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Introduction
Few companies elicit reactions from investors as quickly and passionately as Netflix (NASDAQ:NFLX). The company has had a huge impact on consumers and how they entertain themselves, and has transformed the industry more than once. Netflix has made a lot of people rich, and recently made a lot of people less rich. On another level, everyone has their opinion of Netflix content. Many have a poor opinion of the quality of the company’s offerings (It’s 90% crap, they say! Perversion and immorality, they say!), while at the same time it breaks records and is watched by more people than any other streaming company by far.
The Thousand-Foot View
All these things and more make it difficult to look at the company objectively. This article will take what is called “The Thousand-Foot View,” meaning we will step back from the blizzard of commentary about the current state of business and take a broader, longer perspective. Every company is a product of its history, its leaders, and its culture. These are the things that created a company’s past and what will create its future. Companies survive and thrive by facing and meeting challenges and opportunities. The nature of the challenges is almost irrelevant when a company has the ability to respond effectively. Can the present challenges Netflix faces lead to a permanent diminishment of the company? The thousand-foot view says Yes. Is that the inevitable, or even the most likely, future? The thousand-foot view says No. Netflix has faced serious challenges before, some that could be called existential, and emerged stronger. As this article will show, there’s no reason to believe that this time is different.
The History
There have been at least three times when Netflix’s future has been seriously questioned, much like what we are seeing today. The first was around the founding of the company in 1997. Founder Reed Hastings has said that at the time he had no idea if the public would respond positively to the idea of DVDs by mail. In retrospect the idea looks like a “no-brainer,” but at the time it was anything but that. The home video industry had many moving parts. Blockbuster, owned by Viacom, had over 8,000 stores. Cable systems were upgrading to on demand video and growing, and studios were trying to lock up DVD distribution deals with established companies. But Netflix was a success, to the extent that Hastings turned down an offer from Blockbuster in 2004 to buy the company for $50 million.
The second time was when Netflix announced it would begin offering a streaming service. Investors were alarmed that the company was pushing aside the very successful DVD by mail business to bet on a new, unproven concept. Various reasons were given why this change would fail, from the destruction of the mail business to the refusal of subscribers to accept a new pricing model. As we know, in retrospect, it was a fantastically smart decision by Hastings and company.
Another major crisis arose around 2012 when major content production companies like Disney (DIS) and Comcast (CMCSA) started signalling they were going to stop making their content libraries available to Netflix, in the interest of starting their own services. A large portion of Netflix’s offerings, including huge draws like Friends and The Office, were going to be gone, never to return. The content cornucopia that had fueled the company’s success would dry up and go directly to the competition. This situation was bad enough, but to many observers the Netflix solution made it worse. The Netflix response was to replace the lost titles by producing their own content. Various reasons were given for why this would fail, from Netflix’s inexperience with movie and TV production to the costs being too high. In fact, while the costs have been at a previously unimaginable level they have proved manageable to date. As for their inexperience, the very first year of original content included the hugely popular and critically acclaimed House of Cards and Orange Is the New Black. Netflix is now a regular contender for the annual Academy Awards.
While the strategic decisions above now seem obvious, at the time they were anything but. Choruses of doubters arose during these and numerous other times of change over the years. The fact that Netflix has been almost always strategically on target illustrates the key to their future: their leadership.
Leadership is the key
Every serious student of corporate America understands that leadership is the most important factor in a company’s long-term success. Every business is the same; it’s a series of opportunities and challenges. Success lies not in what the opportunities and challenges are, but more in the ability of leaders to create, recognize, and turn them to the company’s advantage. Much investor attention focuses on the here and now. The latest quarterly results or economic numbers sometimes have import, but durable success has little to do with what happens in a quarter or two. It depends instead on things like vision, discipline, inspiration, and thinking differently.
There are many well-known transformative leaders, like Steve Jobs, Larry Ellison, Howard Schultz, Elon Musk, Thomas J. Watson, Jeff Bezos, and David Packard. Each of these men had a vision that faced serious, sometimes existential, threats, but was able to create a successful company that changed America. Reed Hastings and Ted Sarandos, the leaders of Netflix, are in this select group. They are the reason for Netflix’s past success and why Netflix will move beyond its current difficulties into a bright future.
Reed Hastings
Some background information on the company’s leadership is a good place to start studying the company’s success. (Many of the facts here come from Wikipedia articles on Hastings, Randolph, and Sarandos). Reed Hastings, Co-Founder and current Co-Chief Executive Officer, is an engineer by training with degrees in math and computer science. When Netflix was founded in 1997 the concept of DVDs by mail was so novel that co-founder Mark Randolph felt in necessary to put a CD in a greeting card when Randolph left in 2002 Hastings had a thriving company based on several important innovations: subscriptions with no due dates and unlimited access, a queue to allow users to specify the order of DVDs to be sent, an automatic delivery system and most importantly, a system for exploiting the massive amount of data collected on user behavior.
Hastings was also the force behind Netflix’s admired corporate culture, called “Freedom and Responsibility, which, among other things, nourishes open communication between all levels of employees. This culture has been studied for many years, and was the subject of New York Times bestseller No Rule Rules: Netflix and the Culture of Reinvention, by Hastings and Erin Meyer.
Ted Sarandos
Ted Sarandos joined Netflix in 2000 and is currently Netflix’s Co-Chief Executive Officer (along with Hastings) and Chief Content Officer. Among many achievements, he has had a major role in the way Netflix does business today: the international reach, the industry-leading breadth, depth, and diversity of content that caters to a broad base of viewers, prioritizing the needs and wants of consumers, and even binge viewing. He initiated the original programming strategy, which has permanently changed the relationship between industry producers and providers. He originated the concepts of ordering multiple seasons without pilots and locking prominent producers into long-term exclusive contracts.
The Hastings/Sarandos story is one of constant innovation reinvention, and superior execution. In terms of business success in the 21st century, Netflix is clearly at the very highest level. The sustained success over more than two decades is hardly luck or just hard work. It can only come from leadership with vision and skill.
The Current Challenge for Netflix
Netflix’s current predicament boils down to one thing: They can no longer count on regularly growing numbers of subscribers to increase revenue, income, and fund production budgets. The causes are increased competition for streaming dollars and production talent that is only going to continue growing. Netflix knew they were going to get to this point, but strategically chose not to actively address it before now.
The answer boils down to one thing as well: the company has to establish new ways of generating revenue. Strategies are actively being developed. The most well-known are reducing free password sharing and initiating an ad-supported tier. They are also considering gaming, ecommerce, and more. One example is their new contract with super-producer Shanda Rhimes of Bridgerton fame, which includes film, games, VR, branding and merchandising, live events and experiences. Our purpose here is not to debate the merits of these initiatives. They have already generated mountains of opinion and commentary. The thousand-foot observation is that for an industry-changing company with strong, visionary leadership like Netflix, facing and navigating challenges and opportunities is part of the normal course of business. The exact way in which Netflix meets the current challenges is yet to be seen, but their history points to success. The respected SA author David Allan Clark, in relation to a different company, wrote:
Pervasive cynicism about a stock can drive the price so low that it exaggerates the investment’s perils and belittles its future prospects.
This is where we are with Netflix. The recent debate about password sharing is a good example. Let’s say Kenny is sharing his password with his sister Coco. There are five possible outcomes:
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Kenny keeps his plan, Coco gets a cheaper ad-tier account. Revenue positive.
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Kenny keeps his plan, Coco or he pays a password sharing fee. Revenue positive.
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Kenny keeps his plan, Coco signs up for a full plan. Revenue positive.
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Kenny keeps his plan, Coco loses access. Revenue neutral.
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Kenny drops his plan. Coco loses access. Revenue negative.
Only one outcome, possibly the least likely, is revenue negative, yet many commentators are not commit to the idea that fixing password sharing will make a meaningful difference.
Risks
An evaluation of Netflix, positive or negative, must acknowledge the very real present challenges. Competitive changes in the streaming environment may be enough to permanently impair Netflix’s position. Strategies Netflix uses to address industry changes could be ineffective or send them in the wrong direction. The strategies could take longer than anticipated. Or, as has been suggested, the huge sums Netflix has committed to original programming may turn out to be bad investments. All of these things will take time, possibly years, to play out. Investors are cautioned about reading too much into the next several quarters of financial reports, before changes by Netflix will take effect.
Implications for Investors
In the longer term, perhaps over the next 9-12 months, Netflix is a Buy at anticipated lower prices. What those prices will be is impossible to say, because conditions in the company, industry, and economy are always changing. Any positive signs of progress could start moving the stock up again, but there will be time to buy in. I look forward to writing again, on perhaps a nine-month time frame, when company, industry and economic circumstances have created more positive conditions for the business. Netflix is a great example of how stocks overshoot to the upside in good times and to the downside in poor conditions. The next 12 months should provide the best buying opportunity in at least five years.
The thousand-foot view must rate Netflix as a Hold based on what the stock is likely to do in the near future. The headwinds are real and will impact results over the next year. Sentiment is poor, and investors are likely to look for anything negative in coming quarterly reports as a reason to sell. The stock stair-stepped down about 20% and 33% after the last two quarterly reports, and a similar result could follow the Q2 2022 report due in a few days (this article was submitted for publication on July 16). The company itself has acknowledged that its initiatives will take at least a year to have a meaningful effect. A recession will put even more downward pressure on the stock. My only hesitation about giving a short term Sell recommendation is that sentiment can change very quickly, as shown in the July 15 8.2% gain after the Microsoft ad partnership was announced.
The thousand-foot view sees an established company that has successfully addressed every challenge in its 25 year history, and taken full advantage of the opportunities it has been presented with. It has veteran, tested leadership that is creative, innovative, and adaptable. Netflix will emerge from the current stresses and challenges as a strong company, and continue to lead the industry.
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