After Apple’s story of revolutionizing mobile computing, I want to discuss Netflix’s story of disrupting linear TV. Netflix’s story is full of twists and turns and probably one of the most valuable learning experiences for contrarian investing. Netflix’s stock pushed me to the limits of my conviction as no other stock. Therefore the story has many valuable lessons.
But to begin on a lighter note, as in the last article, I will start with a short story.
In January 2011, while snowboarding in Mammoth, I tried an ill-advised jump and badly hurt my knee. While my friends were on the mountain, I was sitting in the cabin semi-depressed about having to miss the rest of the snowboarding season. So I downloaded the recently release, very first Netflix app for the iPhone.
I started watching a TV show on my phone. I don’t remember which show, but it was probably “Friends”. I continued watching for several hours. All of a sudden it dawned on me that this could be the future of TV.
At that time Netflix was still broadly know as a DVD-by-mail company. The mobile initiative was three months old and there was no original content at all. I had been following Netflix’s stock for couple of months but sporadically.
I became consumed by the mobile app and started to play with it to understand the complete watching experience. Later some of my friends on that trip were asking, why I was being so anti-social.
When I returned from that trip I decided to initiate a small position in Netflix to start understanding the company better. This is how I usually start a new position, because it helps me follow the company with minimal risk. The key is to understand what story is Wall Street looking at, when evaluating the company. Wall Street was highly divided on Netflix. Some saw the disruptive potential of the company and others looked at a flawed business model. The monthly subscribers and content costs were the two key metrics Wall Street was paying attention to. After few weeks of analyzing the company, I gained some confidence in Netflix and increased my position.
A month later, in February 2011, I decided to do a stock pitch for one of my MBA classes. The premise of the pitch was that although Netflix was still a DVD-by-mail company, the Internet was going to disrupt TV and there was no way around it. Netflix was the leader and only important player in this TV-over-Internet space. With the introduction of Internet-TVs, smartphones and tablets (iPad 2 had just been released), the viewing would spread to several screens. Below is a slide from that 2011 stock pitch.
Several of my MBA classmates were not impressed. One friend even approached me after the pitch to tell me that she had just done a report on Netflix for another class. The conclusion was that Netflix’s business model is flawed. The flaw that many sited was about Netflix’s reliance on content from the traditional studios. If Netflix’s profits went up, the studios would just charge more money for their content. Netflix had no leverage, therefore there would never be much excess profit left for Netflix.
This was not a new insight. Many investors, including the short-seller Whitney Tilson, had short positions based on this thesis.
What I learned from investing in disruption is that sometimes business models could seem flawed early on from an old perspective, as the dynamics of the new market structure have not played out yet.
Netflix’s stock kept rising and by July 2011 it was up about 70% YTD. The subscriber numbers kept surprising to the upside. There was a lot of euphoria and I was happy with my position.
But then over a period of two months Netflix was hit with the perfect storm.
First Netflix decided not to continue its content agreement with Starz. Considering viewing data on that content, CEO Reed Hastings did not think it was worth the asking price.
Then to align itself with the digital future, Netflix decided to split the DVD and Web services. Netflix decided to price the services at $8 each, which media channels started to hype as a 60% price hike compared to some previous $10 bundle.
Consumers were outraged and people decided to cancel their services. On the next earnings call Netflix had a disappointing subscriber number.
On top of that Netflix had decided to expand into Latin America. Wall Street panicked thinking that, with the declining subscribers and additional international expansion cost, the company would run out of money.
Between July and December 2011 the stock dropped precipitously from $220 to about $70 per share. During this continues drop I panicked, since I had never experienced anything like it before and sold some of my position.
But deep inside I still believed in the Netflix’s story and was trying to find the hidden upside.
- Even if consumers were outraged about the higher price, there was no comparable service on the market at a lower price. So over time they would return to Netflix if they wanted to watch movies.
- Wall Street viewed Netflix’s not extending with Starz as a sign of weakness and lacking funds, but one could also look at it as a sign of strength. Walking away from a negotiation by not agreeing to pay a higher price can also signal that one is not desperate for that content.
- Reed Hastings insisted on the value of going global, because he considered it an important, long-term value for Netflix’s brand. I could see his point in it.
- I believed that another reason Netflix was going global was to diversify its content supply base, so it can have a better negation position with individual content suppliers.
- And lastly in March 2011, Netflix had briefly announced plans for original content. This announcement mostly went under the radar. The significance of this move had not really dawned on me or anyone else on Wall Street. This was the twist in the business model that many had misunderstood, because it had not played out yet.
To analyze the market behavior in retrospect, here are some typical market confusions that played out in this case: (from the confusions list in the introductory article on contrarian investing)
- The market is misunderstanding the economic dynamics in a marketplace (long-term pricing power with consumers)
- The market is thinking too short-term (neglecting brand value of global expansion)
- The market is misunderstanding an important, larger dynamic involving a company (original content and negotiation power shift)
- The market is overreacting to a perfect storm (many negative news at the same time)
So there were many reasons for upside and I continued to closely follow and analyze the company. I even emailed a friend, who was leading a similar Video over IP company called Viki. I wanted to better understand some of the content negotiation dynamics in the industry. I would be lying if I said that I was comfortable in my Netflix position, since no one seemed to share it. I had been burned so badly by the huge stock price drop. All this was occurring when I was on my MBA exchange in Sydney and it was stressing me out to say the least.
To appease the consumers, Netflix decided not to split the company and move slower in this transition to Internet TV. Reed Hastings realized that it was alienating the subscribers. Over the next 12 months Netflix stock muddled along near its recent lows. I continued analyzing the stock, the company and Reed Hastings. I read a book called “Netflixed” by Gina Keating. The book increased my confidence in the CEO’s judgment. But I still felt pretty alone in my conviction and was severely tested. I was even considering giving up on Netflix.
Then at the end of 2012 Carl Icahn took a large position in Netflix. I remember discussing this move with my roommate. For me it was a glimpse of hope, but he viewed Icahn’s move as a corporate raid. This did not make sense, since there was little capital or other assets in Netflix to be raided, so we had a long discussion. Funny enough my roommate ended up working for Netflix about a year after that.
At this point I was too scared to take a larger position in Netflix. I maintained a small position and would usually play with options through my levered portfolio, especially around earnings releases. But the stock had not moved much for over a year.
Then came time for the January 2013 earnings report. Prior to this earnings report I decided to buy “way out of the money” call options on Netflix. I got lucky! The earnings came out and it was a huge hit. The subscriber number was a big beat and there were signs of international traction. The stock price soared over 30% in 2 days and the gain on the options made up for all the losses I had suffered in the 2011 decline.
I felt some hope again. Netflix also started discussing its original content strategy. House of Cards was getting ready to be released.
House of Cards was released in February 2013. It was very popular and received positive reviews. I maintained my small position in Netflix and decided to buy options prior to the April earnings report as well. The April earnings were also a big hit, as people had started flocking to Netflix because of House of Card.
At this point it became clear that the business model flaw was not actually there. If the content suppliers wanted to charge more for their content (significantly above cost) than Netflix could just make that content itself.
In addition, Netflix had detailed viewing data because of superior technology. Therefore Netflix could make better and wiser content investments than the traditional studios.
So at this point I increased my position again. Over the following year Netflix continued to surprise to the upside as its original content continued to be very popular. In addition since the studios realized that they had lost their leverage over Netflix, many studios including Disney decided to create close collaborative agreements.
This is usually a “tipping point of disruption”. It is when the opponents of disruption have no choice but to partner up with it or be left behind.
Then in late 2013 Netflix had another great earnings report and the stock climbed significantly in after-hours trading. But on the next day Carl Icahn decided to sell most of his position, after having made billions on his big bet in late 2012. So the stock gave up its gains after that outsized selling pressure.
Few days after that a friend called me and asked for some stock tips. I usually avoid giving tips. But after some discussion I suggested that maybe he should buy Netflix. I said that it had great long-term potential and the current price did not reflect the most recent earnings report, because a large investor had liquidated his position. He took my suggestion. Netflix stock continued to go up and I continued to add to my position. In 2015 Netflix was the best performing S&P500 stock with a yearly return of 135%.
Today Netflix is a household name in global entertainment and paved the way for other tech companies like Amazon and Google to get into content creation. It has even created a slang-term with “Netflix and Chill”.
In 2011 Netflix was a daring innovator and therefore misunderstood by Wall Street. Everyone around me seemed to think that Netflix was doomed. No stock has caused me more headache in its days of uncertainty. But it also was a great learning experience for contrarian investing, because it taught me how drastically and completely Wall Street can be wrong when it comes to disruption. It has given me a precedent to have the courage to bet against Wall Street even if very few others held my position. This occurred for example after Facebook’s IPO.
The point of this article is to illustrate that even if everyone on Wall Street and outside of Wall Street is convinced about something, they can all be wrong about a “big elephant in the room”. Sometimes if one has specific reasons to disagree with the market thesis, it could take more than a year of patience for the truth to come out. So the key to contrarian investing is to develop independent conviction and patience.
In the next article I will discuss Facebook’s story and how it defied all the doubters and disrupted the media industry.
Since I am a dyslexic, I am prone to spelling and grammar mistakes. Hopefully it does not distract from the substance of the article.
Thank you for reading this article :)