I Will Not Abandon Netflix in 2012

Rarely is a single earnings report so important that it deserves to be elevated above the others. But with Netflix (Nasdaq: NFLX  ) , tomorrow night's fourth-quarter report is about as crucial as they come.

So many questions are unanswered right now:

  • What will fill the gap when the Starz agreement fades to black next month?
  • What will Netflix do with its free cash flow now that buybacks are no longer an option?
  • Has there been progress brokering affordable but fair streaming agreements?
  • What, if any, edge does Netflix have in negotiating for new content?
  • Will there be more exclusive agreements, such as the deal to air new episodes of Arrested Development?

Investors seem concerned that CEO Reed Hastings doesn't have answers to any or even most of these queries. That's why some say he's one of 2011's worst executives as others say he should have been fired. Me? I still think Hastings is the right guy for the company he founded.

Mistakes are inevitable; great executives make them all the time. The difference between great, mediocre, and awful executives is that the great learn from gaffes and get smarter, the mediocre simply try harder, and the awful remain in denial. Hastings knows he screwed up, and he's smarter for it.

Why I still believe in Netflix
For those with an itchy pitchfork finger, go ahead and skewer me now for buying shares of Netflix at $171 a pop. That's right; I'm down more than 45% as of this writing. I didn't see that heavy content investments would erase all short-term profits.

Yet I still believe in the underlying business because it most closely resembles the Apple (Nasdaq: AAPL  ) design principles that the late Steve Jobs made famous. Netflix is simple. Start a show on an Apple TV, continue on an Android tablet, switch to a Chromebook, then to a Wii console, and conclude on a Mac. Try that with any service other than Netflix, and you're bound to pull your hair out.

Distribution matters, Fool. Yes, I realize I've offered an extreme example, but I've performed similar switcheroos plenty of times. Last week, I began an episode of the BBC series Sherlock on my Mac during lunch, switched to the Chromebook while waiting to pick up my kids from school, and then finished on our Apple TV. Hulu isn't available on the Apple TV. Neither is Amazon.com's (Nasdaq: AMZN  ) Instant Video nor Google's (Nasdaq: GOOG  ) YouTube video-rental service.

All that could change, of course. But if it does, it won't happen quickly. Amazon has become increasingly competitive with Apple thanks to the new Kindle Fire, which, interestingly, hosts Hulu Plus. What's more, both YouTube and Amazon Instant Video feature a la carte pricing reminiscent of Apple's iTunes Store. Netflix doesn't. Simple pricing sets Netflix and iTunes apart, increasing the odds the service will become a standout on Apple's interactive TV sets when they morph from rumor to reality.

Negotiating the non-negotiable
Netflix's priorities are also different. Have you noticed that while Microsoft (Nasdaq: MSFT  ) and others are mostly negotiating with distributors that Hastings and team are negotiating with creators and studios? I think that's brilliant, and it's reminiscent of how Jobs changed music with iTunes.

As Rolling Stone reports it, Jobs called the president of what was at the time AOL Time Warner to complain about labels suing Napster and others rather working to make digital music downloads legal, affordable, and easy to obtain. The rest is history, of course.

Admittedly, I don't know Reed Hastings. I've never met the man. But if you look at what his company is doing, it becomes clear that he cares about content in the way that Jobs cared about music.

Consider the deal with AMC Networks for broadcasting its original content; including acclaimed post-apocalyptic thriller series The Walking Dead. Or the exclusive deal for the CW's past and future scripted shows. Or the exclusive rights to broadcast David Fincher's House of Cards. Or, again, the Arrested Development arrangement. All of it speaks to a passion for content, whereas distribution is a software problem solved by great engineering.

Hastings wants to give viewers an all-you-can-eat smorgasbord of great content. I get my fill weekly, with the 2005 re-up of Dr. Who and the aforementioned Sherlock as current obsessions.

Critics will say Hastings has also made enemies in Hollywood, and they're right about that. The original Starz deal angered some studio executives for how it allowed Netflix to exploit a loophole in getting newer releases to subscribers. But is that really so different from how Jobs muscled music labels into accepting $0.99-per-track pricing? Both moves caused early discomfort while favorably changing the dynamics of aging industries.

Making the call: buy
Yet work remains to define the industry standard for what makes a fair streaming deal. Maybe it'll never happen. But for my money, Hastings is moving the industry forward by negotiating with the right people and signing the right deals. Accordingly, I've decided to hold my shares and stick with an outperform call I made in CAPS back in late 2007.

Do you agree? Disagree? Either way, if you're a tech investor, it makes sense to be studying the broad implications of the post-PC world emerging around us. The Motley Fool recently homed in on how mobile computing, in particular, is changing fortunes in a report titled "The Next Trillion-Dollar Revolution." Thousands have already requested the report, which is available for a limited time. Get your copy before this offer expires -- the research is 100% free.

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Apple, Google, and Netflix at the time of publication. Check out Tim's Web home, portfolio holdings, and Foolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.

The Motley Fool owns shares of Google, Apple, Amazon.com, and Microsoft. Motley Fool newsletter services have recommended buying shares of Google, Microsoft, Netflix, Apple, and Amazon.com and creating bull call spread positions in Microsoft and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (10)

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 January 24, 2012, at 11:30 PM, Mega wrote:

    "Yet I still believe in the underlying business because it most closely resembles the Apple (Nasdaq: AAPL ) design principles that the late Steve Jobs made famous."

    Um... Actually AAPL most resembles those principles. And trades at a much cheaper valuation.

  • Report this Comment On January 24, 2012, at 11:37 PM, delatopia wrote:

    More hope, much like the Motley Fool article by TMFZahrim from an hour ago. The headline of the article sounds much like something one says right before fading to black (and I don't mean black ink). I read stubbornness, desperation and anxiety in this article, and very little detail or concrete to buttress your case. Good luck, but I'm not optimistic for your side.

  • Report this Comment On January 25, 2012, at 12:13 AM, flatpickn wrote:

    "Mistakes are inevitable; great executives make them all the time"

    True, but great executives don't do it twice. He didn't understand his customers several years ago when they tried to get rid of profiles. And he didn't understand his customers in the recent debacle.

    The content in the on demand service is only so-so. The highly touted personalized recommendations are only so-so (thanks to there being no profiles for on demand). And the price is now higher.

    Peter Lynch said "invest in what you know". I am a netflix subscriber and a netflix investor. As a subsciber I do not get near the value from the on demand that I got from the CD mailing program. As an investor, I can't help wonder why he would want to divorce himself from that part of the business.

  • Report this Comment On January 25, 2012, at 12:16 AM, delatopia wrote:

    BTW, no one deserves to be skewered for having bought NFLX at $171 or any price, but one is measured by what does when presented with another opportunity (which happens every moment in this biz). Would you honestly buy NFLX at this level? Going forward, where is the upside in terms of breakthroughs and brilliance? I see a lot of retrospective wistfulness in lauding Reed Hastings, but lots of people have one great idea. I don't see this one great idea heading much further considering the headwinds moving against all-you-can-eat streaming, shrinking profitability in the DVD sector and difficulty negotiating deals with studios and networks. "Reed Hastings proved himself once and had a brilliant idea once" is not a plan for future profitability in my mind.

  • Report this Comment On January 25, 2012, at 12:30 AM, techrefugee100 wrote:

    Taking the Apple comparison a bit further - streaming is like the Apple's licensing clones period. Netflix has much less control on end to end in the streaming world than the DVD world. Are you going to blame netflix for the buffering/loading messages or your ISP, your neighbor, your other family member, your router, your computer or your wireless/wired connection? Not to mention they can't just go buy a stream and rent it like they can with a DVD. I have seen people IN LINE at Redbox and even when they have the new double kiosks. I don't understand why it takes so many employees to stream content - youtube was doing it with a handful many years ago. Seems Netflix is going the way of Yahoo. This earnings announcement will indeed be interesting. Reed has come a long way from being pissed by Blockbuster late fees.

  • Report this Comment On January 25, 2012, at 7:49 AM, TMFMileHigh wrote:

    Great comments, everyone. Really enjoying what you have to say. I may need to write another article to explain my thesis more fully, but I can't do that without responding first. The discourse here is just too good.

    >> Would you honestly buy NFLX at this level? Going forward, where is the upside in terms of breakthroughs and brilliance?

    Excellent and extremely Foolish question @delatopia. Yes, I would because I believe that Netflix's strategy of negotiating with content providers rather than distributors is smart and timely.

    Meanwhile, we know that the likes of Cablevision have considered carrying Netflix as a channel in the same way you access it via a set-top box. That's the beauty of a software business -- it's portable.

    Secondly, I like the valuation. Netflix trades for about six times cash flow, less than half the lows we've seen in most years since 2007. You have to believe Netflix is already dead not to buy at these levels, in my view.

    >>Um... Actually AAPL most resembles those principles. And trades at a much cheaper valuation.

    @MegaShort, does it really? As of this writing, Apple trades for more than 13 times cash flow. It'll go higher when the shares rally today.

    >>I have seen people IN LINE at Redbox and even when they have the new double kiosks. I don't understand why it takes so many employees to stream content - youtube was doing it with a handful many years ago.

    @techrefugee100, I see where you're headed with this, but let's consider the limitations these other businesses impose on users.

    Redbox makes you drive somewhere in hopes the DVD you're looking for is still there. A good service for the money, I think, but not as service-friendly as Netflix.

    Secondly, YouTube only recently got into paid distribution. It didn't need as many employees because users could just upload and play whatever they wanted, too often in violation of content copyrights.

    Thanks again everyone. Very Foolish discourse here.

    FWIW and Foolish best,

    Tim

    --

    Tim Beyers

    TMFMileHigh, Motley Fool Rule Breakers Analyst

    Web: http://timbeyers.me

  • Report this Comment On January 26, 2012, at 2:04 AM, Mega wrote:

    "What will Netflix do with its free cash flow now that buybacks are no longer an option?"

    That's an easy question to answer. Free cash flow will be nearly zero in 2012 (along with earnings) and cash flow will be down substantially.

    And as you probably know, free cash flow and earnings are generally more relevant to the value of a company than cash flow is. In your comment above, you're just cherrypicking the only financial ratio which looks good for NFLX.

  • Report this Comment On January 26, 2012, at 7:39 AM, TMFMileHigh wrote:

    @MegaShort,

    >>And as you probably know, free cash flow and earnings are generally more relevant to the value of a company than cash flow is. In your comment above, you're just cherrypicking the only financial ratio which looks good for NFLX.

    Allow me to clarify. The multiples referred to above are for free cash flow compared to enterprise value. As of today, Apple trades for 14.89 times EV while Netflix trades for 4.7 times EV.

    Other multiples, all of which look great for Apple:

    EV-to Revenue:

    -- Apple = 3.02

    -- Netflix = 1.52

    P/E:

    -- Apple = 12.7

    -- Netflix = 22.3

    Price-to-Book:

    -- Apple = 4.6

    -- Netflix = 8.1

    Please understand that I'm *not* saying Netflix is a better buy than Apple or vice versa. (Apple is my largest personal holding, after all.)

    I'm saying giving up on Netflix at these levels is a poor investing choice.

    FWIW and Foolish best,

    Tim

    --

    Tim Beyers

    TMFMileHigh, Motley Fool Rule Breakers Analyst

    Web: http://timbeyers.me

  • Report this Comment On January 26, 2012, at 7:47 AM, TMFMileHigh wrote:

    Also, if I might, Netflix posted excellent results last night and the stock is up 18% pre-market.

    Some notable facts:

    * While free cash flow fell Y-o-Y, it still came in strong at $54 million.

    * 610,000 new subscribers in the U.S. market.

    * Steady gross margin at 34.3% despite higher content costs.

    FWIW and Foolish best,

    Tim

    --

    Tim Beyers

    TMFMileHigh, Motley Fool Rule Breakers Analyst

    Web: http://timbeyers.me

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