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Investing for Nerds: Exploring Netflix

by on September 29, 2011

I’m sure all of you are well aware of Netflix’s (NFLX) recent woes. The separation of its DVD and streaming services, combined with a price hike, has prompted an angry outcry from Netflix’s customer base. To save face, the company rebranded its DVD service Qwikster, a change which has been widely ridiculed. Recently, the company has cut its forecast by a million subscribers. This has sent Netflix stock into a plummet of more than 50% of its 52-week high. Now, I’m trying to decide if there is opportunity in this bad press, and if this is a massive overreaction or a reasonable correction.

In July, after the announcement of the service split-up, our own Nicole Campos wondered whether she would keep Instant Play and explored some of her more frivolous viewings. I’m sure most folks had a similar debate with themselves over which service to choose or to just suck it up and accept the new price. As she mentions in her article, an additional $5.99 doesn’t seem like much but, when compared to the $9.99 the service started at, it’s a 60% increase for essentially the same service. As a consumer, I totally understand this sentiment. If Starbucks hiked its prices by 60% I might have to rethink my occasional Salted Carmel Mocha, because $4.50 is a bit steep, but over $7 for a freaking coffee?!?! Robbery!

This customer reaction is basically investors’ worry about Netflix alienating its customer base, and the massive price dip reflects that. We’re no average investors though. No, sir. WE ARE NEEEEERRRRDS (read like the eternally shirtless fellow in 300). Most seem to agree that streaming video is Netflix’s future, and, clearly, CEO Reed Hastings agrees. The company’s management is generally agreed to be pretty good at the whole business thing, so it can’t be that they just lost their shit, right? They acknowledged that the change in service pissed off customers in an official statement, so they seem to get it. The DVD spin-off seems to make sense in that it allows the company to focus on improving their streaming service, which investors should love because everyone agrees that’s where the business is headed.  Sure, “Qwikster” is kind of a dumb name, but was the name “Netflix” that great?

The market tends to overreact to breaking news, and I think that is exactly what’s happened here. No one likes to hear that the company that’s exploded over the last few years is slowing down. But if you think the company was worth its valuation of 60 to 80 times earnings over the last year, you’ve got to love the fire sale that’s brought a P/E of 30 with a future P/E of about 20. Buying now would be a vote of confidence in the company’s commitment to its streaming service. Negotiations with content companies are clearly difficult and this should help it continue to get more content and improve the service.

We should note that this isn’t the first time Netflix has made such a bold change to its services. Former CEO and founder Marc Randolph writes in his blog that he thinks this change is just another example of the laser focus Netflix has showed since its inception. He explains that when the company first started in 1998 it rented out DVDs with due dates and allowed customers to buy DVDs. Randolph estimates that about 95% of its revenue came from selling DVDs after their first year and that it recognized the eventual massive competition that was to come in DVD sales from Amazon and just about every other retailer, so it stopped selling and focused solely on renting. Randolph remembers that this was a difficult decision for him to make but the company realized that “by trying to run a business that did two things well, we inevitably were forced to make an endless series of compromises that resulted in us doing neither of them well.” He praises Hastings and thinks this was a bold move that will contribute to the company being able to build the best streaming service it can.

How can I disagree with someone who, while he hasn’t worked at Netflix for quite a while, has a unique perspective on the company and its current CEO? Personally, I went into writing this article with the intention of stating that there is clearly a lot of potential here but that I wouldn’t buy because their fate lies too much in the hands of others. If Netflix could consistently add to its premium content and complete seasons of popular television shows to continue growing its customer base and become more easily integrated into televisions, then maybe it can convince content providers it’s got the power the way Apple did to the music industry with iTunes. That’s a lot of ifs. But investors look for long term value, and smart management in a burgeoning industry certainly creates plenty of that. I’m not sure I’ve changed my mind, but I’m certainly closer to the fence after writing this, anyway.

What do you think? Were you a Netflix owner before the price plunge and have you kept your stock or sold off? Are you planning on buying now? Or even speak up if you’re a Netflix user with an opinion on where the future of the business is going. Have any recommendations for your fellow nerds or topics you’d like to see me write about?

Twitter: @jontrainor

This column should not be construed as recommending or advising on specific investments. The views and opinions expressed in this article or column are the author’s own and not necessarily those of Nerdist Industries; No endorsement by Nerdist Industries of any advice or trading strategy is implied.