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