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