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TMF's Reed Hastings Interview

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By TMFDavidG
October 23, 2003

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TMF: Reed Hastings is the CEO of Netflix. He joins us from Los Angeles, California. Reed, welcome back to The Motley Fool Radio Show.

Reed Hastings: Thank you.

TMF: You just reported a third quarter profit that exceeded expectations. You ended the quarter with 1.29 million subscribers. That is a 74% increase from last year. Your stock now trades around $50 a share, Reed, compared to $12 a share when our show last had you on in January. What is going on?

Reed Hastings: Well, we have continued to grow our subscriber base. First quarter we were up 75%, second quarter we are up 75% year over year and now third quarter we are up 75% year over year. It has just been a tremendous growth and it is driven from I think a great service that customers want to tell their friends about, one of these amazing word-of-mouth phenomena.

TMF: So your third quarter report is just out. What is the highlight Reed, and importantly, what is the lowlight in your opinion of your third quarter earnings?

Reed Hastings: Well, the highlight is we had record revenues, $72 million. We had gap net income of $3.3 million, about three times what we expected. Our monthly churn has decreased from 72.2% to 6% and now in Q3 hit a record low of 5.2%. So those are the big highlights.

Lowlights, I am stretching for that one. We did not issue guidance for 2004. We will do that in January.

TMF: Explain for our listeners what a "churn rate" is and why it is important that yours has been falling.

Reed Hastings: Sure. The churn rate is how many subscribers quit in a given month. Our service is $20 a month and there is no commitment. It is easy to get in of and out of. What we do is sometimes consumers will leave the service for a few months, similar to how people treat HBO. They might turn it off for a few months and then come back to it. The rate at which they leave is the churn and that is again, about 5% per month now.

TMF: We are looking over the numbers, Reed. At your present rate, we estimate you will churn out of about 900,000 customers by year's end. You begin here with about 850,000 customers, which I guess begs the question, how long is your median customer maintaining his Netflix membership?

Reed Hastings: Well, the mean customer life is roughly one divided by the churn, so that is about 20 months at this point, 19 point something. I am not sure on the median, but it would probably be pretty close. I don't think there would be anything skewed there. So what we have done is really extend the customer life by reducing the churn. Many of the people who leave the service come back to it. So they are not leaving because they are unhappy with it. They are just turning it off and to be most straightforward, we report that as churn, even though they say that they are going to be coming back.

TMF: To the extent that there is any tradition in the world of DVD rentals, I will say for many people it is a pretty impulsive act. They walk down to their video store. They check out some of the aisles. They spend more time than they wanted to looking and they end up renting something and then taking it home. Now with Netflix, customers wait to get the movie in the mail. So is getting people to rent from Netflix involve changing consumer behavior from here?

Reed Hastings: It does. It is one of the great challenges of Netflix marketing. It is a consumer behavior change. It is why our best marketing program ever has been our free trial to let any consumer try Netflix for free. What we find is once they have tried it, they realize oh, I get to keep three movies at home at any point. I don't have any late fees or due dates. So then Friday night comes and it actually feels more spontaneous because I can just pick up one of the DVD's from the top of the TV and watch it. But until someone tries it, that is a bit of an abstract concept. So we have really invested heavily in this free trial notion. The way you can see that at work is 9 out of 10 people who try our service for free become paying subscribers.

TMF: Reed, the U.S. isn't the only country with a well-developed postal infrastructure. Will Netflix expand internationally and if so, when?

Reed Hastings: Sure. It is absolutely something we are looking at. What we realize though, we will do about $270 million of revenue this year in the U.S. That is only about 3% of the domestic video rental market. It is about a $10 billion market. So we are really at a very small penetration here in the U.S. and we may be as well served in focusing in the U.S. for a little while, continuing to build that share, get to our five million subscribers, billion dollars of revenue goal and then expand at that point. So we are debating that back and forth.

TMF: Reed, we asked you this earlier this year if you were going to expand in video games or maybe audio books. You didn't seem interested that much in the idea at that point. Since emerging services like Gamefly, Audible.com, they are now doing those things and they seem to be succeeding. Your reaction?

Reed Hastings: We are continuing to watch them and grow the movie markets. We are really focused on the movie market. Again, it is at $10 billion and we are only at 3% market penetration, so we are sticking with consistency.

TMF: Your company obtained a patent for the process by which you send DVDs through the mail, though I think it covers sort of the idea of subscribing to a service like Netflix. Am I right about that?

Reed Hastings: Yes, in general terms. It is a little more specific than that to do with the queue and other elements of our service. Patents are a great thing to get, but mostly defensively you want to have a series of patents so that if anyone ever sues you, you have got a lot of grounds to counter sue them. Fundamentally, we look at the patent and say you know, we want to win in the marketplace by building the best service ever. That has been our strategy, continues to be our strategy and the strategy is working. We have been competing with Blockbuster for a year, with Wal-Mart for a year. We have continued to exceed all of our growth targets.

TMF: Reed, your company's red envelope. They are an increasingly recognizable package to U.S. Postal workers. Hundreds of thousands of customers open these up each month with delight. Our question for you then, Sir, on behalf of some shareholders who may think you are leaving money on the table, when will you sell space on those red envelopes to outside advertisers?

Reed Hastings: Well, if you look at some of the great brands that have been created, Starbucks is an example. A lot of people would like to advertise in the Starbucks store, but they have been very strong about creating a unique space and a unique brand. That is our philosophy also. We have got a very clean brand. We have got a brand that really represents something special and we don't intend to expand into advertising, no matter what the associated revenues and it is really focused on, again, creating this pureness and this great brand. We think that is the right strategy to build the most valuable company.

TMF: Reed, who ended up selecting the color red for those envelopes and was there a debate about it?

Reed Hastings: That was our VP of marketing, Leslie Kilgore, who selected the logo and the color. That has worked out very well for us.

TMF: Reed, do you all have any plans to turn your customers evangelists into sales people for your business? Is there a Tupperware model that exists for this sort of company, given that it takes a little bit of time to explain Netflix services to the new customer?

Reed Hastings: You know, that is a great example of where I think we are doing the right thing. That is we let you tell your friends about the service. You can give your friends a free trial, but we don't pay you to turn your friends in. What we realized is if you love the service, you will tell your friends about it because you want to. If you don't like the service, you are not going to sell us your friends' names for $20 or $50. So what we should do is not focus on the $20 or $50 spiffs, but instead focus on building a great service that people rave about and then they will want to tell their friends about it.

TMF: Reed, will Netflix in any way, shape or form ever offer pornography rentals?

Reed Hastings: Well, it is not something we have ever done in the past couple of years. It is something we don't want to get into. It is a very different market. So I highly doubt it.

TMF: Reed, let's look at over the next, let's call it five to seven years. I want to present you four competitive offerings and get your view on them. I would love it if you would rank these for us and here they are: Blockbuster, Wal-Mart.com, Video On Demand and illegal Internet movie downloads.

Reed Hastings: Which are the most threatening to Netflix?

TMF: That is right.

Reed Hastings: OK. Most threatening is piracy; second most threatening is Blockbuster, third is Wal-Mart and fourth is Video On Demand.

TMF: And why is Video on Demand such a small threat, in your opinion?

Reed Hastings: Well, because it is much more an opportunity for us. We named the company Netflix and not DVD By Mail for a reason, which is we plan to lead the downloading market and over time we will offer both DVDs by mail and downloading. The consumer will be able to choose. Some will prefer downloading to the TV and to the computer; some will prefer getting a DVD by mail because it is portable. They can play it in the car, on the airplane, etc. So we intend to lead both of those sectors. So that is why I look at VOD as more opportunity than threat.

TMF: You listed piracy. Services maybe like Kazaa and others where people can come in and download sometimes-rough versions but a full-length movie as number one on that list. I am not sure whether you would consider that a very serious threat or not, but certainly Napster and Napster-like services have hurt the music industry.

Reed Hastings: Well, I think it is a very serious threat, again, over the next five years, not necessarily next year. But over time, if the culture takes hold that no one pays for movies and everyone just steals them, then that is going to hurt the entire industry. There will be less movies made. It will be dramatic. So it is very much in entire industries and in the retailer's interest to avoid that. Netflix is one of the services that makes, is a piracy-inhibitor basically because it is such a good value. If for $20 you can rent unlimited movies, your incentive to do piracy is a lot less.

TMF: OK. Are there any specific steps that you expect to be taking as the CEO of Netflix to combat piracy head on?

Reed Hastings: No. I think the real focus for us is to provide a great legal alternative that is cost effective, has incredible selection and in that way lessen the incentive for piracy.

TMF: Reed, given your success, is it possible that studios will begin wanting a bigger share of retail profits?

Reed Hastings: Well, studios always want a bigger share, whether we are successful or not, they want a bigger share of the movie theater's profits; they want a bigger share of Wal-Mart's profits. That is a healthy and creative tension. They recognize that new channels often bring in new customers. From what we have seen over 25 years is growth in the movie market from about $6 billion 25 years ago when it was the movie theater only to nearly $30 billion last year when there is rental, sell through, pay-per-view, all of the different channels and that they really tend to reinforce and grow each other. So the studios have been very supportive of us. Not because they love us particularly, but because they are always supportive of new channels because that creates more revenue for them.

TMF: There has been serious innovation in the provision of entertainment services in America over the last ten years. How do you think the movie viewing and movie making experiences are being changed by all these new services?

Reed Hastings: Well, movie making hasn't changed that much. Obviously there is digital cinematography, and that helps to a certain degree. But the film expense is small compared to the actors and the set up of the sets and all of the promotion aspects. On the consumption side, the big change has been home video. Home video is now 59% of the studio's revenue and 41% is everything else combined. The movie theater, pay-per-view, TV, etc. So home video has gone from nothing twenty years ago to essentially 60% of studio revenues. So that is a phenomenal engine. DVDs - only about 50% of households have it today. So we are looking at another doubling as DVD grows and I think you will see that DVD just becomes a monster success over the next five years.

TMF: Reed, changing gears now, yours is one of the few growing technology companies to begin expensing stock options. Have you received any backlash from other technology companies for breaking from the ranks?

Reed Hastings: No, I think we are in pretty good company with Amazon, Expedia and Microsoft and Netflix, in terms of expensing stock-based compensations. So we feel very comfortable with that, as those companies do.

TMF: Speaking of Amazon.com, have you ever had any thought about maybe veering away from traditional stock option grants and going more towards the restrictive stock units?

Reed Hastings: We have and we stayed with stock options. We think they are preferable from the employee's point of view because in restricted stock, when the restrictions lapse, then there is tax immediately due, essentially force through some sales. That is not true with option vesting. So we believe that stock options are better for the employees.

TMF: OK. We are going to put you on the spot, Reed. Tell us something that might surprise us, something that we don't know about Netflix.

Reed Hastings: Something that you don't know about Netflix.

TMF: It could be corporate culture, what people are wearing, what the work hours are like. It could be an aspect of customer experience that we may not be aware of.

Reed Hastings: We take all of the salaried employees of Netflix to the Sundance Film Festival each January. So we are quite a force there in Park City, if you guys ever get out there. It is part of celebrating the love of film and building that within the culture of Netflix.

TMF: Great. What do people wear on a daily basis when they come to work at Netflix?

Reed Hastings: Clothes. (Laughter.)

TMF: Reed, looking back over the past year and studying Netflix, the performance has been extraordinary. The stock is up multiple times in value and yet there was a lot of skepticism about the business and certainly that skepticism increased when Wal-Mart announced that it would get into the game. If you would, advise us as investors, small investors looking for great growth stocks, what is it that we could have seen in Netflix a year ago that would have suggested that the probabilities favored your success?

Reed Hastings: I think if you look at the Internet space generally, consumer Internet, people may have made money or lost money on different stocks but it wasn't because of competition. Yahoo!'s ups and downs were because of market size, how the business model worked. Amazon's ups and downs were again not because of competition. AOL was up and down but not because of competition. So competition really has not been a critical driver of shareholder value in the Internet space. Once someone gets a space, they tend to own it and it tends to be driven by business model and market size issues. So I think any investor, large or small, could look at that and then substantially discount how effective Wal-Mart and Blockbuster were going to be against Netflix.

TMF: So let's leave competition aside. What sort of variables would you have a small investor look at to evaluate Netflix's performance a year ago or going forward today? Top line growth? Free cash flow? Total number of new customers? Churn rate?

Reed Hastings: Sure. A year ago I would have looked at free cash flow, which had been positive at that point for three quarters so that gives you a safety net that there is not going to be a liquidity crisis, that things are steadily growing and that protects the downside alot. Then I would look at the San Francisco Bay area adoption, which we have released over time and shown that it has grown to about 5% household penetration, because we have had overnight delivery in the San Francisco area for four years. Then of course two years ago, we rolled out overnight delivery to much more of the country and all of those areas are following the Bay area penetration curve exactly. They are continuing to grow. So we joke internally when we look at these graphs of household penetration steadily up and to the right, that to get to a billion dollars in revenue we just have to get these colored lines to follow that colored line, representing the San Francisco Bay area.

TMF: Reed, stepping away from things, Tom and I are certainly familiar with Netflix. I myself am a customer and somebody who has recommended your stock and happy to have done so because it has done so well. I put myself in the position of somebody just hearing this interview for the first time and learning about this business and I think the big question on that person's mind is, "OK, I get you. DVDs are hot. They are taking over VHS tapes. In the next few years it is a huge business." But, I think that person might wonder, where will Netflix go when DVDs do get outmoded, presumably one day, by Video on Demand? Where is the business then and why would I buy the stock now?

Reed Hastings: Sure, I think that is a great question. First, DVD is of course, only 50% penetrated and has many years left before it peaks. Second, Internet consumer and Internet commerce comfort is steadily growing. So we are riding two very big trends that are sort of ten and twenty-year trend stories positively over the next couple of years.

Second, the DVD is a huge part of the studio's revenues. Sixty percent now could be growing to 70% or 80% of studio revenues over the next five to ten years. So that adds a lot of stability. There will be no quick changes in that because the studios will protect the DVD market in a very significant way.

Third, we are very well set up as an Internet business to essentially go from paper tickets to e-tickets or in this case from DVDs to downloads. That is actually a very simple transition for us. Instead of paying the post office to deliver the DVD, we pay one of the telcos and cable companies to deliver the Internet bits to our customers.

So it is several years away. The studios have a huge desire to keep the market strong for DVDs because it is such a big part of their revenue. We are very focused on following that evolution. It is why we named the company Netflix. Ten, twenty years from now we want to emerge as one of the world's leading media companies using Internet movies as the core driver.

TMF: Reed, are there any small, emerging companies that you encounter, either as competitors or partners or just in your observation of business, that impress you?

Reed Hastings: Small companies that impress me. There is a real small one, Audible.com that I am now using on my iPod, which can get spoken word, audio books. It is great for anyone who has got a long commute and now to be able to download those onto my iPod.

TMF: Reed, what is your plan as CEO of the company? Do you expect to be heading up Netflix for the next 15 years? Do you look that far forward? What do you think your professional career will hold for you over the next ten years?

Reed Hastings: I certainly intend to do it for the long term. I ran a public company, a software company, Pure Atria Software, in the early 90s. That got acquired in 1997 and it took until now to get back to running another public company and I would like to do it for a very long time.

TMF: Let's close with our game, Buy, Sell or Hold. You have played it before. We will be throwing out things happening in business or culture and ask you, Reed, if these were stocks would you be buying, selling or holding right now and a sentence about why. Are you ready?

Reed Hastings: Yeah, I am ready.

TMF: Let's start it off with, well, it is a hot product today, but still pretty pricey. If they were a stock, buy, sell or hold plasma TV?

Reed Hastings: Sell.

TMF: Why?

Reed Hastings: LCD TVs are more stable and growing faster. They are going to replace plasma.

TMF: Your Motley resume includes being president of the California Board of Education. So Reed Hastings, buy, sell or hold the likelihood that governor-elect Schwarzeneggar can balance the California budget without raising taxes?

Reed Hastings: Hold. I think he has got a credible chance to look at through the audit, to look at the process fresh and find a lot of savings.

TMF: It was a much-maligned movie to say the least. Buy, sell or hold renting the DVD of that Ben Affleck-Jennifer Lopez movie last summer?

Reed Hastings: That would have to be a sell. We showed it at Netflix as an employee gag and no one showed up. (Laughter.)


TMF: Reed Hastings is the CEO of Netflix. Reed, thanks for joining us again on the Motley Fool Radio Show.


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