupled and trust the senior managers for each team to maintain tight alignment. Loose coupling with all teams pushing hard for the same goal allows for a breathtaking pace of change, but it's coordinated change. There are inevitably some missteps, but those missteps are recognized and corrected quickly because nobody buries a problem out of fear of embarrassment or other loss of face or prestige. The only prestige gained is through the whole company delivering on its promise to its stakeholders. For the customers, an exceptionally convenient and fabulous movie choosing and watching experience at an incredibly low price. For the studios, new incremental revenues for content. For shareholders, consistent earnings growth.

From Reed on down, every manager is focused on those goals, and makes decisions within that context. You can't have any one of them without satisfying all three of them. I've both heard stories about and directly witnessed the making of difficult decisions that could have gone disastrously if not for the relentless use of those three lenses.

I have an incredible amount of trust in the management team that they are anticipating a large number of threats that haven't even occurred to anyone with a short thesis. I also have trust that every significant threat raised so far in public has been thought about and there is a plan for dealing with it.

Relationships

Netflix has many relationships with external entities that are enormous off-balance sheet assets. These include relationships with the studios, with the content delivery networks, with Amazon for their cloud services, and most importantly, with every one of their 20,010,000 customers.

From an engineering perspective, the most constrained computing resource in any datacenter is between the ears. You can always rack and stack more servers (or request more instances from EC2), but there is a strictly limited amount of attention that can be paid to things that need to be done by a person. The same constraint applies in every other part of an organization. More importantly, the same constraint applies between organizations. When you have a studio that owns content, there is only so much time in the day for negotiating contracts and for distributing that content. When you have someone like Netflix that can come in and promise to write a big check, you are certain to get someone's attention.

Granted, someone like an Apple or Amazon (NASDAQ:AMZN) can come in and write checks just as big or bigger, but Netflix is the incumbent and the expert at negotiating terms compatible with all-you-can-eat pricing. Every other new entrant to the field will need to pay those same prices or greater, and those new entrants won't have the customer base that can make those prices economically as attractive. Amazon may come close with the 17 million Prime customers, but Prime revenue also has to pay for the other services of Prime. Amazon may dent Netflix's market share, but they won't be making any money doing it. Just as there used to be a saying in IT that "nobody ever got fired for buying IBM", I can see a day where studio execs might say "nobody ever got fired for licensing to Netflix".

A similar tale can be told for the relationship with CDNs. Netflix was the first mover, and now has a huge advantage in negotiations for these services. Before streaming was even launched, it was very difficult to get any kind of an economically viable deal for content delivery. The networking and sysadmin teams went out and built and deployed a Netflix CDN. It didn't have tens of thousands of endpoints, just a limited number of very strategic peering points. However, once Netflix could tell the CDNs "we've done it ourselves, never mind", they were able to negotiate much better pricing. Now, Netflix can play all the majors off against each other and continue to extract value from this part of the chain.

In working with Amazon, Netflix has pushed the envelope of scalability and availability of all of the Amazon Web Services. I'm not sure exactly who has learned more from the exchange, Netflix or Amazon. It looks to have been a mutually beneficial relationship, however. Netflix gets to spend their time and attention on building a fantastic service, and Amazon gets to learn what the real use cases and usage profiles for their IaaS product are. It's true that what Amazon is learning certainly helps them in supporting the infrastructure for their own offering, but for them, that is one offering among many, and Netflix is focused only on doing this one thing incredibly well.

That brings us to the customers. All 20 million of them, with billions of ratings and watched movies and clicks on the website. All of these things are stored, tracked, analyzed and thought about with the intention of making the service even more personal, more compelling, more sticky and more invaluable to each and every one of those customers. With all those customers being skillfully guided to catalog releases that are just as satisfying as newer releases that the studios are currently pushing, that's a lot of demand generation for the studios that they'd never otherwise see. It's also a lot of customer satisfaction being generated. Netflix's churn is somewhat deceptive, since they very conservatively include folks that only leave temporarily as part of the churn number. A great deal of those that leave eventually come back.

Expanding Markets

Finally we come to the question of just what you're buying. You're buying a company that is still in the vertical part of their s-curve growth. You're buying a company that knows how to stay in that part of the curve. You're buying a company that has learned how to sell America the idea of movies they can enjoy a lot that they may have never heard of before Netflix put it in front of them.

Take all of the growth that we've seen in the 100 million homes in the US, and expand that out to every other country in the world. Similarly, in the last conference call, Reed discussed how the future is more individual accounts on more and more mobile and personal devices. Maybe the addressable market in the US isn't the 100 million households, but the 330 million people in the country.

Conclusion

That is what you're getting when you buy Netflix. I don't know if it goes up or down from here for any particular time frame, but I believe in this company's ability to execute. More importantly, I believe in this company's management's ability to pick the right things to execute on and the right direction to push toward.

Disclosure: I am long NFLX.

Additional disclosure: I have some covered calls. I recently divested about 10% of my (former) employee stock options.

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