Impromptu Speech Topics: Making Free Money Online

Netflix is one of the best performing stocks this year, up 225 percent year-to-date, with a $9.3 billion market cap. But it is also priced to perfection, with a lot of short sellers hoping to profit from its fall and antsy Wall Street analysts downgrading the stock. Today, CEO Reed Hastings defended Netflix’s prospects in a very public, very detailed, and very unusual blog post on Seeking Alpha. The post was in response to a specific short seller, Whitney Tilson, who last week laid out his case against Netflix in another Seeking Alpha blog post. By addressing this one short seller, of course, Hastings is trying to address the market’s jitters as a whole, and he does a pretty convincing job of it.

Tilson raised a number of concerns, ranging from the recent resignation of Netflix’s CFO to pressures on Netflix’s margins to market saturation and increasing competition in streaming video. Hastings acknowledges that Tilson “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.”

Hastings then goes on to rebut the short seller’s argument (short sellers are investors who bet against a stock). I’ll summarize each of Hasting’s counter-arguments below:

The CFO left because he wasn’t going to become CEO anytime soon.

The First Sale Doctrine (which allows Netflix to rent DVDs after purchasing them) may be under attack, but it won’t change in 2011. And Netflix’s video streaming business is growing so fast that by the time it does have any impact on DVD costs, it won’t matter anymore.

Internet bandwidth costs should continue to decline, and while ISPs might like to charge content providers for data, that won’t happen in 2011.

Free cash flow has taken a hit because of the increased payments Netflix is making to media companies and content owners, but Netflix will begin smoothing that out on a quarterly basis instead of taking big hits once a year.

Market saturation in streaming video over the Internet is not yet an issue. Market demand is still accelerating.

Criticisms about “weak content” are not supported by subscriber’s voracious appetite for what Netflix has to offer, but Netflix is trying to get better movies and TV shows all the time.

Content costs are going up, but postage costs are going down as viewers shift to streaming.

If necessary, Netflix will take a hit to growth before taking a hot to margins. ”Management at Netflix largely controls margins, but not growth.”

Netflix is facing a growing number of competitors in streaming video, but it maintains advantages in scale and brand.

TV Everywhere could become a long-term threat, but it is more of a defensive move fro the cable companies rather than a new profit engine.

International expansion could have an impact on margins in the short term

Let’s drill down further into some of these issues. Netflix is obviously betting big on the transition to streaming video. The more it can get subscribers to watch streams instead of DVDs, the more it saves on postage. On the flip side, video content owners are demanding more money for those streaming rights. Hastings thinks that concerns about too many streaming services coming online is overblown at this point:

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. Since 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.

And while a major new streaming competitor could come in and blow away Netflix’s lead, Hastings makes the case that Netflix has a huge competitive advantage when it comes to the number of existing paying subscribers and its cost to acquire new ones:

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

Finally, in terms of the quality of the movies and TV shows Netflix makes available for streaming versus what people get on cable TV, Hastings points out:

. . . 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.

The key question is whether some combination of Netflix, Hulu Plus, YouTube, Google TV and other Internet video services will some day effectively replace the cable TV experience. And if it can, whether that combination will cost more or less than the $80 or more people pay for cable today. But remember, people are already paying for Netflix, which helps Hasting’s case.

Whether or not the stock will keep going up is another question entirely. At $178 a share, would you buy or short the stock?

It’s that magical time of the year when brand preferences are being lodged in the consumer psyche by any means necessary, be it free online shipping offers or conventional “doorbuster” style shopper stampedes. (Plus, in an admirable show of advance conditioning, there are those sidebar Four Loko-fueled parking lot brawls.)

But the romance of the brand is a notoriously ephemeral thing, as any casual survey of thrift-store Tickle-Me Elmo and Tamagotchi displays will promptly demonstrate. To do the job right, in this as in so many other realms, we would do well to heed the example of the Germans. As Bloomberg’s Chris Reiter reports, Deutschland’s Big Three automakers—BMW, Mercedes, and Audi (now a Volkswagen property)—have long been locked into a battle for the overtaxed attention spans of the youth market.

Back in February, Audi made a dramatic bid for high-end kiddie allegiance with a $13,300 model of a 1930s roadster, evidently calculating that a Weimar-era collectible is the perfect bridge to the true sturm-und-drang of a privileged adolescence. The model comes replete with “an aluminum frame, hydraulic brakes, seven speeds, leather-clad steering wheel, and oak dashboard,” and nearly sold out of its initial 500-unit manufacturing run, Reiter notes.

The idea behind such lush toy marketing, of course, is to instill intense brand-loyalty among the market’s littlest thought leaders. "Merchandising is important not because you can make huge money with it,” Audi sales chief Peter Schwarzenbauer tells Reiter, “but because it's another means of positioning your brand.” That means that Audi isn’t confining its initiatives to pint-sized drive trains, but is branching out to other durable badges of status, such as a $17,000-plus table soccer game—the idea here, evidently, being not so much to cultivate hooligan-style soccer fandom in the plutocratic young, but rather to inculcate the more genteel and respectable habit of full-scale team ownership.

It’s true that Audi isn’t neglecting more downmarket kiddie consumers in its push, with a $60 branded teddy bear and a $400 red-plastic version of the roadster; here, the functional array of model accessories include “an adjustable rollover bar, hand brake, over-sized tires with Audi-style rims, and padded seats.” But the main event is clearly the scrum for top-line market cachet, which is why Audi’s rivals are stepping up their game. Mercedes, for instance, is planning a spring rollout for “the foot-powered SLS Bobby-Benz, featuring headlights, grill, and rear end similar to those of the company's $183,000 SLS sportscar. The toy SLS features quiet-running tires, an Ackermann steering system with tight cornering for living-room maneuverability, and a steering wheel that absorbs impact to prevent injury in the event of a collision.” The model will boast a comparatively modest $120 asking price—but that loss-leader price point is a small sacrifice when you’re grooming future six-figure auto customers. "All the products have to live up to Mercedes' standards for quality and safety—especially our toys, which are all-time favorites with the next generation of Mercedes-Benz customers," reports Christian Boucke, who heads up the Benz accessories division.

BMW, meanwhile, appears to be the most horizontally minded lifestyle competitor in the luxe-branded market, brandishing a wide panoply of gear from a $460 kid-scale version of its M3 GT2 race car to a pair of $50 rain boots. The Beamer accessories division also turns a healthy 7 percentish profit—even though its brand-keepers, too, stress their real stake is in the longer-term loyalty game. “We are first and foremost a marketing initiative, and the main objectives are to broaden the brand's presence and strengthen loyalty," says Thomas Goerdt, who directs BMW’s distinctly un-German-sounding merchandising and lifestyle unit.

Still, the great risk of too-rampant accessory branding is market saturation—which is why Michel Gabriel, a branding specialist who has advised past Audi projectS, draws the line at underwear, even though “a lot of money can be made from a product” aimed at the intimate end of the brand market.

We can’t help thinking, though, that the Grosse Drei auto barons are selling short tomorrow’s financial titans with mere miniature knockoffs of luxury rides—and not just because their British competitor, Aston Martin, still owns the highest tip of the market with a Volante Junior model fetching a cool $24,000 with a devoted consumer base of young royals—who have duly gone on to modify their fullscale Astons to run on wine.

After all, the lesson of branding the world over is that a truly consummate brand eventually eclipses its mere material referent—hence the power of the glyphlike Nike swoosh (which only cost the firm $35 when design student Carolyn Davidson submitted in in 1971), or the “i”-themed Mac brand interface. Likewise, the business model for Mercedes has involved coaxing lavish multimillion-dollar subsidies from U.S. lawmakers at the same time it’s presented itself as an above-the-fray survivor of the 2008 global auto downturn.

Likewise, BMW has briskly seen to it that influential state congressional delegations have placed its own export interests ahead of the bailed-out U.S. auto industry—while Audi’s corporate parent Volkswagen has at least been candid in soliciting U.S. bailout funds, while also putting in for homeland funds to shore up its rickety loan operation. (Needless to say, this corporate pursuit of public-sector handouts doesn’t seem to have softened VW’s stand on American union drives, since like other foreign automakers, it’s expanded operations in anti-union right-to-work states to evade higher labor costs at home.) All of which is to say that, if doting plutocratic parents are looking to instill formative brand preferences this holiday season, nothing says “heed daddy’s example” like a simple, influence-subsidized government check. And Lord knows that for the properly connected family or industry, a good government kickback is about as hard to obtain as a pair BMW rain boots.

You, valued and valuable reader, are invited to join Chris Lehmann and your other fellow rich people to celebrate the publication of Rich People Things, this Thursday, December 2nd, at Le Poisson Rouge in New York City, from 7 to 9 p.m. There will even be a brief chit-chat with Thomas Frank and Maureen "Moe" Tkacik.

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Wednesday, December 22, 2010

Making Free Money Online

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