Whitney Tilson: Why We Covered Our Netflix Short

| About: Netflix, Inc. (NFLX)
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By Whitney Tilson and Glenn Tongue, Managing Partners, T2 Partners LLC

When the facts change, I change my mind - what do you do, sir?

-- John Maynard Keynes

In mid-December, we published a lengthy article on why Netflix was our largest bearish bet at the time. With the stock up nearly 25% since then, one might assume that we’d think it’s an even better short today, but in fact we have closed out our position because we are no longer confident that our investment thesis is correct. There are three primary reasons for this:

1) The company reported a very strong quarter that weakened key pillars of our investment thesis, especially as it relates to margins;

2) We conducted a survey, completed by more than 500 Netflix subscribers, that showed significantly higher satisfaction with and usage of Netflix’s streaming service than we anticipated (the results of our survey are posted here); and

3) Our article generated a great deal of feedback, including an open letter from Netflix’s CEO, Reed Hastings, some of which caused us to question a number of our assumptions.

In summary, while we acknowledged in our December article that Netflix “offers a useful, attractively-priced service to customers, is growing like wildfire, is very well managed, and has a strong balance sheet,” we now believe that it is an even better business than we gave it credit for. The company has enormous momentum and substantial optionality (for example, international growth), and management is executing superbly. In particular, we tip our hat to Reed Hastings, whom we had the pleasure of meeting last weekend. In addition to his success building the business and navigating the transition from DVD-by-mail to streaming media, he’s also one of the most down-to-earth, honest and straightforward CEOs we’ve ever encountered.

To be clear, in covering our short and writing favorable things about Netflix in this article, we are not recommending purchase of the stock. Many things will have to go very right for the company to justify its current market valuation, but we no longer think it’s wise to bet against Netflix.

This is particularly true in light of our belief that this market is filled with much better short opportunities that are in our sweet spot: outright frauds (our very favorite), industries in decline or facing major headwinds, weak or faddish business models, bad balance sheets, and incompetent, excessively promotional and/or crooked management. It’s so much more rewarding, both psychically and financially, to short these types of businesses.

Our Short Thesis
Our short thesis was predicated on the following stream of logic:

1) Netflix’s future depends on its streaming video business (rather than its traditional DVD-by-mail business);

2) The company’s streaming library is weak, which would lead to customer dissatisfaction and declining usage;

3) This would either cause subscriber growth to wither or force Netflix to pay large amounts to license more content, which would compress margins and profits;

4) Either of these two outcomes would crush the share price.

We are no longer convinced that #2 and #3 are true.

Customer Satisfaction With Netflix’s Streaming Service
To measure the quality of Netflix’s streaming movie library, we looked at the top 50 grossing movies of all time, Internet Movie Database’s 20 top-ranked movies of all time, Rotten Tomatoes’ 20 top-ranked movies of all time, and the 10 top-selling, top-renting and top-video-on-demand DVDs for the week ending 11/28/10. In our December article, we shared our findings: “of these 120 movies (including duplicates), Netflix has a mere 17 (14.2%, and 0% of the current most popular movies) vs. 77 for iTunes (64.2%), 63 for Vudu, 62 for Amazon, and 41 for cable.” A similar analysis for TV Guide’s list of the 100 most popular TV shows showed that Netflix streamed fewer than 25% of them.

Thus, we concluded that Netflix’s streaming library is weak and customers would be dissatisfied and reduce their usage of the streaming service – but our survey of more than 500 current Netflix customers revealed increasing usage over time and reasonably high satisfaction:

  • In response to question #8, Compared to the first month that you started using Netflix’s streaming service, has your usage changed?, 36% of respondents said they were streaming more than twice as much, 25% said somewhat more, 23% said it’s about the same, 12% said somewhat less and only 4% said less than half as much. In other words, 61% said they were using the service more and only 16% said less. (For details, see appendix A; all of these percentages exclude respondents who said “I’m new to the service or don’t stream.”)

  • In response to question #9, Overall, how satisfied are you with Netflix’s streaming service?, 40% said highly satisfied, 40% said moderately satisfied, and only 11% were dissatisfied. While these are lower satisfaction levels than Netflix’s DVD rental service (our survey showed 65% highly satisfied and 24% moderately satisfied), Netflix’s customers are much more satisfied with the streaming service and are using it much more than we expected.

The most commonly cited explanation by the Netflix customers in our survey for their increasing usage and overall satisfaction is that they appreciate the easy-to-use, widely available service and perceive good value. For a low monthly price – typically $7.99 or $9.99, less than the cost of a single movie ticket and a tiny fraction of their cable bill – they can have unlimited access to nearly 20,000 movies and TV shows. While many respondents complained about the weak streaming content, most seemed to understand that at such a low price point, they’re not going to get the latest, hottest movies like Avatar.

Here are some representative comments from our survey:

  • Needs more & better content, but everyone knows that!

  • I believe we get what we pay for.

  • Not enough selection and not enough updates. Still great convenience & video quality.

  • I can watch what I want, when I want, for a price I can afford.

  • Great value, simple, problem free, no advertising.

  • Easy to use, good selection, and getting better all the time. It’s the best deal out there, even with the recent price increase.

  • Streaming itself is great. The library of streamable choices is lacking, especially for movies. Once you get hooked on a TV show Netflix carries, though, the streaming is awesome!

  • I’m not married to Netflix. I would easily switch to a carrier with the fastest and widest selection of titles. The flip side is I haven’t tried other services because Netflix is easy. I’m not a tech expert and don’t even know what Hulu does.

  • Good product at good price. Online quality is much better than I expected. Lots of kids content to stream (don’t need the latest). Netflix finds TV shows that I may like but did not know existed and/or would not rent as DVDs. Have gotten rid of the expensive cable bill as a result.

Margin Compression
In our December article, we pointed out that Netflix was paying increasing amounts for streaming content, which pressured margins in Q3 10 – and we predicted that this trend would continue. We wrote:

Our belief that the increased costs of streaming content will negatively impact Netflix’s margins isn’t just a theory. Last quarter, strong evidence emerged to support our view: in Q3, Netflix’s operating margin was 12.6% and net margin was 6.9%, down from 14.9% and 8.4%, respectively, in Q2. That’s a huge decline in only three months.

The result was a 12.5% sequential decline in earnings from $0.80 in Q2 to $0.70 in Q3.

When Netflix reported Q4 earnings on January 26th, we were exactly right about the impact of higher streaming costs on gross margin, which fell to 34.4%, down from 38.0% year over year, and 37.7% sequentially. Yet the margins that count, operating and net, rose to 13.1% and 7.9%, respectively, up from 12.6% and 6.9% in Q3 10. How did this happen? To our surprise, marketing expense fell to 10.5% of revenues, down dramatically from 15.9% year over year and 14.7% sequentially.

Of course, any company can goose its margins and profits in the short term by slashing marketing spending, but this usually triggers a fall-off in sales and customers. Yet this didn’t happen to Netflix: in Q4, the number of paid subscribers jumped by 2.4 million to 18.3 million, up 53.5% year over year and 15.2% sequentially, both the highest levels going back more than four years. Subscriber growth isn’t merely high, but it’s accelerating. Such a large gain in subscribers fueled at 34.1% year over year jump in revenues, the highest percentage gain since Q1 07.

This surge in subscribers and revenues is creating a virtuous cycle for Netflix, both in terms of word-of-mouth buzz (which is, of course, the best – and cheapest – form of marketing) and financially. Allow us to explain the latter. In our December article, we wrote the following:

Netflix’s Dilemma
Why is Netflix’s streaming content so weak? The primary reason is that, unlike its competitors, Netflix isn’t willing to pay what content providers demand for the best movies and TV shows. For example, Netflix’s competitors typically charge $4.99 to stream a popular movie, of which $3 goes to the content provider, and the economics are similar for the $1 TV shows.

But this model doesn’t work for Netflix because it’s only charging $7.99 per month for unlimited streaming. 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.

Netflix’s Q4 earnings report underscored for us that there is a fourth possibility – one which is very pleasant for the company: high subscriber growth leads to higher revenues and profits, which allows Netflix to license more/better streaming content (without sacrificing margins), which leads to even more subscribers.

To see how this might work, let’s consider the scenario in which Netflix continues to grow its net paid subscribers by 2.4 million for each of the next four quarters (9.6 million incremental). Last quarter, the average paying customer generated $11.64/month in revenue (based on $596 million in revenue divided by 17.1 million average paid subscribers). Let’s assume that the new customers are mostly signing up for streaming (at $7.99/month), so that the average revenue is $10/month: that’s an incremental $1.15 billion in annual revenues for Netflix.

It’s harder to estimate the incremental profitability these 9.6 million subscribers would generate, but we’d guess that it’s a high number, given that each additional streaming user costs Netflix very little since its streaming licensing agreements are for fixed amounts. Thus, robust subscriber growth would allow Netflix to spend many hundreds of millions of additional dollars each year on streaming content– more than enough to renew the Starz deal and license much more content as well – without impacting its profit margin.

Of course, this rosy scenario depends on Netflix being able to continue to attract huge numbers of new subscribers, which is far from assured given the possibility of saturation and the many current and potential competitors that we highlighted in our December article (since then, Comcast has launched a competing service for its customers, and Amazon appears likely to as well). That said, Netflix has a big head start so we don’t want to bet against its subscriber growth.

At today’s closing price of $222.29, Netflix is trading at 75.0x trailing EPS of $2.96. In more than 12 years of managing money professionally, we can’t recall an instance in which we paid more than 20x our estimate of normalized, current year earnings for any stock – and this has worked very well for us – so we won’t be buying Netflix anytime soon. But just because we don’t think it’s a good long doesn’t make it a good short.

To download a PDF version of this article (with appendix), click here.