September 2019 - Streettalk.blog

Nobody knows anything: the Netflix story

I just finished reading Netflix founding CEO Marc Randolph’s That Will Never Work: The Birth of Netflix and the Amazing Life of an Idea. While it trails off a little towards the end, I highly recommend it, both for investors and aspiring entrepreneurs.

At a time of peak cynicism about the companies/IPOs coming out of Silicon Valley, Randolph’s “memoir” of the DVD rental-cum-streaming service’s early years offers a timely case study of an idea that not only worked but overcame many of the challenges/issues that have plagued today’s up-and-coming tech stars.

The book covers the period roughly from the company’s foundations in 1997 to its IPO in 2002, since Randolph bowed out not long after the company went public.

Here are some insights that I took away from reading the book:

Success is not linear, even for really good ideas. It’s tempting to think the setbacks that startups face reveal some fatal flaw in their business model that will eventually bring them undone. Not really. Netflix had its share of existential moments, not least the tech bust in 2000 which dried up sources of capital and forced the company to put its finances on a sustainable footing and refocus by slashing its staff. But it came back stronger after that setback, as it has done a few times. Luck cannot be underestimated as an element of success either. Netflix got into DVD rentals before/just as DVD players and DVDs began replacing video cassettes, and was lucky that the big electronics manufacturers were prepared to support it (by putting its promotional material in their boxes). Even then it wasn’t clear that online DVD rental would be a success. Later on, Netflix didn’t let success go to its head, recognizing the need to constantly reinvent itself. The company knew that DVDs would not be the preferred format forever and made an early effort to investigate streaming, even when download speeds were too slow to support it.
Leadership is everything. Already a seasoned and successful tech entrepreneur, Reed Hastings put up much of the early money. But he wasn’t so hands-on until he realized Netflix could be something really big. Hastings comes across in the book as an enigmatic figure (I suspect the full extent of Randolph and Hastings’ relationship is a little sanitized), but an extremely decisive person and someone not afraid to make very tough business decisions or criticize the way the business is run. Randolph often doesn’t agree with Hastings but later accepts that he was right almost every time. Hastings’ track record prompted the VCs to overlook some deficiencies in the company’s pitch, enabling Netflix to get enough early financing.
Focus on where there is less competition. A key early decision was to ditch DVD sales and focus solely on rentals, even at a time when sales of DVDs were overwhelmingly the company’s largest source of revenue. Hastings and Randolph knew that Amazon (which also offered to buy Netflix early but not for much) would eventually sell DVDs as well as books and margins would collapse. It was much harder for anyone else (even Blockbuster as it turns out) to get into the online DVD rental business, which didn’t really take off until the company introduced a monthly subscription service.
Balancing scale and profitability is not easy. It is easy to criticize recent IPOs for coming to market before they are showing profits. But businesses that are growing fast and are subscription-based will chew up cash. Netflix was giving away free rentals to new subscribers while collecting only a small amount on a monthly basis from its existing subscribers. Though the book did not mention it, I went back and checked the original IPO filing. Netflix went public when it had 600,000 subscribers and was still to pass through $100m of revenue. It had just reported a $30m quarter so it would have passed through that threshold that year. The company also reported a $4.5m loss in that quarter, but was Ebitda positive and operating cash flow positive. WeWork has a lot more revenue but reports negative operating cash flow. Incidentally, Netflix went public at $15.00 (versus the $13-$15 range) with a $310m market cap, whereas the shares now trade at more than $260.00 each with a $115bn-plus mark cap (the shares traded as high as $386.00 last year). To the extent that WeWork was/is looking to get a $10bn-$47bn valuation, it is a lot harder to see WeWork producing Netflix-like returns (if WeWork ever goes public).
Nobody knows anything. Randolph cited screenwriter William Goldman for this line, which is saying no one really knows what the future holds. When we see the hype around WeWork and Uber, it is sometimes easy to think their success was pre-destined. Similarly, when analysts and others write them off they are stating an opinion – they may be right but a lot comes down to whether management makes the right decisions about the next steps for these businesses.
Rules for success. Randolph provided a list of rules for success handed down from his father. These are particularly good for modern kids whose parents are starting to worry they are getting a little too entitled. Here they are: “Do at least 10% more than you are asked. Never, ever, to anybody present as fact opinions on things you don’t know – takes great care and discipline. Be courteous and considerate always—up and down. Don’t knock, don’t complain—stick to constructive, serious criticism. Don’t be afraid to make decisions when you have the facts on which to make them. Quantify where possible. Be open-minded but skeptical. Be prompt.”

We gets down to work

Update 9/16/19: Latest reports say WeWork is considering delaying its IPO until next month at the earliest, and maybe until next year.

It’s hard to think of a recent IPO that has garnered as much bad press as The We Company, better known as flexible office space provider WeWork. And it hasn’t even launched yet.

For contrarians like me, poor headlines are not necessarily a reason to keep away from an IPO (or a stock). All that negativity can sometimes translate into a bargain buying opportunity.

Yet the reality here is the majority of investors are going to remain extremely cautious about backing the WeWork story, whatever the price.

The deal has zero momentum heading into its possible launch tomorrow, though there is a faint hope the cut-price valuation lures in some meaningful interest.

As you might have read once or twice, there are big reservations about WeWork’s business model, including that its growth depends on entering into more long-term leases (with the associated long-term liabilities) or buying real estate, both requiring WeWork to come up with billions more in cash with no guarantee it will turn a profit.

I have heard some sources suggest the business, which charges entrepreneurs a membership fee rather than rent to use its space, could become profitable in just a few years if it slowed down its growth rate.

But it’s a Catch-22 situation because without growth investors are unlikely to be much interested in paying up for the stock. And WeWork starts to look more like a boring REIT than a sexy technology company (which it is not, but anyway).

There is also the awkward timing of the deal and how WeWork would fare in a recession. WeWork’s members are highly sensitive to any change in economic (and financing conditions), plus start-ups can find cheaper alternatives if they are feeling the pinch (after all, WeWork is all about flexible use of space).

Then there’s the potential for commercial landlords to essentially copy the WeWork model to deal with their vacant space.

Still, investors should reserve judgment until they see the valuation, which is only revealed at the launch of the offering.

That is supposed to happen tomorrow (Monday) morning, which means the official roadshow will begin (with the release of a slick online version for retail investors) and the IPO probably price on September 25 or thereabouts ahead of the stock’s Nasdaq debut the next day.

Of course, a late change of plans is always possible, especially as investors might be facing a volatile week after the troubling events in Saudi Arabia over the weekend (production disruptions from a drone strike on the country’s oil facilities). So really nothing is going right for WeWork and its 40-year-old founder Adam Neumann.

In recent weeks, WeWork’s purported valuation (market capitalization or enterprise value we are not sure) has reportedly come down on several occasions to just $10bn from more than $20bn and versus the last private financing round at $47bn (not a real number to be fair but we won’t go into that).

The company has made a series of corporate governance concessions as well, including reducing the number of votes attached to Neumann’s supervoting shares. Not to diminish the importance of corporate governance, but generally it is not a huge consideration for investors in tech IPOs because they tend to be more focused on the growth prospects of the company concerned.

WeWork’s biggest supporter, Japan’s SoftBank, is expected to take $750m of the shares in the offering. Its name is bound to be emblazoned on the cover of the IPO filing to highlight its show of support.

As embarrassing as it is for SoftBank to be averaging down from its previous pre-IPO investment at a $47bn valuation, this anchor order will leave less stock for others.

Without SoftBank, WeWork would be selling 30% of the company at the IPO – it has to raise $3bn in order to also secure $6bn in debt from the banks – yet this is far larger than the 10%-15% free float on hot tech IPOs (tight supply and excess demand is one of the reasons they often surge massively on debut).

SoftBank’s enthusiastic backing is a small positive, but a positive nonetheless (worth watching if the stake is locked up for six months or a year).

At $10bn, WeWork will be coming to public markets at a significant discount on an EV/sales basis to Uber (roughly 3x-4x 2019 sales of around $3bn at the current growth rate versus 4.5x for Uber). WeWork’s underwriters clearly figure some will find WeWork irresistible at these levels, but the risk is they will be hedge funds rather than long-only/long-term investors, increasing the chances of a calamity on debut.

A WeWork office in Harlem, New York City.

The “R” word: Possible, yes, but how bad will it be?

Recent surveys suggest as many as three in four economists believe the US will go into a recession by 2021. Maybe they are right. I don’t know about 2021 (and they don’t really either) but as night follows day, there will be a downturn eventually.

To me, the bigger question is this: How deep the next downturn will be?

Now I am not really going to answer that question but I think this is what people should consider before they buy into doom-and-gloom prognostications.

There hasn’t been a US recession since 2007-2008, which means forecasting one in the next year or two is almost like insurance for a professional forecaster. Forecasts are mostly wrong too but that doesn’t stop people from making them.

In fact, countries can go for very long periods without a recession (Australia, for instance, hasn’t had one since the early 1990s).

Next year’s US Presidential election also means there is a huge political dimension to the economic commentary that appears in the press, and one should be especially wary of any politician trying to pass themselves off as an economist.

A recession is arguably the only event that assures Donald Trump will lose. His opponents know that when they discuss the economy.

I think it is possible that the next recession could well be more of the “statistical” variety and quite shallow.

For one thing, economic activity in the past year or so has been juiced by the 2018 corporate tax cuts (people seem to forget about them).

Greater corporate earnings flow through to the economy in a variety in different ways and quite quickly too (one reason why governments prefer tax cuts to spending on big projects when trying to quickly stimulate the economy).

If the growth numbers were in any way exaggerated in the past year, which seems entirely possible, then it is simply a mathematical reality it is going to be harder to grow at the same rate and better those conditions a year or two hence.

Real GDP grew 2% year-on-year in the second quarter of 2019, but you can see on a long-term chart (below) GDP growth has flattened over time as the economy has got bigger and bigger save for large blips like 2007-2008.

Growth is harder to come by when you are already the biggest economy in the world (a $20trn economy), so let’s not pretend it is easy to do so.

US GDP through time. Source: US Bureau of Economic Analysis

A recession also means different things to different people.

Here’s an article from the New York Times published in December last year:

“Some say (a recession) happens when the value of goods and services produced in a country, known as the gross domestic product, declines for two consecutive quarters, or half a year.

“In the United States, though, the National Bureau of Economic Research, a century-old nonprofit widely considered the arbiter of recessions and expansions, takes a broader view.

“According to the bureau, a recession is ‘a significant decline in economic activity’ that is widespread and lasts several months. Typically, that means not only shrinking GDP, but declining incomes, employment, industrial production and retail sales, too.”

All true, but you might also say that a recession means different things to different people, in that during this period one person can lose their job and come under financial duress, and another can be completely unaffected (if they have a steady job in a good industry). What I am trying to say is that the numbers in themselves don’t matter as much as how a recession actually affects people’s lives.

A deep recession would mean a spike in unemployment, which is really the key statistic.

Yet the data continue to show US job growth.

The chart below shows US unemployment (3.7%) is at its lowest level since the 1960s. Is a big spike in unemployment around the corner? Are these numbers even relevant any more?

The gig economy seems to be changing the definition of work and driving down the unemployment rate with lowly paid jobs. This may also mean unemployment doesn’t rise sharply in a downturn like it might have done in the past (as everyone picks up gig jobs if they have to).

US unemployment rate through time. Source: Bureau of Labor Statistics

Though some are talking about another credit crunch, there is no doubt the economy and companies are cushioned by low interest rates, in turn facilitated by low inflation.

By the way, that is another thing many economists have got wrong in the past decade. They expected inflation to break out because of the Fed’s rampant money printing, but funnily enough, it never happened and the Fed has had no choice but to keep rates low to try to ward off outright deflation.

The Fed is likely to cut rates later this month for the second consecutive meeting, somewhat reluctantly and unusually all while the economy and jobs are still growing.

The politics can’t be discounted here either, by which I mean the Trump Administration has much riding on there being no recession in the next year at least. This is why Trump is riding Fed chair Jerome Powell to cut rates and holding out the prospect of more tax cuts.

There is always a risk of a large downturn and the US economy has problems that stem from too much consumer and government debt and high healthcare costs, but my point is that pays to keep things in perspective.