Netflix CEO To Whitney Tilson: "Cover Your Short Position. Now"

Tyler Durden's picture

In what is rapidly becoming a mockery of the investing process, after Netflix recently advised shorts to cover during their investor call, the firm's desperation has hit a new all time low. Today NFLX CEO, Reed Hasting, has responded directly to ongoing attacks by Whitney Tilson that his company is due for a major correction, by posting in financial website Seeking Alpha. Hastings' stunning conclusion: " Whitney lays out a series of potential issues for us: Our CFO’s
recent resignation; threats to the First Sale doctrine for DVDs;
Internet bandwidth costs potentially increasing; declining FCF
conversion; market saturation; weak streaming content; paying more for
streaming content; and increased competition hurting margins. He only
has to be right on one or two of these issues in 2011 for him to make
money on his short of Netflix. Odds are he is wrong on all of them, in my view. Let’s take them one at a time." And while Tilson has indeed suffered major losses so far on this short, we are very confident that his perseverance will pay off. As we noted previously, the major concern facing Netflix is not so much margins (which is a major concern), but cash flow generation. As such, we continue to view the probability of a follow on offering by the company to be very high, as the firm already issued high yield bonds recently and has very little dry powder left under the "indebtedness incurrence" basket.  In the meantime, we can all enjoy the spectacle that is NFLX' defense of its ludicrous 100x+ fwd P/E position.

From Seeking Alpha:

Netflix CEO Reed Hastings Responds to Whitney Tilson: Cover Your Short Position. Now.

A great investor and a wonderful human being, Whitney Tilson recently posted an article about why he is short Netflix (NFLX).
Whitney, who is a major co-donor with me to charter public schools like
KIPP, writes that he has lost money betting against Netflix, and that
he is still short Netflix in a big way.

At Netflix we mostly
focus on building our business and letting the numbers do the talking.
But Whitney is such a big-hearted donor to causes that I care about that
I am writing this open letter for him to try to get him to cover his
short now. My desire is to increase his odds of making money next year
so he can donate even more to the charter public schools that we both
think are important to our country’s future. For the record, I think
short sellers are a positive force in capitalism, and I acknowledge that
CEOs are generally biased in their bullishness on their respective
firms.

Whitney’s core short thesis in his article “Why We’re Short Netflix” is:

In particular, we think margins will be severely compressed and growth will slow over the next year.

This is the natural outcome of his view that:

We
don’t believe that Netflix has a better business model, better
management or a meaningful competitive advantage in the business of
streaming movies and TV shows.

Whitney
lays out a series of potential issues for us: Our CFO’s recent
resignation; threats to the First Sale doctrine for DVDs; internet
bandwidth costs potentially increasing; declining FCF conversion; market
saturation; weak streaming content; paying more for streaming content;
and increased competition hurting margins. He only has to be right on
one or two of these issues in 2011 for him to make money on his short of
Netflix.

Odds are he is wrong on all of them, in my view. Let’s take them one at a time.

As
to the CFO issue, Barry McCarthy is a very accomplished executive who
was working for a successful, younger CEO, so he correctly figured the
chances of him becoming the CEO of Netflix were not high. In early 2004
he had the same feeling, and let us know that we should launch a search
to replace him by the end of 2004. During that year we entered into a
huge fight with Blockbuster (BBI), and Barry felt it would be low integrity to leave us in the midst of battle. So, he agreed to stay for a few more years.

By
2008, we had substantially exited from our hand-to-hand combat with
Blockbuster, and he started talking with me about the need
for him to someday
soon go seek his future broader role. Two weeks ago, he informed me
that it was time for him to move on. He was willing to stay for up to a
year, like in 2004, if we wanted to do a search. After discussions
with the board, we chose his longest-serving finance lieutenant, David
Wells, as our next CFO, instead of doing an outside search, and
announced the transition. We feel great about David Wells as our CFO,
and there was no reason to ask Barry to stay further. Barry is a
super-principled guy, and if there were any known major danger, he would
never have left us. It is precisely because things look so good going
forward that he allows himself to think about his own career ambitions.
Some lucky firm will get him as CEO.

On the First
Sale doctrine, which only applies to DVDs and provides our right to rent
a DVD after its first sale, even Whitney acknowledges that any
potential change would not happen for several more years. Given the
rate of our streaming growth, by the time there was any change to the
First Sale doctrine, we would be not very sensitive to DVD costs. This
issue is not a material threat to 2011 results, and thus not a potential
reason to be short Netflix now. Perhaps Whitney was just trying to be
thorough.

Next in Whitney’s catalog is the issue of
potentially increasing internet bandwidth costs, given the recent fracas
between Level 3 (LVLT) and Comcast (CMCSA).
The cost of sending or retrieving a gigabyte of data has fallen every
year for at least 30 years. Advances in technology are making all the
parts of data transmission cheaper and cheaper, roughly following
Moore’s Law. The odds that the cost of moving a gigabyte of data
materially increase in the next few years are extremely low
.
It is vastly more likely that the costs continue to fall as component
prices fall. There is some chance that consumer ISP networks like
Comcast will prevail in their battle to not only charge consumers of
data, but also charge suppliers of data (e.g., Google (GOOG), Netflix, Apple (AAPL), etc.). This has been an ongoing battle for many years.

A
valid concern over the long term is how much power the consumer ISP
networks will have to charge data suppliers (i.e. content). In the case
of ESPN3, however, it is the reverse: ESPN3 charges consumer ISP
networks like Comcast for the privilege of transporting the ESPN3 data
to the ISP’s consumers (in essence, Comcast and peers are forced to
share some of the revenue of the $45 per month broadband package with
ESPN3). We don’t have any plans to go the ESPN3 route, but the odds of
material negative Netflix P&L impact from broadband pricing trends
in 2011 are very low.

Moving to more interesting
angles, Whitney documents our recent decreased FCF conversion due to us
paying for content earlier than we had in the past. With this angle,
Whitney does draw a little blood. Our new CFO David Wells and our
content team are all over our need to get more consistent about
pay-by-quarter for content going forward rather than pay-by-year, even
if it means we’ll pay a little more. We will be working to improve the
FCF conversion trend in 2011. On a long term basis, FCF should track
net income reasonably closely, as it has in the past, with stock options
as an offset against small buildups in PPE and prepaid content. Nearly
all of our computing is through Amazon (AMZN) Web Services and CDNs, which are pure opex.

Next
in the litany of Whitney threats is market saturation. In 2011, this is
unlikely to affect us. Streaming is growing rapidly; it is propelling
Hulu, YouTube, Netflix and others to huge growth rates. Streaming
adoption will likely follow the classic S curve, and we’re still on the
first part (acceleration) of the S curve. S
ince we expanded into streaming, Netflix
net subscriber additions have been 1.9m in 2008, 2.9m in 2009, and over
7m this year (estimated). While saturation will happen eventually,
given the recent huge acceleration of our business specifically, and
streaming generally, saturation seems unlikely to hit in the short term.

The next issue is what Whitney calls our “weak
content.” While Whitney may think “Family Guy” is weak content, our
subscribers do not. Furthermore, our huge subscriber growth to date has
been built on this “weak content,” so imagine how much upside we have as
we improve our content, as we are always trying to do. I think what
Whitney may be misunderstanding is that at $7.99 per month, consumers
don’t expect to have everything under the sun. A variant of this
misunderstanding is when DirecTV (DTV)
advertises against Netflix, calling out some Netflix content
weaknesses. When an $80 per month service is picking on an $8 per month
service, the $8 per month service just gets more attention from
consumers and grows even faster.

Moving on to the
widely-discussed issue of increased content costs, it is true that we
are paying more for any given piece of content than we were two years
ago, and that in two years, we’ll pay more than we pay today. Part of
our goal as a business is to make money for content producers and to
become one of their largest and best revenue sources. Fortunately, our
subscriber base is growing fast enough, and DVD shipments are growing
slow enough, that we can afford to pay for the existing streaming
content we have, and also get more content. We try not to comment on
specific deals, like the Starz renewal, as that rarely helps us get
deals done.

Investors sometimes see the content
cost threat as an issue around our margins. But we have no intention of
overspending relative to our margin structure, and there is no specific
content that we “must have” at nearly any cost. In our domestic business
we spend 65-70% of revenue on COGS (which is mostly content and
postage). So if content costs rose faster than we expected, then in
practice we’d have less content than otherwise, rather than less margin.
This would ultimately show up in less subscriber growth than we
wanted from a not-as-good-as-it-would-otherwise-be service; it would not
likely show up as a sudden hit to margins. Management at Netflix
largely controls margins, but not growth.

Turning
to competition, there is a legitimate short thesis in the unknown of who
enters directly against us and when. Some offerings like Hulu Plus have
some content we do not, but we are making progress on that gap. In the
near term, some of our subscribers will also subscribe to Hulu Plus, but
very few will quit Netflix because we have lots of streaming content
that Hulu Plus does not. For a competitive firm to materially hurt our
growth, they have to have some positive differentiator (price,
additional content, integration, etc.), and then they have to market
their service effectively. This wild-card of major new competitor
offering great content and marketing aggressively is the single best
near-term short thesis, but no one knows if it will happen in 2011.

The
core competitive barrier for direct competitors is
brand/subscriber-evangelism. Our large subscriber base is very happy
with Netflix, and tells their friends about Netflix. That means that the
cost of acquiring the incremental 1m subscribers is lower for us than
for a competitor, and thus our net additions are higher. There are also
lots of other smaller competitive barriers, but the happy subscriber
base is the big one.

Another competitive threat is TV Everywhere. If MVPDs (multichannel video programming distributors) are
successful at getting their subscribers (which is practically everyone)
to use TV Everywhere, which is free, instead of Netflix, for streaming
video, then the market opportunity for supplemental services like
Netflix and Hulu Plus will be much smaller. There is no additional
profit for MVPDs in TV Everywhere, but they are motivated to slow the
growth of supplemental services because of the fear that someday the
combination of ESPN3, Netflix, CNN.com, Hulu, YouTube, and others could
be an effective MVPD substitute over the internet. The TV Everywhere
threat will grow over time, but is unlikely to bite in 2011 in a
short-satisfying manner.

An issue that Whitney did
not bring up is potential Netflix international expansion that would
shrink global margins in the short term. We announced in October that we
were so pleased with our initial results in Canada, which, if trends
continue, will mean we can get to breakeven there one year from launch,
that we were likely going to invest heavily in further international
expansion, and that if we did so, it would be to the tune of a $50m hit
to global operating income in the back half of 2011. We think the
international opportunities for us to build profitable businesses may be
quite large, but the rapid expansion will lower global operating
margins as long as there are additional markets in which we can wisely
invest. Starting next year we’ll break out domestic versus international
for investors so they can track our progress for themselves.

To
wrap up, I have to agree with my friend Whitney that there are many
risks ahead for Netflix, that our valuation is substantial, and that it
is possible that one could make money shorting Netflix today. But
shorting a market leading firm as it is driving a huge new market is a
very gutsy call. On balance, I would rather have my co-philanthropists
on the long side of this particular bet.

Whitney: Short or long, I look forward to dinner and drinks together in the New Year.

Respectfully, your ally and admirer,

-Reed

Disclaimer:
The foregoing comments contain certain forward-looking statements
within the meaning of the federal securities laws, including statements
regarding threats to the First Sale doctrine for DVDs, internet
bandwidth costs potentially increasing, declining FCF conversion, market
saturation, weak streaming content, paying more for streaming content,
and increased competition hurting. These statements are subject to risks
and uncertainties that could cause actual results and events to differ.
A detailed discussion of these and other risks and uncertainties that
could cause actual results and events to differ materially from such
forward-looking statements is included in our filings with the
Securities and Exchange Commission, including our Annual Report on Form
10-K filed with the Securities and Exchange Commission on February 22,
2010. We undertake no obligation to update forward-looking statements to
reflect events or circumstances occurring after the date these comments
are posted.

Disclosure: I am long NFLX

Additional disclosure: I am CEO of Netflix

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Oh regional Indian's picture

Is there enough breadth of ownership in NFLX to cause a run if it were so decided?

Retail investors get out first? Cause a run on NFLX!

You can do it.

ORI

http://aadivaahan.wordpress.com

bobert's picture

I'm speechless......

I purchased Netflix service a year ago.

I wish I had purchased their stock at the same time.

pan-the-ist's picture

Same here.  I have a cable modem and netflix (no cable service), the kids watch blues clues all they want.  Occasionally I will send for a DVD.  If netflix can make money on my @9.99 a month, WTF did the cable company do with the $100+ more a month I used to give them?

bobert's picture

Blues Clues; Wiggles; and Veggie Tales @ my house!

Wild and crazy........

RKDS's picture

Buying infinite and ever-expanding copyright laws from Congress is expensive, as is paying/extorting for their "right" to be a local monopoly.

bobert's picture

RKDS:

It's too early in the morning for moral arguments.

I need a cup of coffee first!

-Michelle-'s picture

We just switched to their $7.99 streaming only after I realized that the DVD I have on my countertop has been sitting there for, oh, about 4 months or so.  We don't watch a lot of TV.  When we do, we're pretty sure to be interrupted within minutes.  Netflix is perfect for us and for our budget.

In the current economy, I would expect them to gain more customers as people realize that their cable and satellite service is full of expensive crap.

goldfish1's picture

I like the Blockbuster $1 per night new release available at the grocery store. Saves $$$ and time. Who doesn't need milk bread eggs lettuce fruit? Family video...on the way down in our town...how can you justify the overhead and payroll?

 

Perhaps they should put them in Speedway or WAWA or Circle K. Wow, what a brilliant idea.

blunderdog's picture

Just to be fair: the cable company has to maintain the infrastructure that Netflix uses for free, and that requires a fairly large base of service employees.

That's pretty expensive.

It'd be interesting to see how things played out if cable-providers started failing because of declining base of high-margin subscribers.  Could Netflix remain in business without them?

pan-the-ist's picture

Netflix doesn't use it for free, I pay the cable company for their service - how many times must the cable companies be compensated for this service?

blunderdog's picture

You're paying the cable company to maintain that infrastructure for you.  If Netflix was your ISP, you'd tack on another $40-$70 to the subscription price.  That's the point.  Did you really not understand that?

Although no one actually does it, a cable provider provides effectively unlimited data-bandwidth for delivery of teevee.  Your Internet connection can't handle that.  If you had 100 teevees all plugged in to your cable box, you could watch 100 different full-motion video pictures.

You're not going to pull that off with Netflix over a basic 5-10Mbit connection.  You can buy increased bandwidth, sure, and that starts to cost a lot more.

Don't get me wrong--I'm all for hating the cable companies.  Haven't had teevee for a decade, myself.  But you asked a question above that grossly misrepresents the comparison.

pan-the-ist's picture

I don't have 100 TVs, I only have 2.  I would guess that one would need 5 to 7 Mbit per TV.

Netflix isn't my ISP.

I pay for my bandwidth and bandwidth is (and should be) getting cheaper.

What's your point again?

-Michelle-'s picture

Not sure I understand the argument either.  I pay my cable company roughly $70 for internet and limited basic cable.  It's almost the end of the month.  According to my account information, I've yet to use half of my high-speed internet data allowance. 

Why should Netflix get an additional charge from my cable company again?

Taxes are used to build and maintain roads.  Auto manufacturers distribute products that use up space on those roads and cause wear and tear.  Should municipalities charge manufacturers a fee per car sold in order to help maintain infrastructure?

TexDenim's picture

When the CFO of a mail-order company tells you to cover, you cover, right? Or is Netflix incredibly overvalued?

SheepDog-One's picture

Hey only a 100 PE, Im sure its TOTALY justified and not a bubble or anything, due for big ups.

Also, just buy the f'n dips.

Oh regional Indian's picture

Cause a run on NFLX!

Move gains into PM's.

Double system whammy!

This could be ZH's Max Kieser movement/mement!

ORI

http://aadivaahan.wordpress.com

The Answer Is 42's picture

Well can't blame him for doing his job, which is managing a one-stock hedge fund.

firstdivision's picture

Hey, even Paulson & Co. lost money in the beginning of their massive short with the Advantage Fund.  I am certain that Tilson will eventually be right. The only thing is how much longer for this to top. 

Right now it looks like POMO's have been directed at putting a lid on the commodities.  Oil should be closer to $95 right now, but there seems to be a lot of resistance at $90 (as that makes the administration show that it is failing).  Wonder what equity outflows will look like when this new bubble breaks in the next year or two?  Getting massively burned thrice should make people realize they were duped into the most massive ponzi. 

eigenvalue's picture

Well, oil perhaps is a bit anaemic at the moment but look at sugar, cotton and other agricultural products. A drought is developing in Argentina. Guess next year, agricultural products will perform even better.

firstdivision's picture

You are correct and that just shows how much further a fair amount of commodities will run from here.  I still believe that the recent POMO's have mostly been used to try to put resistance into the commodities to prevent a further run up.  With the further upward pressure, they will snap like a rubber band again with limit up days happening frequently. 

*regarding the Advantage Fund comment*

Let's not forget that when Paulson put on his housing sector short, there was a lot of posturing from "knowledgeable" people that housing was not a bubble and was strong.

eigenvalue's picture

I haven't studied the fundamentals of Netflix so I can't comment too much on this company. But I think we shouldn't think that people like Paulson are correct all the time. We had better do our own research and make our own judgment instead of copying others' strategies.

firstdivision's picture

You are correct, we cannot believe that those that bet against are always right.  The issue with NFLX is that they are under the assumption that they cannot be charged extra for bandwidth, and that consumers will not be charged extra for bandwidth. 

While right now those views seem valid, the problem is with 2011.  I see the biggest threat to them are the ISP's.  ISP's are trying to boost their revenue streams as well. 

firstdivision's picture

*wtf...another duplicate.  I only hit save once, and I did not hit refresh.*

Al89's picture

And a possible civil war in Ivory Coast will make people's chocolate bars a little more expensive to say the least.

Iam_Silverman's picture

"And a possible civil war in Ivory Coast will make people's chocolate bars a little more expensive to say the least."

 

Except for the fact that Armajaro (Anthony Ward) is dumping their big acquisition form the summer.  It seems like their (his) bet on a smaller than average yield this year was a bad call.  Armajaro had gathered quite a position, and then took delivery, roiling the markets and getting a lot of publicity.  Too bad you can't sell publicity - it would have made up the difference in the beating they are taking now as they unload their 240,100 tons of cocoa.

So, it may not look so grim for the chocoholics after all!

buzzsaw99's picture

From a customer perspective netflix seems a fair value, for now. As for NFLX stock and CEO one thing is sure, Hasting and other insiders will become filthy rich no matter what happens.

RobotTrader's picture

Shorting strong stocks on a strong tape is pretty stupid.

If anyone wanted to be short stocks, they should have shorted the weak ones, not the strong ones.

Here's an example:

buzzsaw99's picture

The only weak company you could think of was a small cap?

firstdivision's picture

I am still waiting for CMR to pop.

Bay of Pigs's picture

Predictable. I assume you will be on the right side of the trade if Netflix corrects? And you badmouth the miners as the "get righ quick" crowd. What a joke.

Dismal Scientist's picture

Shorting momentum stocks is a fast way to lose money. Most funds cannot take the unrealised losses mounting up in a liquidity driven environment. Shorting tends to work far better for business models which have been proven to be broken, ie: Blockbuster. Netflix ate their lunch, they were the short.

IQ 145's picture

 Don't pay any attention to these negative comments; you have a really pretty bra, and that's the important thing.

unununium's picture

The mark of the momo trader.  Buy high, sell low.

SpeakerFTD's picture

Compared to some of the shriller responses of CEOs defending faulty business models,  I thought that was a pretty classy response. 

In essence, I agree with both heart of both arguments.  NetFlix has a nice business model.   It is a good business.  It is also widely overvalued by the stock market.

Here's to hoping that both NetFlix has a long, prosperous future as a media company, and that Tilson gets paid for calling shenangians on the mo-mos.

 

Al89's picture

I think the response had a very arrogant tone to it. I also think the latest earnings call, judging by the transcript, sounded a little arrogant, but some how less assured than other calls.

The financial statements look weaker, sure they added 2million new subs in Q3 but their income dropped and their margins were squeezed badly. This stock may not be a bad company but it is overvalued and in a highly competitive market.

This response makes me feel more confident in holding my puts. Hastings is not a philanthropist, he doesn't want to save anyone short his stock any money, a CEO in charge of a company in which he has total confidence should not need to make these petty statements on forums like SeekingAlpha. 

SpeakerFTD's picture

I agree with you there.  The tone reminded me of the The Ben Bernank as he uttered his 100% confidence call. 

As the old saying goes,  hubris goeth before a 15% gap down open.

 

 

IQ 145's picture

 A quiet smile, and "no comment" would scare the "short" out of the shorts. He needs a new pr guy.

Bartanist's picture

Agreed. In a world where performance and fundamentals mattered a CEO should not care about stock price because stock prices would take care of themselves as performance improved.

However, in this world, it is not performance and fundamentals that matter, but those with financial weapons aimed at the back of your head and those with an implied threat always on their lips that matter. When one gets in bed with snakes and spiders, it is best not to fall asleep. (of course only a desperate man would get in bed with the snakes and spiders in the first place)

Al89's picture

goddamn multi posts. NFLX must be hogging all the bandwidth again. 

Al89's picture

delete. Post was meant to be in response to the guy below me.

monopoly's picture

I always find it intersesting when a CEO lashes out at any wall street analyst. My experience advises there is something wrong when they do that and it is just a matter of time before the stock moves lower.

But, am not short any, have not been for months and may have to review shorting stocks again since I almost forgot how to short.

max2205's picture

-15% from the highs...buy the dip?

bobert's picture

Netflix is paying for space on ZH along with some other 

companies that I respect like BMW & AMTD.

They must be pretty smart.

pan-the-ist's picture

Zerohedge's add agent (I think) searches your cookies to see what you're interested in and presents and add accordingly.  Nothing overly magical...

bobert's picture

Oh. I get it.

Makes sense.

Still good companies :)

TheProphet's picture

So you're getting gay porn ads?