Full Disclosure: this blogger bailed on Netflix prior to the Netflix train wreck. Netflix didn't carry a series that is in its third season on the FX cable channel: "Justified." Amazon Instant Video loads the current episode the day after it runs on FX. Stay tuned for the best opening theme music since "The Sopranos."
[x YouTube/Fotokino Channel]
Long Hard Times To Come
By Gangstagrass & T.O.N.E.Z.
If this is a (fair & balanced) reason to leave Netflix for Amazon Instant Video, so be it.
[x Vanity Fair]
Seeing Red
By William D. Cohan
Tag Cloud of the following article
Reed Hastings, 51, the C.E.O. of Netflix, is bloody but only slightly bowed. When his company was at the pinnacle of success, just last summer, he refused my repeated requests to discuss his apparent business prowess. He claimed to be reticent about being interviewed, disdaining the limelight and the attention it brings to him and his family. His low-key, unrehearsed manner—he is prone to gaffes involving hot tubs, among other things—makes it clear he is not having fun when he talks to the media. What little publicity he does is only to benefit Netflix. “It’s an appropriate and necessary sacrifice . . . but on a personal basis, it’s pure downside, because then you just get more recognized,” he says. “You lead a less normal life. I hate the photo shoots. I hate all that stuff.”
But after presiding over perhaps the worst self-inflicted corporate wound since Coca-Cola introduced New Coke, in 1985 (and then promised to continue making the old Coke after a tempest of consumer ire), he finally relented in early December and met me at a Midtown Manhattan hotel. He still had on the garish burgundy shirt and tan jacket he had worn earlier in the afternoon during a UBS investor conference. Despite his stratospheric Silicon Valley reputation and quasi-billionaire status, he comes across more as the preppy hockey player he once was than the high-tech mogul he has become.
As if working his way through some sort of corporate 12-step program, Hastings forthrightly admits that the events of the summer were not his or his company’s finest hour, but he believed it was “healthy” for leaders to have “a reservoir of self-doubt, because it’s how you create an internal dialogue and how you check your assumptions.” Still, despite the company’s rebound in early 2012 (share prices have nearly doubled since December), many Netflix investors wish Hastings had doubted his instincts a bit more than he did.
The son of a lawyer who once served in the Nixon administration, Hastings has degrees in mathematics, from Bowdoin College, and artificial intelligence, from Stanford University, but he was never a desk-bound geek. After stints with the Marines, the Peace Corps (teaching math in Swaziland), and various software start-ups during the initial Internet boom—when he made a first fortune of around $75 million after selling Pure Software, a debugging company—he co-founded Netflix, in 1997, with Marc Randolph.
The series of catastrophic missteps in question regarding Netflix started July 12, when—without a whole lot of preparation or warning—the company announced that if its customers wanted to continue receiving the movies and television shows on DVDs that arrive through the mail in Netflix’s signature red envelopes they would have to pay $7.99 a month for the privilege. If they wanted monthly access to streaming content over the Internet—no DVDs or mail involved, just instant gratification—the cost would also be $7.99. If they wanted access to both DVDs and streaming content, the price would be $15.98 a month ($7.99 plus $7.99), up from a combined monthly price of $9.99. “We think $7.99 is a terrific value for our unlimited streaming plan and $7.99 a terrific value for our unlimited DVD plan,” Jessie Becker, Netflix’s vice president of marketing, announced on the Netflix Blog with the typical corporate happy talk that often accompanies really bad news. “We hope one, or both, of these plans makes sense for our members and their entertainment needs.”
Since this was not rocket science, it took about a nano-second for Netflix’s 24 million or so customers to realize that they were being hit with a 60 percent price increase; what had once cost $10 a month would now cost $16. Even though the price to see a first-run movie in a theater on the nation’s two coasts averages around $13 per ticket, the social networks and the blogosphere lit up with such instant fury you might have thought Hastings had dropped a nuclear device on his customers. Greg Heitzmann, a University of Missouri graduate, was typical of the nearly 13,000 people who went on the Netflix Blog to express their anger: “To say the least, I am shocked and appalled at your recent behavior,” Heitzmann wrote. “Your nominal price increase, while unexpected, does not deter my loyalty. However, your mouthpiece Jessie Becker’s presentation of this upcharge—as an added choice for my own benefit—insults my intelligence and reveals the breadth of your arrogance. Had I been treated like an adult and informed of these changes in a straightforward, honest manner, perhaps we could rekindle our spark. Unfortunately, this course of action is no longer available; your condescending and manipulative tone has irreparably ruined our relationship.” Heitzmann canceled his subscription. He was not alone. More than 800,000 Netflix subscribers dropped the service within months of the July announcement.
As customers continued to flee, Hastings leapt into the fray to try to explain. “I messed up,” he wrote on the Netflix Blog on September 18. “I owe everyone an explanation. It is clear from the feedback over the past two months that many members felt we lacked respect and humility in the way we announced the separation of DVD and streaming, and the price changes. That was certainly not our intent, and I offer my sincere apology.”
“We weren’t doing the price change to raise profits or something,” he elaborated to me. “We were doing it because we were so focused on becoming the streaming company and the global streaming company that we always wanted to be, and always have wanted to be.” He said that he sees the future of Netflix similarly to how big telephone companies see their futures in wireless, rather than in landline, phones. “Most companies that are great at something—like AOL dialup or Borders bookstores—do not become great at new things people want (streaming for us) because they are afraid to hurt their initial business,” he wrote on the blog.
Hastings took the blame for the failure to communicate better with customers. “In hindsight, I slid into arrogance based upon past success,” he wrote. “But now I see that given the huge changes we have been recently making, I should have personally given a full justification to our members of why we are separating DVD and streaming, and charging for both. It wouldn’t have changed the price increase, but it would have been the right thing to do.”
But with the mea culpa behind him, he proceeded to make matters even worse, by announcing that the DVD-by-mail service would be split off from the streaming service and renamed Qwikster—“because it refers to quick delivery,” he explained—with its own Web site and its own C.E.O. The streaming service would still be called Netflix and be the focus of the company’s energy and its future growth. There would be no more price increases—“We’re done with that!”—but keeping both services would now be even more cumbersome, requiring two separate accounts, two separate monthly credit-card charges, and twice as much effort as before. “So if you subscribe to both services, and if you need to change your credit card or email address, you would need to do it in two places,” he announced. “Similarly, if you rate or review a movie on Qwikster, it doesn’t show up on Netflix, and vice versa.” With that, he said, he hoped to regain the trust of his customers.
Accompanying this surprising announcement was a lame video of Hastings along with Andy Rendich—the presumptive new C.E.O. of Qwikster. Hastings was rocking the casual look in a Gap T-shirt underneath some sort of flimsy, ill-fitting teal work shirt. His Oakley sunglasses rested in front of him on his IBM ThinkPad. At one point, he flubbed a line and repeated it—a homey touch that remained in the video. He observed correctly on the Netflix Blog, “You’ll probably say we should avoid going into moviemaking after watching it.”
Faster than you could say “Qwikster,” the amateur video became fodder for the late-night comics. Conan O’Brien spoofed it with a parody video that claimed returning a Netflix DVD was now as easy as just throwing the red envelope out of a moving-car window or putting it in a hedge or flushing it down the toilet. “Don’t worry, we’ll get it,” he cracked. "Saturday Night Live" recorded its own parody of the Hastings/Rendich video—replete with the goofy attire—and released it on the Internet. (Hastings believes it wasn’t funny enough for the actual show, although it was pretty darn funny.) Then a fake Hastings appeared in another "S.N.L." spoof, of a "Charlie Rose" show. After Rose asks Hastings if Netflix and Apple could be compared, Hastings says, “Comparing Apple to Netflix is like comparing apples to oranges, especially if the oranges made so many mistakes that people stopped eating oranges and just went back to Blockbuster.”
Hastings’s screwups were taking their toll not only on Netflix’s customer base but also on its financial prospects. Fewer customers meant less revenue and cash flow at the very moment Netflix’s ambitions required larger and more expensive deals with the Hollywood studios that provide the content to stream. For more than a year, Netflix’s stock had been a rocket ship as nearly every one of the company’s pronouncements had been met with dizzying investor approval. For instance, after the company announced on the morning of July 5, 2011, that it was set to offer its services in 43 Latin American and Caribbean countries—a potential new broadband customer base estimated at 45 million people—the stock jumped from $268 per share to an all-time high of $291 per share and a market capitalization of more than $15 billion. Shortly thereafter, the stock hit nearly $305 per share. A year earlier, it had been at $117; two years ago, it was at $40. That Netflix traded at a price-to-earnings ratio of more than 80 times its historical earnings seemed to be lost on most investors.
But after Hastings’s missteps, the stock went into free fall, dropping to $113 per share in early October, from $210 in the second week of September. It would hit a low of $62 a share in November. The few—but vocal—short investors (someone who bets a stock’s price will fall and then does what he can to make that happen) and research analysts who had long felt the stock was grossly overvalued and overhyped were wallowing in Schadenfreude.
Finally, on October 10, Hastings pulled the plug on Qwikster. The explanatory blog post was short and sweet. “It is clear that for many of our members two websites would make things more difficult, so we are going to keep Netflix as one place to go for streaming and DVDs,” he wrote. “This means no change: one website, one account, one password . . . in other words, no Qwikster.”
And not a moment too soon. Some $12 billion of Netflix’s market capitalization had been wiped out, and some Hollywood suppliers to Netflix had begun to wonder if the company could continue to pay its bills on time. Wall Street’s faith in the company was shattered. People were calling for Hastings’s head. Things were looking so desperate that on November 22—after not having bothered to tap the capital markets when the stock was at or near its all-time high—Netflix raised a fresh $400 million in equity: $200 million from a longtime investor, Technology Crossover Ventures, and another $200 million from public investors at $70 a share. This was seen as a sign by some that the company was strapped for cash.
The question lingers how Hastings, who sits on the boards of both Microsoft and Facebook, could have made such spectacular blunders. Just a year earlier, Fortune had put him on its cover as its “Businessperson of the Year.” His three appearances on "Charlie Rose"—in 2005, 2006, and 2011—were treated as the Second Coming. Had Hastings come to believe in his own invincibility? Was this a case of pride going before the fall? Or a failure to listen to advice? Or was this a simple failure of public relations?
In an October 24 article in The New York Times, Hastings recalled that he had been soaking in a hot tub with a friend (Hastings lives in Santa Cruz with his wife and two teenage children, after all) when he shared with him the news that Netflix planned to separate the DVD business from the streaming business. “That is awful,” his friend responded. “I don’t want to deal with two accounts.” But Hastings “ignored the warning, believing that chief executives should generally discount what their friends say.” Now he admitted that he had been “guilty of overconfidence and of ‘moving too quickly,’” and “hubris,” even. The harsh reaction from his customers was due to the “angry mood of the country,” he said, citing both the Tea Party and Occupy Wall Street political movements. He again clarified that he did what had to be done. “We still need to move quickly in streaming,” he said.
That same day he told investors on Netflix’s third-quarter earnings call that the decision to create Qwikster was “hard to justify” and that after the price increase “Qwikster became the symbol of Netflix not listening.” He reiterated that “we quickly changed course on that. And we are going to stick with DVD as part of the Netflix brand. And going forward we will be very aggressive on promoting streaming Netflix and the benefits, and anyone who wants to also subscribe to DVDs will be very welcome, but we are going to be pushing and promoting streaming.”
If their critics are now legion, Hastings and Netflix retain the unequivocal support of many of the Hollywood studios, of which Netflix has become an increasingly important customer. “They continue to be a good partner for us,” says Philippe Dauman, the C.E.O. of Viacom. “Reed is a guy who’s smart, who takes calculated risks, and when something goes awry, he admits it, and he moves forward. The subscriber count is stabilized, and actually Reed mentioned that to me when I saw him recently. It’s still a great service. They keep acquiring more content, which makes it more valuable to their customers. In my mind they continue to have a good consumer proposition, and of course they raised some capital, so they’re on very solid ground.”
Explains Ron Meyer, the longtime head of Universal Studios, “When you have the resources they have and the reach that they have—we’re all looking for new revenue streams—they’re the newest and most exciting, and biggest.” How important a customer is Netflix to Universal? “On a scale of 1 to 10, they’re a 10,” Meyer says.
Les Moonves, the president and C.E.O. of the CBS Corporation, thinks Hastings and Ted Sarandos, 47, Netflix’s chief content officer, whose portfolio is dealing with Hollywood, are two of the smartest people in the industry. “Our goal as a content provider is to get paid in as many ways as we possibly can,” says Moonves. “And the reason we welcomed Netflix into the marketplace is they’re paying us in a brand-new way that opens up many horizons for the future.” And that future may include CBS-produced original content for Netflix, Moonves announced on a conference call this month.
Jeffrey Katzenberg, the C.E.O. of DreamWorks Animation, is perhaps Hastings’s biggest booster, claiming that Hastings is one of the few in Silicon Valley who truly deserves being called a visionary. “He has shown a great sense of being able to adapt to a rapidly changing world of how people want to see movies and how they value great movie and television content being brought to them, and how their habits are changing,” he says. Katzenberg thinks Hastings proved to be an effective leader during the summer: “He has shown two of the most exceptional qualities of a great C.E.O. and leader, which is first recognizing how his business is transforming and being very aggressive about innovating and adapting to those changes as they’re going on. It’s just he, I think, moved too far ahead of the transition from hard goods to digital. There’s no question whatsoever what he was pursuing is in fact what ultimately is going to prevail. And the fact that he did it a beat too soon I think is the only mistake.
“Quality number two,” Katzenberg says, “is that, having made a very bold and important and looking-into-the-future decision and then seeing that he got ahead of his customers, he did again what others find so difficult to do, which is acknowledge the mistake, fix it, and reset the business back. There may have been an awkwardness in the process of doing it, but those decisions were bold, smart, and imperative. What those short-term knocks are has just made him and the company smarter and stronger.”
All of this praise is simply too much for Rocco Pendola, one of the most outspoken “shorts” on Netflix’s stock, who unleashed a November 28 tirade against the company on the Seeking Alpha blog. Pendola had been reading Haruki Murakami’s latest book, 1Q84, and he concluded that, like Aomame, the main character in the novel, “I must be living my own reality separate from [Netflix] bulls.” He wrote that he could not understand why, despite the separation fiasco and the near collapse of the stock, any number of publications and research analysts were still trumpeting Netflix as an investment. “Simply put, these moves that Reed Hastings made represent nothing more than desperate reactions to a broken business model,” he wrote.
He then wondered why, if Netflix’s business fundamentals were so good, it had suddenly decided to raise $400 million in new equity—what another blogger called “a desperate cash grab” with absolutely horrible terms. Pendola called “comical” the explanation from Steve Swasey, Netflix’s V.P. of corporate communications, that, while the company had no “pressing need” for the cash, “it’s always nice to have more money than you need.” Concluded Pendola, “If you cannot clearly read the writing on the wall after everything that’s happened, you deserve to lose your money and average this dog down as it craters to below book value. Or, as Murakami stated so well: ‘If you can’t understand it without an explanation, you can’t understand it with an explanation.’”
One of Pendola’s heroes is Tony Wible, who since 2008 has been the media-and-entertainment research analyst for Janney Montgomery Scott, a small Philadelphia-based brokerage that wouldn’t know a tarp loan if it were hit over the head with one. Wible could not be more different from Hastings. At 35 he is chunky and balding but with the irrepressible confidence of youth. Wible used to work for Citigroup—until that company almost went under during the financial crisis—and for years his cubicle was outside the office of Jack Grubman, the infamous telecom analyst who specialized in trading favorable research reports for hundreds of millions of dollars of investment-banking revenue. Grubman, who was paid more than $48 million between 1999 and 2001, pumped up the stock of WorldCom during the years before that telecom company imploded in an ocean of accounting shenanigans. “I vividly and painfully remember those days,” Wible says. “Having gone through seeing what happened with WorldCom, having seen what’s happened with other companies, I feel like you can’t fully trust management. You have to look at what the numbers tell you, and nobody’s going to tell you in advance if something’s not working. I’m sure the guys at Enron and WorldCom would have said everything’s fine. They’re never going to say they’re not fine. I don’t know of any management team that ever goes out proactively to say that things aren’t working or when they’re not going to work.”
When it comes to Netflix, Wible sees red flags everywhere. On June 14 he issued a rare “sell” rating on Netflix’s stock, when it was trading at around $257 per share. (Only 2 percent of Janney’s research reports carry a “sell” rating, and, unlike analysts at both Goldman Sachs and Citigroup, he knows his company won’t be doing investment banking with Netflix anytime soon.) Wible estimated that the true value of Netflix’s stock was then $170 per share, or one-third less than where it was trading.
Wible claimed the company was using two accounting gimmicks to prop up its profitability: not properly amortizing the cost of buying its streaming content (the value of which it was depreciating twice as slowly as that of its DVD content) and doubling the amount of time it took to pay its bills. Both of these, he claims, allowed Netflix to overstate the amount of cash flow it generated in 2010, when it reported $118 million in “free cash flow”; Wible figures the company really lost $12 million, and its cash flow has declined for three of the past four quarters that preceded 2012. The lower cash flow spells trouble, according to Wible, since Netflix is having to pay more and more for its content as well as for the increased broadband usage of its subscribers. The only way it can counter this double whammy is either to raise prices or to increase the number of its subscribers to 60 percent (from its current 30 percent) of homes with broadband by the first quarter of 2012, which it was unable to do. But higher prices were likely to result in fewer subscribers—he predicted correctly—not more.
Wible was also bothered by the sudden resignation of Netflix C.F.O. Barry McCarthy, in December 2010, who had spent the previous year selling his Netflix stock, worth $58 million. And, worse, he believes, Hastings had been continuously selling his stock for several years, some $81 million worth, according to S.E.C. filings—“although we are encouraged to see that he has stopped selling stock as of early October,” says Wible. In December 2011, Netflix announced that Hastings’s total compensation for 2012 would be $2 million, 43 percent below his 2011 compensation of $3.5 million.
The Netflix executives disagree with nearly every one of Wible’s arguments. According to them, Netflix is not stretching payables. It is not misleading anyone about its accounting. (Netflix’s Web site provides a clumsy explanation.) It will be able to continue to grow its subscriber base both in the United States and in foreign countries. The C.F.O. left because he wanted to pursue a C.E.O. role. (He now works for a venture-capital firm.) They don’t waste a moment worrying about the stock price; instead, they spend their time thinking about how to improve their business and how to serve their customers better. Yes, they will pay more for content in the future, but only in a way that makes financial sense for the company and for its subscribers. As for his ongoing stock sales, Hastings says, “I think the message that it sends is the C.E.O. is prudent. I think investors want companies to be led by prudent people, and I should have a stake in the company for sure. I have a huge stake, but you want it to be led by someone who’s also prudent.”
On November 22, with Netflix’s stock down to around $75 per share, Wible issued another “sell” rating with a new price target of $49 per share. He sums up the core problem with Netflix’s business model this way: “If they didn’t position it as a cheap rental service, they probably wouldn’t have gained as much market share, but by positioning it as a cheap rental service, they’re probably not able to take up pricing as much. And what I have maintained is that Reed is a smart guy, but I believe that he’s managing to the best of bad outcomes.”
In recent weeks, following a better-than-expected fourth-quarter 2011 earnings announcement (which saw 220,000 new streaming-only customers and a profit of $52 million in that segment), Netflix’s stock has rebounded to around $124 per share. The bears remain incredulous. “What we have here is a momentum stock divorced from its underlying company’s reality,” Pendola wrote January 27 on the Seeking Alpha blog. “It would not shock me in the least to see [Netflix] move on air back to $300 a share before its next earnings report. At some point, however, the same thing that happened in 2011—a full-on implosion—will take shape sooner, rather than later.” Added Wible, in a recent e-mail, “Seems like we are back to 2010 again.”
By the time Hastings made his first-ever appearance at UBS’s annual global-media-and-communications conference, in Manhattan on December 6, the room was packed with investors wondering what he would say next. “Last year, you couldn’t take a step without people asking about Netflix,” one investor remarked. “This year, everyone is here for the funeral.”
Seated at the front of the room, Hastings took his lumps and tried to move on. “Last year, you were the talk of the conference, I believe,” said Aryeh Bourkoff, the head of investment banking for the Americas at UBS, by way of introduction. “I think there was a combination of mystique and envy and fear—”
“Now it’s just pity,” Hastings quickly interjected.
During our interview, Hastings insisted on putting the whole mess into perspective. “When I look at the challenges that Gandhi had, or the various leaders through history, our challenges pale in comparison to this,” he said. “Over the last 10 years, I’ve read a ton about Winston Churchill and Abraham Lincoln. I’ve worked very hard, but my life’s always been fun. It’s not been the Civil War of 1862. That was dark, and how you hold things together at a time like that is completely different than what we experienced. When we had our stumble—in comparison to a health crisis—I slept well every night. I didn’t get all tense. Our issues were ones that were unfortunate business judgments, not of morality or ethics or scandal.” Ω
[William D. Cohan is a contributing editor at Fortune, and award-winning former investigative newspaper reporter based in Raleigh, North Carolina, who worked on Wall Street for seventeen years. He spent six years at Lazard Frères in New York and later became a managing director at JP Morgan Chase. Cohan is a graduate of Duke University. He has written The Last Tycoons: The Secret History of Lazard Frères & Co. (2007), House of Cards: A Tale of Hubris and Wretched Excess on Wall Street (2009), and Money and Power: How Goldman Sachs Came to Rule the World (2011).]
Copyright © 2012 Vanity Fair — Condé Nast Digital
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Sapper's (Fair & Balanced) Rants & Raves by Neil Sapper is licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 3.0 United States License. Based on a work at sapper.blogspot.com. Permissions beyond the scope of this license may be available here.
Copyright © 2012 Sapper's (Fair & Balanced) Rants & Raves
