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Friday, September 23, 2011

Moneyball: It's About Investing, Not Baseball

Moneyball: It's About Investing, Not Baseball

By Joseph Hogue

The movie adaptation of Michael Lewis’ book, “Moneyball” comes out today to what will surely be big box office bucks (if advertising is any indication). The book is based on the front office career of Oakland A’s scout Billy Beane. Around 2002, Beane adopted Bill James’ Sabermetric approach to recruitment in order to help the team compete against teams with upwards of three times their salary power. Not able to recruit the big name athletes, the A’s had to find undervalued players. They did this by using statistical analysis of uncommon metrics, but ones with higher correlations to career success in athletes, than the more traditional metrics like stolen bases and RBIs.

The movie is sure to be a feel good romp about an underdog story and determination. What most will never know is that the book, “Moneyball: The Art of Winning an Unfair Game,” was written by one of the great financial journalists and has significant importance for investors. Those of us without the money power of institutional investors would do well to learn something from Mr. Beane and the Oakland A’s.


Sabermetrics places emphasis on in-game statistics rather than the industry norm of career averages. Key metrics include: "late-inning pressure situations" (LIPS) and my favorite "narration, exposition, reflection, description" (NERD). What is important to investing is the idea that many measurements, i.e. price-to-earnings, debt-to-equity, and earnings per share are so popularized as to be commoditized and of relatively little value. To compete with the institutional players, investors must look deeper into stock metrics to find measures more highly correlated with success and less often used. To this end I will present two methods of measurement not universally used and with proven success.

The first method will be the Piotroski Score, named after the University of Chicago Professor, Joseph Piotroski. Piotroski argued that because value stocks are often distressed companies, investors should implement a way to distinguish between companies with good future potential and those more likely to be value traps. The scoring is built on a series of nine criteria for evaluating a firm’s financial strength. Over a 20-year test period, those stocks scoring highest also outperformed a portfolio of all value stocks by about 7.5%. Additionally, those stocks scoring lowest were up to five times more likely to file bankruptcy or de-list their shares. Piotroski immediately came to mind when I first saw the commercials for "Moneyball." Both the movie and the method involve finding undervalued picks with a good future. Both Sabermetrics and the Piotroski Score look at ‘in-game’ (financial statement) statistics instead of getting caught up in the more popular relative valuation methods.

The scoring is fairly simple and straightforward with one point given for each of the following criteria:

Positive prior year net income.
Positive prior year operating cash flow: This is a better gauge of income and less susceptible to management manipulation.
Current year return-on-assets is greater than prior year: A good measure of profitability.
Prior year operating cash flow exceeds net income: A warning sign of income statement manipulation by management is net income that significantly exceeds operating cash flow. Managers can manipulate accounts to show higher net income, but it is much harder to manipulate actual cash flows.
Ratio of long-term debt to assets is lower than prior year: Lower liabilities relative to assets is a sign of improving financial stability.
Increasing current ratio (current assets divided by current liabilities): This is a signal of improving access to working capital and solvency.
Number of shares outstanding is equal or lower than prior year: An increasing number of shares outstanding means that prior investments are being diluted.
Current year gross margin exceeds prior year: Margins measure the company’s competitive position.
Percentage increase in sales exceeds percentage increase in total assets: An improving asset turnover means the company is improving productivity.

DR Horton (DHI) and Dell Inc. (DELL) both did well in a Piotroski screen with top scores of nine. DR Horton is a $3.1 billion homebuilder operating in 26 states. Its stock price has been pressured along with the rest of the homebuilders, losing 11.4% over the last twelve months. Eighty-seven percent of the shares are held by institutions and 12.5% are held by insiders making the float relatively limited. Another 26 million shares are sold short, about 11.2% of float, meaning there could be some support as short-sellers return to buy back their positions.

Dell is the $27 billion computer-maker and retailer that was once the darling of wall street and the kind of stock that made you rich. In the ten years to 2000, the stock price increased by 846 times, but has not been able to catch a break since. The stock is up 14.7% over the past year but still off 15.1% from its July highs. The company’s CEO, Michael Dell, recently told Bloomberg that they would continue to look for 8-10 acquisitions per year of companies with proven technologies. The stock price is relatively cheap at only 8.0 times trailing earnings though return on assets is fairly low at only 7.5%.

Big Lots (BIG) and Eastman Kodak (EK) did not do as well on the screen with scores of 0 for Big Lots and 3 for Eastman Kodak. Big Lots operates a chain of cost-leader retail stores across the 48 contiguous states and 88 stores in Canada. Though the stock has been supported over the last few years as a low-cost retailer, lowered expectations on economic growth and a generally tired consumer are holding the company back. The stock, at $33.62, is up 1.4% over the year but well off its highs of $43.68 per share.

Eastman Kodak, that once great camera company is now only a $700 million shell of its former glory. The company operates in three segments: consumer digital imaging; graphic communications; and film, photofinishing, & entertainment. Looking over the financial statements is depressing with negative profit margins, return-on-assets, and cash flow. The stock is down 38.7% over the last year and has a negative book value when goodwill is backed out.

The Altman Z-Score is similar to the Piotroski Score in that it is a predictor of financial distress and used primarily in value investing. The method, published in 1968, was named after Professor Edward Altman of New York University. It uses five ratios, multiplied by a coefficient for weighting of importance, to predict the likelihood of bankruptcy within two years. The model was found to successfully predict 72% of corporate bankruptcies two years prior to filing chapter 7 and only falsely predicted bankruptcy in 6% of cases. Subsequent studies have found the method to accurately predict distress 80-90% of the time with 15-20% false predictions (pdf).

The five ratios and their coefficients are:

Working Capital/Total Assets (1.2): Measures liquidity of assets and the financial flexibility of the firm.
Retained Earnings/Total Assets (1.4): A measure of profitability relative to the company’s size.
Earnings Before Interest and Taxes/Total Assets (3.3): A measure of operating efficiency outside of tax and debt considerations.
Market Value of Equity/Book Value of Total Liabilities (.6): It is a possible warning signal when the market value of the firm is substantially below the book value.
Sales/Total Assets (1.0): A measure for total asset turnover and efficient use of firm assets.

The scores for each ratio are then summed and interpreted as follows:

Score>3.0 - The company is safe based on financial figures.
2.7><2.99 - The company is on alert and investors should be cautious.
1.8><2.7 - There is a good chance the company will file bankruptcy within two years.
Score<1.8 - The probability of the company filing for bankruptcy within two years is high.

One notable Altman Z laggard is media conglomerate Time Warner Inc. (TWX) with a score of negative .50 and a high probability of financial distress. The company trades for a persuasive price-to-earnings growth (PEG) ratio of just .78 and an even price-to-book value. The stock is only off 3.6% over the last year but has traded flat since 2002 and is off its 2007 highs by more than half. Media companies have had a tough go of it lately as more content goes to the internet and traditional media loses advertising revenues. Though the company’s margins and revenue growth are in-line with industry averages, a deeper look into the financial statements presents a possible unstable future.

There is some redundancy between the two measurements and not much research as to which is the better predictor. They are relatively easy to calculate and an Excel spreadsheet template makes the process even faster, so I use both for my value investments. Stocks scoring well on both metrics usually make the cut for value picks, while those scoring well in one but not the other would need further scrutiny. A note of caution, I’ve found several screens on the internet that give different scores for the same stock so you will want to take the time to dig into the financial statements and do the actual scoring yourself.

Adapt or Lose Money

Another key take-away from the book is the idea of adaptation to market efficiency. The success of the A’s Sabermetrics approach brought imitators and competitors in the field. Today, most big league teams have a staff of statisticians analyzing a slew of data. To continue their run, the A’s had to continuously search for neglected metrics that would correlate with success.

This is just as true in investing. The first guy to discover the January Effect probably made some good money. The millions of investors that have tried the approach since then haven’t fared as well. As soon as a metric or strategy is popularized, the market starts pricing for it and the easy money is gone. Investors must continuously adapt their strategy to stay one step ahead of the market.

Investing, like professional baseball, is an extremely competitive field. Those that do not spend the time to find novel and superior analytical tools will be fodder to the big dogs, i.e. the Detroit Tigers. Further, without an analytical staff to back our stock picks, regular investors like you and me need to analyze and adapt our strategies continuously to gain those coveted few percentage points above the index. The two measurement tools above will help to assess financial stability and solvency, but you’ll need a few other predictors to build out your toolbox.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Monday, September 12, 2011

Payout Ratio: Important Dividend Metric, Too Often Overlooked

Payout Ratio: Important Dividend Metric, Too Often Overlooked
1 comment | September 12, 2011 | includes: DUK, ETE, FTR, MO, NOK, T, VGR

I was recently talking to one of my friends last week. He had about $600,000 invested in high yield stocks. These were companies paying well above what they were earning. I told him to be careful as these companies could cut their dividends in the future. This seems like a common problem for investors who overlook one simple metric, which is the payout ratio. The payout ratio is simply the percentage of earnings that are being paid out in dividends. Here are four companies that are actually paying out more than they take in.

Frontier Communications Corporation (FTR), a communications company, provides regulated and unregulated voice, data, and video services to residential, business, and wholesale customers in the United States. It offers local and long distance voice services, including basic telephone wireline services to residential and business customers.

Frontier pays nearly 11% in dividends. It sounds nice, except for the fact the payout ratio is around 450%. The company pays 75 cents a year and isn't even expected to earn half that next year. Another issue with Frontier is that it is in a dying area of business. It primarily deals with landlines. Landlines are quickly going away as people start switching to wireless telecom carriers.

Nokia Corporation (NOK) manufactures and sells mobile devices, and provides Internet and digital mapping and navigation services worldwide. Its devices & services segment develops and manages a portfolio of mobile devices, such as mobile phones, smartphones, and mobile computers; services; applications; and content.

Nokia pays a 7.6% dividend. The payout ratio is about 110%. This is set to increase as the company's earnings are set to decrease. Apple (AAPL) and Google (GOOG) have been taking a bite out of Nokia's market share. Nokia is already said to be stumbling as it tries to find new ways to innovate.

Energy Transfer Equity, L.P., (ETE) through its direct and indirect investments in the limited partner and general partner interests in Energy Transfer Partners, L.P., engages in midstream, intrastate, and interstate transportation of natural gas, as well as in storage of natural gas in the United States.

Energy Transfer Equity pays a 6.5%. The payout ratio is more than 200%. ETE has a good business model and I do like the MLP space, but the fact that it pays out so much is a huge red flag.

Vector Group Ltd., (VGR) through its subsidiaries, engages in the manufacture and sale of cigarettes in the United States.

The company pays an 8.5% dividend. The payout ratio is over 200%. Vector's brand of cigarettes have a very small market share. With the company paying out all its earnings and taking on debt, it is not putting any capital into potential growth opportunities.

The payout ratio can tell us what future distributions will look like. A few things to note is that you also need to look at future earnings growth. If a company cannot match distributions with earnings, it may be time to sell. Here are three companies that have a nice yield and low payout ratios.

AT&T Inc., (T) together with its subsidiaries, provides telecommunication services to consumers, businesses, and other service providers worldwide. Its Wireless segment offers wireless voice communication services, including local wireless communications service, long-distance service, and roaming services.

AT&T pays a 6.2% dividend. The payout ratio is 50%. The company has a strong base of customers. There is plenty of growth in the dividend as well. The company is a strong blue chip as well as being a Dow component. AT&T is a favorite amongst many dividend investors.

Altria Group, Inc., (MO) through its subsidiaries, engages in the manufacture and sale of cigarettes, smokeless products, and wine in the United States and internationally.

Altria pays a 6.1% dividend. Its payout ratio is 93%. However, its earnings are suppose to increase substantially over the coming years, meaning the payout ratio will decrease. The company has some of the strongest brands around. Although, the dividend may not be as high as Vector's, the company is much safer.

Duke Energy Corporation (DUK) operates as an energy company in the Americas. It operates through three segments: U.S. franchised electric and gas, commercial power, and international energy.

Duke currently pays a 5.3% dividend. The payout ratio is 64%. Duke is one of the largest utility companies in the U.S. Americans will always need energy and consumption is set to increase. Duke is an extremely stable company and with its recent purchase of Progress Energy (PGN), the company is set to increase its earnings power.

These three companies are great example of strong dividend payers with a low payout ratio. Always be careful when investing. Sometimes companies have high yields for a reason simply because there exists more risk. The best advice I can give in this case is "Slow and steady wins the race."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Tuesday, April 5, 2011

Netflix's Market Opportunity Is A Lot Bigger Than You Think

Our INTERVIEW OF THE WEEK this week is with one of the most successful Founder-CEOs in the history of the online industry: Reed Hastings of Netflix.

In the past decade, Reed has built Netflix from a little DVD-by-mail company into an international behemoth with a $12 billion market cap that is disrupting the traditional TV distribution business.

Along the way, Netflix's surging stock price has made fools (and paupers) of no end of skeptics.

What's next for Netflix? Will the skeptics finally be right? Or will the company's second decade be even more impressive than its first?

SAI's Dan Frommer and Henry Blodget spent a half-hour on the phone with Reed last week discussing the following topics...

* The size of Netflix's market opportunity (bigger than you think)
* "Personalized" Netflix accounts (one for every person in the family)
* The competition
* Why Netflix isn't offering pay-per-view
* Whether Netflix will offer "tiered" streaming prices
* Whether content companies will screw Netflix in the next round of negotiations
* Whether the cable cos will try to crush Netflix by enacting bandwidth caps
* The three key aspects of Netflix's culture that have helped it become such a success
* Whether Reed will be running Netflix for the next 10 years

And more...


(And thanks to Business Insider's Ellis Hamburger for transcribing the call.)

Henry Blodget: Welcome, Reed! Thanks for doing this. Ten years ago, I remember when Netflix was originally thinking of going public, you were a tiny DVD-by-mail business, and everybody smart I talked to said there’s no chance in hell this thing ever works. Here we are ten years later, 20 million subscribers, two billion in revenue, 12 billion dollar market cap. Where do you think you’ll be ten years from now?

Reed Hastings: Well sticking with ten years ago, we couldn’t even get a meeting with you. (Laughs) Anyway, where are we in ten years? I don’t know, I couldn’t have predicted where we are from then.

BI: So it’s bigger than you thought it might’ve been?

RH: Oh, bigger and different. We were back in 2001. We were not yet profitable. We were growing on DVD and wondering how things will work. There are a lot of differences.

BI: Well, let's look forward 10 years. Do you think you’ll still be running the company?

RH: Ten years is always too long to make any useful prediction.

BI: But that’s your ambition? You’re not ready to hang up the skates?

RH: I can certainly say that I’m not thinking of retirement this year, but ten years for anyone, it can depend on so many things.

BI: Okay, let's talk about your market opportunity. You have 20 million subscribers now, approximately, in the United States, and there are something like 115 million households now. When you think about the total market opportunity domestically, what should people think is a reasonable number of subscribers that services like Netflix ultimately will have?

Netflix long term stock prices

NFLX stock price.

Image: Google Finance

RH: The way we look at it is on the upper bound, we do it by mobile phone subscriptions, the number of people in the United States that pay for a mobile phone. That cuts out very young kids, people with zero income, and that number is about 300 million.

BI: Our household only has one Netflix subscription. We currently pay you a lot more than eight dollars per month, but I don’t envision a scenario where my wife has one account and I have one account and each of my kids have an account, so you really think that that’s a reasonable way of looking at it?

RH: No, that's the upper bound. So the upper bound, if it was natural for each family member to have a separate subscription, like you each have a separate Facebook account, if it becomes so personalized video that you do want it individualized, than that would be the upper bound. Another way of looking at the market is the number of households that can subscribe to cable or satellite, and that number is about 100 million.

BI: Do you think that you ultimately will start offering personalized accounts? That’s an interesting idea that I hadn’t heard before.

RH: It’s quite personalized now, but not in a way that’s so compelling that you never want to say “I don’t want to use my kid’s account.” The question is, over time, can we make Netflix so personalized that as the kids get to be teenagers and they get their own Facebook account and their own mobile phone, that they also get their own Netflix account?

BI: Do you think that that’s likely?

RH: No, it’s a possibility. It’s an aspiration.

BI: So, as you think about it, do you think the 100 million number is the right market-opportunity number that people should think about, or should it be a 200-300 million type number?

RH: Well 100 million is another upper bound, and that assumes, in this case, that every single cable or satellite household subscribes to Netflix, so both of those are available market figures. As to how they get split between Netflix and its competitors, that’s really hard to tell. Somewhere north of 20 million, south of 300 million.

Netflix subscribers chart small

Image: Silicon Alley Insider

BI: What percentage of the 20 million now have cancelled cable or other TV?

RH: Everyone, essentially, on Netflix has a TV service and also 30% of them have HBO, which is the national average.

BI: So right now, it’s definitely not an either/or, in fact it’s just how many more services can you pile on top of your existing cable service?

RH: Yes, that’s right. We’re like one more cable network. We’ve grown from in the last three years, the number of streaming accounts in the US from zero to 20 million, and MVPD (multi-channel video programming distributor) is basically steady, so last year, total MVPD in the US went down slightly, or the first three quarters of the year, but that was largely due to the recession. And then in Q4, total MVPD households went back up. And if Netflix were a substitute, you would see MVPD going down like landlines have, or something like that, which you don’t see.

BI: We already talked about one possible way that you could get more money per household, which is personalized accounts. Do you think that with streaming, you will ultimately have tiers, the same way that you do with DVDs. Like I get a basic selection for $8, but if I pay $15 I get twice as much stuff, or I get cooler, different stuff. Or if I pay $50, I get everything?

RH: We don’t have any plans for that. We want to focus on a simple proposition: unlimited streaming for $7.99 per month. Our big focus is taking that simple proposition around the globe. We started with Canada seven months ago, we’ve been super successful there, we’re targeting to surpass 1 million subscribers this summer. Less than one year from launch in Canada. That’s been so successful that we’re now expanding to other countries.

BI: What other markets are attractive?

RH: All the markets where people have broadband and like TV.

BI: Must be a tiny opportunity.

RH: Exactly.

BI: Switching gears, let's talk about content deals going forward. I know Time Warner CEO Jeff Bewkes was quoted recently as saying something like “Look, back when Starz did their huge deal with Netflix, they were asleep at the switch, it was just a test, and suddenly, everyone has now woken up. There’s no way anyone would ever cut a deal like that again.” Do you think that’s true?

RH: When we did the Starz deal in 2008, we almost walked away from it because it was so much money for an activity that basically didn’t happen, i.e. streaming, at the time. Now, as we look at renewal coming up the middle of Q1 next year, we will clearly pay more. And there are more people streaming, so we can afford to pay more.

Reed hastings

Image: JD Lasica/Flickr
NFLX Apr 4 2011, 05:20 PM EDT
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BI: Do you think you’ll pay the same way? As I understand it, the last deal was basically a flat fee--will the next deal be a per-sub fee, or is it likely to be per-stream? How do you think the content deals of the future like that will be structured?

RH: I’m not really sure. We’re looking about how to acquire content. Traditionally or generally, most of our content, they want a guarantee, and a flat rate.

BI: They want that even with you going from however many single-digit million subscribers you had when you started the Starz deal to now, with 20 million subscribers, even going forward you think they’ll want that, or will they want an average fee per sub or per stream?

RH: Many of our deals are shorter term, 1-2 year deals, so it’s fixed in the short term, but fundamentally it’s variable in the long term.

BI: You’ve said you ultimately hope to be the biggest revenue source for a lot of the content providers. The objection that I hear raised to that very quickly is “Oh come on, look how much the cable companies pay, that’s why the bills are $160 per month, Netflix is $8, how could that possibly be?” What’s your reaction to that?

RH: For some content owners like Relativity Media, where we did an output deal with them, we’re already their biggest customer. So it depends on the content, in terms of the big bill that you referred to. There’s a huge amount of sports content, a majority of the value of MVPD. And then of course there’s news and reality and lots of other content types that we don’t focus on.

BI: Do you think you ever will offer news and reality and other types of content? I know I read a presentation a couple of years ago from you saying “No, we’ve picked our market, we’re going to focus on that market.” I know a lot of subscribers hope that you’ll go into sports and things like that. Is that possible?

RH: Now we’re very focused on TV shows and movies, and there’s an enormous opportunity. If you look at our selection, it’s really good. But it’s still a small part of the total universe of TV shows and movies. So both on the subscriber view and on the content view, we have tons of room to expand within TV shows and movies.

BI: On the selection issue, certainly with our family, what often happens is that we’ll start talking about watching a particular movie, everyone gets all excited, and the kids will say “Oh it’ll be on Netflix." Then they’ll go check and find out that it’s there via DVD, which is great, but suddenly it seems like Pony Express to wait for the DVD, and it’s often not there on streaming. How long will it take before most of the stuff that we’re all looking for is just going to be there, and it becomes relatively rare that you don’t have something available for streaming?

RH: Really, it is there today, from iTunes or Amazon, it’s just that you have to pay-per-view. So the newer stuff is first available in pay-per-view, and both of the services, iTunes and Amazon, are pretty comprehensive, but you’ve got to pay each time.

BI: Will you ever get into pay-per-view?

RH: Very, very unlikely. We’re focused on the subscription. Unlimited for a flat fee. That simple proposition. So the same answer I gave you about simple possibilities with tiering.

BI: Do you see Apple getting into a subscription thing at any point? There have been talks that they are, in theory, doing that, but we haven’t seen it yet.

RH: You’d have to ask them. Amazon is in subscription as you know with Prime, Hulu Plus is in subscription, and there may be others over time.

BI: But, really, why wouldn’t you offer pay-per-view? You now have this incredible catalog where you can find any movie and it’s either available by DVD or streaming--would it really muddy the waters that much to have a pay-per-view option?

RH: It’s a little like Business Insider doing sports news or something.

BI: We do have sports news!

RH: If you do sports news, you'd find that some of your readers really enjoy it, because you have a unique take on it, but that mostly it’s such a big competitive market that you really have to make your brand stand for something very specific. At least until you’re the size of the Wall Street Journal. And for us, it’s about brand clarity, and that we stand for $7.99 per month for unlimited streaming. That’s what we really want to focus on and we think that’s the optimal strategy. Rather than try to get into every possible thing that our subscribers also want, like should we sell DVDs? Should we offer various equipment? Etc etc.

reed hastings netflix

Image: JD Lasica/
NFLX Apr 4 2011, 05:20 PM EDT
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BI: You guys are on a tremendous number of devices ranging from video game consoles to connected TVs and all that. Have you noticed anything unusual or interesting about the way people are consuming streaming content across any of these devices?

RH: It’s really quite broad. We get great traction on internet TVs, on Blu-ray players, on game consoles, iPads, Apple TV, iPhone. It’s amazing really how broad the viewing of our content is.

BI: Do you have any interest in the complementary social aspects that a lot of startups are focusing on? Getting people communicating on a second screen or even the first screen while they’re watching a show, or is Netflix kind of a private experience?

RH: We’re open to adapting our service as new enjoyment paradigms rise (such as multi-person viewing), so there’s social thing for finding content you want to watch, like these six other people you know just watched X, and then there’s social thing during the watching which is a little trickier with online because it’s asynchronous. Everyone watches at a different time. But, just as social transforms the internet generally, it will also transform the Netflix experience.

BI: So you just had to offer a higher compression streaming option in Canada because of bandwidth caps and overage charges, and I saw you talk quite a bit about this during the last earnings presentation. Do you think this is going to be a problem here in the states where we’re going to have to think about keeping an eye on the bandwidth meter, and do you foresee yourself having to adjust your service here to meet that?

RH: Well in ways we already have caps. If you look at most of the iPad mobile plans, they’re 2 GB, and then $10 per GB after that. AT&T just implemented an 150 GB cap on DSL, 250 GB on U-Verse fiber. So that’s clearly a move by some ISPs at least, and hopefully other ISPs will compete against them on the basis of being unlimited.

RH: With Google’s Kansas City move, hopefully that’s a sign of a long-term future trend that most of America gets Gigabit Ethernet, or Internet, and that these kind of skirmishes around 50 gigs, 100 gigs, 200 gigs are perceived to be like the 640K PC barrier 30 years ago.

BI: There seem to be people who think that MSOs [cable operators] and Telcos will try to stifle competition from people like you by imposing really small caps and high overage fees. Is that plausible or do you think that’s a worry that people shouldn’t have?

RH: No that’s plausible. In Canada, right after we announced that we were entering Canada, a few days after, Rogers lowered the caps on their most popular plans. So those kinds of things can definitely happen and then it’s an ongoing tension. We can do those high-density encodes like you referred to, and hopefully over time, broad, fast, inexpensive Internet becomes more and more a part of every person’s life, and that will open the possibility again over five or ten years for more online video.

BI: That's a good segue into competition. This market is just incredibly noisy and there’s so much competition, you’ve got TV everywhere and you’ve got pay-per-view stuff, you’ve got Amazon now linking streaming to Prime, you’ve got Facebook suddenly doing a deal with Warner, Google TV, so forth. Who scares you?

Streaming Netflix comparison chart

Image: Clicker
NFLX Apr 4 2011, 05:20 PM EDT
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RH: In the beginnings of a new market, it’s really hard to figure out who the long-term competition is, and what we tend to focus on is how to grow our business, and we’ll see what competition emerges. In general, the big incumbents, like the MVPDs, they may turn out to be the biggest competition with TV everywhere. But it depends on what their goals are and how they execute, and in particular, the more consumers see us as truly complementary, to MVPDs, then the less incentive they are to try to stop us or kill us.

BI: What percentage of the 100 million households that have cable and satellite do you think can actually afford a complementary service on top of the cable service?

RH: Your typical cable bill is, what, $70-$80? If you ask how many could afford $7.99, it’s probably pretty high, right?

BI: What do you think is the likely future of cable? A lot of people are saying “Look, there’s certainly a business for cable. Somebody’s got to be the actual hook-up to the Internet, but the idea that somebody else is going to have a box and control all the content is just ludicrous, and ultimately they [cable providers] will be reduced to being big fat pipes. Do you think that’s reasonable?

RH: No, that’s too pessimistic. They certainly will have a broadband business, which has very high profitability because it doesn’t have content costs. They’ll have a telephony business, and many, many more people get telephony from their cable company than they do from Vonage or Skype. Third, they’ll have a video business and they’ll offer unique content bundles, unique other things. I mean look at DirecTV—it’s growing substantially because it’s got incredible NFL content.

BI: On that subject--the sports question--are there folks who will do what Netflix has done in sports and become a very viable alternative option?

RH: Well there’s MLB TV which runs direct to consumer subscriptions today. So that would be a place to start, and then whether NFL and other leagues do the same I’m not sure. Certainly MLB is doing that to a degree today, and I think they try to keep it somewhat complementary. Out of season games, that kind of thing.

BI: Lastly, I have a couple questions about Netflix’s culture. I was fascinated by the presentation you did about that a couple of years ago. For example, the fact that you have no set vacation policy company-wide--that folks can take as much vacation as they want. When I broached that idea here asking if it was a good idea and if we should do that, people freaked out because they said “No, what’ll happen is everyone will work around the clock and I will feel like I can never take a vacation.” Why do you have the no vacation policy?

RH: I would say we don’t have a “no vacation” policy, that’s a little ambiguous. Instead, we have no policy on vacation. Perhaps because I take lots of great vacations it sets a good example. If you [Henry] were more visibly on vacation and then when you asked the question about it, everyone would probably relax. To the degree that you hardly ever are seen to take vacation, that might scare people.

BI: So it’s my fault?

RH: I think so.

BI: And the other thing you said that jumped out was “We’re not a family, we’re a professional sports team. Therefore, we’re going to try to have the best players at every position, and that means that folks who are B-players are going to be working elsewhere.” And when I raised that as a possibility here, people said “It’s ridiculous. There are lots of players who are B’s who want to be A’s. It’s just much too harsh.” What’s your reaction to that?

RH: You’re over-simplifying with A’s and B’s. There’s a lot of graduations in terms of how someone performs. We’ve often had someone who was performing OK at one job so we move them to another job and they do fantastic. So it’s not even that much a reflection on the person. But in general, a sports-oriented model is “If you want to win the championships, you have to have great players who can work together.” You need both of those, and so that’s what we focus on: getting great people who can work together.

BI: How do you convey to somebody that they’re just not quite great enough?

RH: An employee who doesn’t work out usually knows it and the parting is mutual. Most admit they thought it would be for them and ignored signs that it wouldn’t. For example, we hire a lot of seasoned people but we don’t have all the perks – cubes, not offices, very few assistants, small staffs, no traditional HR support (plan your own offsite!). Some find that refreshing, others learn quickly that they’re accustomed to all the trappings and aren’t comfortable without them. It’s an honest and candid environment, and as a result, most employees who don’t work out say thank you when they leave. And severances are generous.

BI: Is there anything else that you think is critical to Netflix’s culture that has helped you become such an incredibly successful company over the past ten years?

RH: It’s like the classic example: Which of the innovations for the DC-10 were most important? The retractable flaps and retractable wings, they all went together, and it’s pretty hard to put a finger on it. Some of the things are symbols -- the vacation policy symbolizes freedom and responsibility. But you couldn’t really do freedom and responsibility without high performance. And so those are intimately linked. And you couldn’t do freedom and responsibility without our kind of context management model.

BI: Which is what?

RH: In our culture deck, there’s a chapter on “context, not control,” which is using your role as manager and leader to educate people and what we’re trying to do and not guiding each specific action a person takes. When someone working for you does something that you think is a bad choice, instead of blaming them, it’s reflecting on yourself in terms of what context you failed to provide. Such as finding a talented person, who would come to the right decision. So it’s always reflecting back on the manager--what context did I fail to set?

BI: Are there other key aspects of it?

RH: The values are really key, that not only should one be clear about one’s values, but that there’s a collective intolerance to bad behavior.

BI: Anything else?

RH: No, I think those are the key elements.

tilson netflix

Image: Stockcharts
NFLX Apr 4 2011, 05:20 PM EDT
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BI: Last thing… you wrote an extraordinary public letter to Whitney Tilson, who had publicly shorted your stock. When CEOs do that it’s usually a huge red flag and everybody in the world says “The company is screwed--I can pile on now.” Obviously you phrased the letter in a way that wasn’t like that at all. You went point by point. Yet, in the middle of it, you say that there are some things that Whitney was right to be concerned about. So what else should people actually be worried about?

RH: I’d refer you to our January earnings letter where we said the two core questions are: “Given our approach, how big will we get in the domestic market?” and second, “How successful will we be internationally?” Those are the two core investor questions.

BI: You never did actually answer the first question we asked about how big you’ll get domestically. How big will you get domestically?

RH: That’s exactly why there are investors who debate that. It doesn’t really matter what I think. It matters what actually happens.

BI: I know it doesn’t matter, but I’m interested. How big do you think you’ll get?

RH: There’s no simple way to tell it. We’re growing very well right now, and we’re focused on making our service better and better. But other than those benchmarks that I gave you, and then the question is “Well, what’s the appropriate discount to apply to those?” That’s where the investor judgment comes in. And then once an investor answers those questions for themselves, then they can figure out if they want to be a buyer of our stock at the current price.

BI: And what about the international question? Are there unique challenges in many of the other attractive markets where there is broadband and people that want to watch TV that will prevent you from being successful?

RH: Yes--in certain markets, in China in particular, it looks very daunting for US companies to build a profitable business.

Now read the presentation on "Culture" that Reed refers to above >