Tom Gardner on What's Next for Netflix

The following post was originally published Monday night for premium members of The Motley Fool's flagship newsletter, Stock Advisor.

Dear Fools,

I'd like to share some of my greatest areas of enthusiasm and my biggest fears about Netflix (Nasdaq: NFLX  ) today. It wouldn't be right to start anywhere but with the fears, given the performance of the past few months and the market's reaction to this evening's earnings release.

The fears
At the top of my list are Amazon (Nasdaq: AMZN  ) and Apple (Nasdaq: AAPL  ) . Amazon has around $6 billion in cash on its balance sheet. Apple -- let's call it around $25 billion in short-term cash. When content providers look for who will pay more and who can take a longer-term view, they'll see Apple and Amazon extremely far ahead of Netflix. 

My fears about Amazon are that, with its Prime membership, it's relatively effectively replicated what Netflix is offering. True, Netflix has a deeper portfolio of content. True, Netflix is embedded in many more devices. But how sustainable are those competitive advantages? How long will it be before Amazon is on a huge number of devices, with an equally deep library of content -- all of which is also accessible via the Kindle Fire? Finally, remember that Netflix is essentially hosted in Amazon's cloud services, AWS.

It certainly looks like Amazon is busily replicating what Netflix has built out, alongside its offering of individual movies to buy or rent. And it's all bundled into a price that includes other core benefits (expedited shipping). With its balance sheet strength, Amazon could continue to strengthen its Prime offering so movie rentals into the home look essentially free.

My fears about Apple aren't anywhere near as immediate. Apple is engaged in larger device battles. But when it brings its pocketbook into content bidding in its attempts to own home network and entertainment offerings, the company just puts more and more upward pressure on content pricing. That will hurt Netflix in the long term. 

So you've got two big dudes in the mix. They've got much more money and highly diverse businesses -- that allow them to run low-margin, maybe even unprofitable, competitive offerings to Netflix -- and I'd throw in that with all the economic turmoil, I don't think the government will have the appetite to look for anti-competitive practices very aggressively these days. On the face of things, Netflix is in real trouble. So ...

Areas of enthusiasm
(1) Until recently, Netflix had a beloved brand. What the casual follower of this doesn't see is that Netflix is responding to what's happening. The company can see that if it doesn't establish a deeper connection with the largest imaginable audience for streaming videos, it will get the shortest short end of the stick. Management decided to go all-in on the strategic shift. They obviously felt that getting the right strategy was more important than formulating the best communication plan and taking the time necessary to evolve the customer base. In a way, I can't blame them. Bring up the balance sheets of Apple and Amazon and look at where their businesses are pointing. Reed Hastings and team felt it was the time to act -- now. It wasn't an irrational choice. It was, however, definitely the wrong choice.

Netflix should have -- and still should -- try to migrate members to their streaming services. To do that, it needs deep attachments with subscribers AND a shiny beloved brand. So why am I listing this as an area of enthusiasm? For two reasons:

  • Netflix is not asleep at the wheel strategically. This is good news. Most companies whose core business is being disrupted shield their eyes from the truth, focus on their exit compensation, and make half-hearted attempts to adapt. Netflix isn't doing this. This is strategically a very smart company.
  • With the proper approach to the consumer, it can actually return the brand to glory. They have to seize the moments here when the news cycle is wrapped around them. Netflix is absolutely core to the mainstream news right now. In failure sits your greatest opportunity. Rather than make explanations, rather than risk sounding like an excuse maker, Reed Hastings should be out in the mainstream media over the next month talking up some simple sweetheart offers that Netflix is making to the world.

Examples might include: deals to show certain high-quality smaller films for free at Netflix.com, announcements of new content partnerships to the extreme (not every deal has to be a large content provider -- Netflix needs to create momentum by announcing many small deals, each of which will be a PR event in today's climate), and deals with film schools to showcase their best work (Netflix needs to get on the side of filmmakers around the world).

What seem like small-potato offerings can build momentum around Netflix's brand -- and head into the holiday season with a new story forming. "Netflix gives thanks to its customers and to the world with the following gifts..."

(2) Netflix is making inroads internationally.

(3) Netflix has held onto 23 million paying members through a communications fiasco. If they can make people feel good about being Netflix members again, this core base of paying members is valuable beyond today's share price. It certainly becomes attractive to a potential buyer that feels like it has fallen behind -- e.g., Microsoft.

(4) Finally, the movie studios will regret narrowing the field of their distributors. In the short term, this chaos is good news for them. Long-term, it may leave them with Amazon and Apple in very strong negotiating positions. The studios are going to have to understand that consumers want centralized areas to consume content, not having libraries separated out by studio. They will hope that Netflix has staying power someday, when fewer larger bidders begin to tighten the screws. (But it may take a while to get there, and the studio leads may not be thinking super long-term.)

Conclusion
Netflix is in a difficult spot. For it to work its way out, I believe the company has to show the world that it's utterly obsessed with its business. When I read Facebook updates by Reed Hastings that are about subjects other than "a total obsession with Netflix," that worries me. This is the time to be all-in, times five. I hope that Netflix HQ is swarming with teams focused on:

  • Continually signing new content deals of all shapes and sizes,
  • Announcing those deals as often as possible,
  • Putting one or two truly special offers on the table for consumers heading into the holiday season,
  • Enabling Netflix members to buy or rent new releases by title,
  • Creating partnerships that showcase Netflix as the home plate for creative filmmakers,
  • Demonstrating publicly, continually, that the company is completely obsessed with delivering great movies into the home.

Finally, an interesting last point. When I go to Netflix, I find it hard to quickly find the best films. Furthermore, its rating system ranks a lot of movies as having less than four stars. It's advertising a huge selection of movies that its own rating system tells me I shouldn't waste my time on. Netflix has to think about how to make the search for great films quicker and easier, and showcase a rating system that doesn't make most movies look like a waste of time (i.e., I think their ratings are coming up too harsh, and bad films should be pared back from the offerings.)

My takeaway from this all, as a long-term investor, is that I felt very right from $20 per share all the way up to $300. The journey here has been painful -- additionally painful because it's not irrational. The thing I desire most now is to see Reed Hastings and his team demonstrate how deeply committed they are to this business -- in every communication they deliver. If I don't see that, then my time horizon will shorten. If I do see it, then this storm may begin to present opportunities for the buyer with patience. I am firmly undecided, but I'm leaning away from being a committed long-term holder.

Netflix leadership needs to demonstrate -- through thought, word, and deed -- its complete obsession with this business.

-- Tom Gardner

Click here to try Motley Fool Stock Advisor free with a 30-day trial.

Tom Gardner is co-founder and CEO of The Motley Fool. He does not own shares of any companies mentioned. The Motley Fool owns shares of Microsoft and Apple. Motley Fool newsletter services have recommended buying shares of Apple, Netflix, Microsoft, and Amazon.com; creating a bull call spread position in Microsoft; and creating a bull call spread position in Apple. The Motley Fool has a disclosure policy.


Read/Post Comments (19) | Recommend This Article (61)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 26, 2011, at 2:57 PM, barrettblake wrote:

    I read this article twice.... I cannot believe anyone really believes what is written in this article.

    Microsoft: If the Windows Phone can gain traction, MSFT will be in the LONE position to take advantage of (link) personal communication devices, business devices and cloud computing in addition to home communications. This company is positioning itself to dominate. - Show some vision.

    Netflix: From $300+ DOWN to $80 dollars should be a hint that greedy executives doomed the company and GAVE market share away. The Conclusion is to hold the executives accountable...then find new executives... simple enough.

  • Report this Comment On October 26, 2011, at 4:27 PM, rrchrdsn wrote:

    "They obviously felt that getting the right strategy was more important than formulating the best communication plan and taking the time necessary to evolve the customer base. "

    You would have caused the same fiasco. Serve the customer. Then when the USPS blows up, we still love Netflix. Serve the customer and maybe reshape the internals of the company, but customers want one site, one place, problems solved for the customer not the company. Serve the customer Serve the customer Serve the customer. Anything else are silly MBAisms and GM and Netflix are now clear examples of the failure of MBAisms. Server your customer because all cash flows from them! BTW, which is the core of why MBAisms fail and why all CFO's should be fired. Trading money with banks is a loss all money flows from the customer.

  • Report this Comment On October 26, 2011, at 4:28 PM, Ronz8In wrote:

    I agree 100% about the really awful search capabilities of Netflix. Try searching e.g. "Ukraine" and "documentary" for (obviously) documentaries about Ukraine, and you get gibberish. I've called their customer service people a couple of times about this, and they give a canned "well, this is really difficult to do" response. Um, haven't they heard of Google???? The people working at Netflix are committed to great customer service, but the infra and management really don't seem to get it.

  • Report this Comment On October 26, 2011, at 4:43 PM, GrumpyOldGuy wrote:

    I haven't been paying much attention to what content NFLX will have once Starz is gone because I don't have any say in it. What I do have a say in is whether I stay or go.

    Attempting to dump dvd's before streaming was attractive /profitable enough to stand on it's own was just plain stupid.

    Hastings misread his customers and is paying for it. I would not own this stock except for a short term trade possibility and will continue to look for alternatives to NFLX for my content provider.

  • Report this Comment On October 26, 2011, at 5:40 PM, MarketingExec wrote:

    I live in Netflix' world - both professionally and personally. Their approach to customer and neighbor relations is "we know best and we are important." Their exec team believes their own excuses and allow no outside breath of professional fresh air, experience or reason to intrude. They also refrain from any support of community in which they reside other than mandatory local taxes. These behaviors form a recipe for long term failure.

    Customers do not come first with the present executive team's "strategic" plan. Perhaps the current exec team's reward will be to watch Amazon and Apple to take over Netflix' market - companies for whuich the customer is king.

  • Report this Comment On October 26, 2011, at 5:56 PM, TradeDragonfly wrote:

    Good words here in this article. Finally a non biased, objective view on the company's future. I'm glad not everyone has either fallen in love with the company or jumped ship. Netflix can survive and even thrive, but things have to change.

  • Report this Comment On October 26, 2011, at 6:16 PM, lucasmonger wrote:

    I missed out on the first run when I started watching NFLX last summer. At that time I thought $100-120 was too pricey. So after the run up to $300 and back down to $75, this seems like a good time to pile in as Tom Gardner suggests.

    I think the jury is still out on whether Amazon can truly make money from their new tablet and the potential revenue from sales it can generate.

    The other reservation I have is not knowing what Steve Jobs had in mind with the TV (some tidbits have recently leaked from the 60 minutes episode and his book) and how close they might be from releasing something. If Steve's vision reinvents yet another industry, then watch out for the iTunes/iCloud steamroller.

    Then again, who says only one provider can win in this arena. With all the cable providers, movie studios, and television networks, maybe there's enough room for all 3 (and maybe others) to all make money. Why not buy all 3 stocks: Amazon, Apple, and Netflix?

  • Report this Comment On October 26, 2011, at 7:02 PM, sikiliza wrote:

    I am not as worried about the competition as I am worried about management continually making missteps a la RIMM. The could implement all the strategies that you mentioned and still come up short . In my humble opinion, this is what they need to do:

    1.Stop forking over cash in share buybacks driven by an aggressive options compensation program.

    2. Figure out how their recent higher prices translate into real added value for the customer

    3. Slow down international until they have a proper and workable go-to-market plan

    4. Explore game rentals as another revenue channel

    5. continue to improve on their platform and user interface (example: you will not believe how often Google reviews and makes tiny little changes to that minimalist home page)

  • Report this Comment On October 26, 2011, at 7:52 PM, MFAbbott wrote:

    One other thing that Netflix might try in it's bid to improve their content might come in their move into the UK markets.

    I'd think there is a treasure of unreleased UK content that might make it onto Netflix for US viewers. Most of my favorite TV shows and movies come from the UK, but I know they have all kinds of series and programs I've never heard of.

    Maybe soon I will.

    I rent about 12 movies a month with Netflix DVDs.

    Now... if I were to go to Blockbusters or Redbox, that'd be 16 trips in the car along with 1.5 hours of wasted time and no doubt it'd cost a whole lot more. Not my idea of convenience at all. I admire those folks who have the patience and time for all that driving and parking.

    Dish network? Sorry... I'm not into the $40 a month basic charge and then wonder what extra charges they'd stick me with. Streaming from Amazon? Not interested in their clunky interface filled with awful choices. I much prefer DVDs since I like detailed movies, not grainy streamed movies.

    Hulu+? I tried it and did not like it at all.

    So all those clever folks who think Netflix is junk and easily replaced will just have to show me a better deal.

  • Report this Comment On October 26, 2011, at 8:26 PM, dandles2020 wrote:

    I was annoyed with Netflix and canceled my subscription. However, I'm probably going to restart it. It's still a great service, and even at 16 dollars instead of 12 for 1 disc and streaming, it's a bargain.

    I'm not subscribing to Amazon Prime when I already get free shipping for purchases over 25 dollars. I love renting on Itunes but they are WAY overpriced for me to do that on more than an occasional basis. Those services are a long way from having Netflix beat, if they ever do.

  • Report this Comment On October 26, 2011, at 8:50 PM, memoandstitch wrote:

    Translation: (for Amusement only)

    I messed up. I owe everyone an explanation.

    It is clear from the feedback over the past two months that many members felt we lacked understanding and due diligence in the way we announced the bullish recommendation for NFLX, and hyped up the stock. That was certainly not our intent, and I offer my sincere apology. I’ll try to explain how this happened.

    For the past five years, my greatest fear at TMF has been that we wouldn't make the leap from success in newsletters to success in social network. Most companies that are great at something – like AOL dialup or Borders bookstores – do not become great at new things people want (social network for us) because they are afraid to hurt

    their initial business. Eventually these companies realize their error of not focusing enough on the new thing, and then the company fights desperately and hopelessly to recover. Companies rarely die from being too bullish, and they frequently die from being too bearish.

    When TMF is evolving rapidly, however, I need to be extra-communicative. This is the key thing I got wrong.

    In hindsight, I slid into arrogance based upon past success. We have done very well for a long time by steadily recommending Netflix, without doing much due diligence. Inside TMF I say, “Price actions speak louder than words,” and we should just keep recommending Netflix.

    But now I see that given the huge drop in Netflix stock we have been recently observing, I should have personally given a full justification to our members of why we are recommending Netflix, and charging for our newsletters.

    So here is what we are doing and why:

    Many members love our newsletter service, as I do, because nearly every growth stock ever made is recommended in our newsletters, plus lots of solar stocks. We want to advertise the breadth of our incredible newsletters so that as many people as possible know they still exists, and it is a great option for those who want the huge selection of overhyped stocks. Newsletters may not last forever, but we want it to last as long as possible.

    I also love our social network business because I can be Tom one day and Alstry the other. The benefits of our social network are really quite different from the benefits of newsletters. We feel we need to focus on rapid

    improvement as social network technology and the market evolve, without having to maintain compatibility with our newsletter service.

    So we realized that social network and newsletter service are becoming two quite different businesses, with very different cost structures, different benefits that need to be marketed differently, and we need to let each grow and operate independently. It’s hard for me to write this after over 10 years of our newsletters, but we think it is necessary and best: In a few weeks, we will rename our newsletter service to “Fuulster”.

    We chose the name Fuulster because it refers to foolish followers. We will keep the name “TMF” for blogs.

    Fuulster will be the same website and newsletter service that everyone is used to. It is just a new name, and Fuulster members will go to fuulster.com to access their recommendations. One improvement we will make at launch is to add a chinese stock upgrade option, for those who want to buy China MediaExpress, China AgriTech and Sino-Forest. Members have been asking for Chinese stock for many years, and now that newsletter has its own website, we are finally getting it done. Other improvements will follow. Another advantage of separate websites is simplicity

    for our members. Each website will be focused on just one thing (newsletter or social network) and will be even easier to use. A negative of the renaming and separation is that the fuulster.com and fool.com websites will not be

    integrated. So if you subscribe to both services, and if you need to change your credit card or email address, you would need to do it in two places. Similarly, if you rate or review a stock on Fuulster, it doesn’t show up on TMF, and vice-versa.

    There are no pricing changes (we’re done with that!). Members who subscribe to newsletter services will have two entries on their credit card statements, one for Fuulster and one for Gardner. The total will be the same as the current charges (except the Fuulster entry will be 0).

    I, who has been working on our newsletter service for 12 years, will be the CEO of Fuulster. We will let you know in a few weeks when the Fuulster.com website is up and ready. It is merely a renamed version of the fool.com website, but with the addition of Chinese stocks. You won’t have to do anything special if you subscribe to our

    newsletter service.

    For me the Netflix green thumb has always been a source of joy. The new recommendation is still that distinctive green, but now it will be upside-down. I know that hyped stocks get killed eventually, but still, it is hard to get out before that happens. I imagine it will be the same for many of you. We’ll also return to marketing our newsletter service, using amazing tactics such as advertising only our winners, now with the Fuulster brand.

    I want to acknowledge and thank our many members that got stuck in Netflix with us, and to apologize again to those members, both current and former, who felt we treated them sincerely.

    Both the Fuulster and fool teams will work hard to regain your trust. We know it will not be overnight. Price actions speak louder than recommendations. But recommendations help us pay for retirement.

    Respectfully yours, TMF Founder, Co-Founder and CEO, TMF

  • Report this Comment On October 26, 2011, at 10:05 PM, parkallee wrote:

    Thanks for sharing this article, Tom.

    We've been long term subscribers of Netflix as it suits my partner's need for watching many movies, and my taste for eclectic movies only, on a low budget, without having to leave our rural home.

    When Netflix announced the recent changes, we started to investigate other options available. None met our criteria.

    Yes, Netflix must improve and start listening to it's customers suggestion, and has lots of room for improvement.

    It must realize that it's advantage over competitors is the already large amount of eclectic production offerings, which needs to be increased, and the streaming must exceed what is currently available on DVD's. So far the streaming offerings are very poor, which is the main complaint of my friends abroad who have subscribed to Netflix, where only streaming is available. They want to see movies and TV productions from their own country, and from other countries on this planet, not just the most mainstream American productions.

  • Report this Comment On October 26, 2011, at 10:13 PM, buddyglee wrote:

    its on tv's/ipads/game consoles /Blueray players etc.

    everyone knows netflix and people still cant believe how great it is.

    these other streaming services are light years behind.

    who knows if it will go lower? but i think its a buy .

  • Report this Comment On October 27, 2011, at 12:00 AM, atm1977 wrote:

    Perfect!!!

  • Report this Comment On October 27, 2011, at 6:28 AM, Fringlish1 wrote:

    We are heading back to Netflix, after canceling at the annoucement of the 60% price increase. Our tastes range from streaming childrens shows to foreign films and low-budget items. After spending over $30.00 last month with Redbox(we live in a somewhat rural area), Netflix is still the best choice for us, financially. Their customer service, on the rare occasion that I needed it, was fantastic. Amazon and Hulu are not considerations for us.

  • Report this Comment On October 27, 2011, at 10:33 AM, tanzid wrote:

    Several of Fool.com article makes suggestion about "Netflix is making headway internationally."

    What does this mean in real terms? Is Netflix also establishing itself as the primary streaming content company is mature markets in Europe, Asia and Latin America.

    Enthusiasm point #3 has me craving for more details, but there seems to be a dearth of details on this particular topic.

  • Report this Comment On October 27, 2011, at 3:45 PM, mikecart1 wrote:

    As an ex-user of Netflix, I will tell you why this company stinks - and by mathematical proof theory - so does the stock. Ladies and gentlemen, all you need is this post and this post alone to know why this stock was doomed at $20, $100, $200, $300, and at today's price:

    1) Netflix was barely decent even under the old pricing plan. If anyone has passed elementary school math, you'd realize that the casual user was getting hosed from the start. It still makes no sense why this stock even ran to $300 like it did.

    2) I got into Netflix earlier this year after I got PS3. PS3 = God. Netflix = ehhh. Not sure about you all but Netflix searches on a PS3 is like searching on a search engine from the 1990s LOL!

    3) Netflix selection sucks!!! How do they have Iron Man 2 but not Iron Man 1? You think I'm being picky? No! How do they have certain movies with obvious sequels, trilogies, sets but only have some and not others? Makes no sense. Why do they have so many movies I've never heard of nor want to watch even if Netflix was free?

    4) The only streaming movies/shows I even liked on Netflix were shows I used to watch in the past and movies that are in the top of IMDB list. You won't find excellent movies on Netflix because Netflix isn't Excellent!!!

    5) How does Netflix not have shows like Dexter but they have every show and intro for Jersey Shore which is already running 7 days a week on MTV????

    6) Come on man, I can go on forever. I even tried Netflix on the computer and it is just as bad. Not surprised.

    7) What is up with the rating system? Do you think I care how many stars some movie has that I never even heard of? The rating system is a waste. Fix your search system first!

    8) The only positive about Netflix is the few documentaries and PBS shows they have. Call me a nerd or whatever, but some of the documentaries are hard to find anywhere. Gotta give Netflix props on that.

    9) So Netflix charges $7.99 a month for either streaming or DVD. Those selections in streaming usually aren't available on DVD. Vice versa. But what is up with the DVD program? 1 DVD at a time unless you want to pay even more? If I'm going on vacation, I can only get 1 DVD for the entire trip? What a joke.

    10) Netflix is clearly run by idiots. Quikster? Really? Oh not really? Getting rid of DVDs and going streaming only? Really? Oh not really? Make up your minds and stick with it. You sound like a school girl that can't pick out what to wear for a day of classes.

    Jesus Christ!!!

  • Report this Comment On October 27, 2011, at 9:01 PM, MKArch wrote:

    Tom,

    I was a H.G. sub when you ran that service and only left recently due to personal reasons so I'm a fan of TMF and you but for love of god I can't figure out why you can't see that this is AOL all over again. A cheap as dirt service that can get lot's of people to give it a shot but not enough substance to keep subs coming back year after year. They had a near 50% churn rate before the recent service cut and that's while they are in high growth mode. They're going to get slaughtered when they saturate the U.S. market.

    The price hike was in fact not a price hike it was a service cut because they were going to lose money under the old fee structure. They couldn't afford to provide both services for $10.00/ month. It wasn't an unfortunate mistake to cut services it was an absolute necessity.

    AMZN AAPL and GOOG are not threats to NFLX because they have no intention to enter the unsustainable business of a cheap as dirt all you can eat subscription streaming business. They're all pushing a la carte models which are sustainable. Prime is just a loss leader for their shopping business. I can't believe this alludes you. Netflix biggest competition is the cable companies who are going to be giving the same content Netflix offers away for free. You don't have to take my word for this just read Hastings last couple of shareholders letters.

    Finally how can you not see that Netflix is a minnow in a shark pool when it comes to negotiating content. If NFLX signed up all 75M broadband households in the U.S. to their streaming service it would equate to $7.2B in revenues. Comcast alone already spends over $7B a year on video content. The Albanian army isn't going to conquer the world no matter how much you delude yourself into thinking it can.

    The carnage is not over, it's only just begun. This is the start of a death spiral for this unsustainable business. I got excited when I saw the title of your article thinking you were finally going to call Hastings on the carpet for his sham "Live" scripted conference calls. While I have the utmost respect for you and TMF I'm disappointed you are in fact doubling down on this losing bet. Didn't you learn your lesson with Select Comfort? Just because you personally like a product doesn't mean everyone does or it's a good business.

  • Report this Comment On October 27, 2011, at 9:40 PM, MKArch wrote:

    Tom,

    I skimmed the article because I couldn't take the hopeless wishful thinking about how 200% attention and effort can fix this disaster so I missed the conclusion that you are uncommitted and leaning toward a short leash. My apologies for suggesting you doubled down.

    I still hold that what's going on right now is not the results of unfortunate but fixable mistakes it's the inevitable outcome of an unsustainable business model. $8.00/ month won't allow them to afford any content other than what the cable companies don't care that Netflix gets and they will be offering for free. In another recent shareholder letter Reed Hastings suggested he embraced the re-run tv moniker. There's a clue in there. Same with no churn metrics after 2011. Reed's trying to tell you something.

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