Netflix Splits: Brilliant or Moronic?

The last two months were not good to Netflix shareholders.  After peaking at over $300 in July, the stock has been in free-fall and by the time of this writing, lost more than 50% of its value.  So what happened?

In July, Netflix announced a significant price hike, which understandably was not taken favorably by its customers. In early September, Starz decided not to renew its streaming contract with Netflix.  Then, later this month Netflix cut its guidance for subscribers in the U.S. by 600,000 (Netflix currently has about 25 million subscribers).  Finally, yesterday, Netflix CEO Reed Hastings in his blog apologized for not communicating clearly the reasons for price increase.  He also stated that streaming and DVD-by-mail operations will be split into two separate entities, with rather uninspiring name Qwikster for its DVD-by-mail operation. Netflix name will be reserved for streaming.

The reaction to the split was quite negative.  Indeed, the two entities will be completely separated, and so customers will have to look for movies on two different websites.  Also, giving up brand name of Netflix doesn’t sound thoughtful.  It appears that Netflix managed to shoot itself in the foot at least twice during the last couple of months.  Did the management lose its touch?

From the current reaction of many customers and from looking at the stock prices, it certainly appears so.  But taking a longer-term view, I think that Reed Hastings made a bold and correct strategic decision.  It is clear that the future is in streaming and so new Netflix can stay focused on it.  It also clear that DVD-by-mail business has peaked and will start declining.  It would be much better that the brand name of Netflix will not then be associated with a dying business.

Despite backlash from subscribers, Netflix still provides the best value.  As a case study, my family pays over $100 per month to Comcast cable and about $20 to Netflix.  I would estimate that we watch Netflix 80-90% of the time.

If someone cancels their DVD-by-mail service, where would they go?  Video stores are almost non-existent anymore.  There is Redbox, but their selection is extremely limited.  Netflix (soon Qwikster) has nearly every title available.

If someone cancels their streaming service, where would they go?  Despite its limited streaming library, Netflix is by far the more comprehensive choice among other options, such as Amazon or Hulu.  Almost every DVD player and many TVs now have Netflix player built-in.  Yes, it is easy for some of us to connect a computer to the TV, but in reality most people do not want this hassle.  You can of course buy pay-per-view movies, but just two of them will cost more than a whole month of Netflix subscription.

In this blog, Reed Hastings wrote:

For the past five years, my greatest fear at Netflix has been that we wouldn’t make the leap from success in DVDs to success in streaming. 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. Eventually these companies realize their error of not focusing enough on the new thing, and then the company fights desperately and hopelessly to recover. Companies rarely die from moving too fast, and they frequently die from moving too slowly.

The split may look moronic today, but it could well prove to be brilliant in the future.

Now, what about stock price?  Sudden and sharp declines of 50% or more are quite common for high growth stocks.  It happened to Netflix before, and it happened to most other growers – such as Amazon, Walmart, and Apple.  While in the short term Netflix stock will continue to be volatile and it may see $100 before it sees $300 again, longer term performance will, as always, depend on company execution.  So far, I have full faith in Netflix management.

A Really Long-Term View of Stock Market History

For the last 80 years or so, stock market performance can be described in terms of alternating so-called secular bear and bull markets.  From 1929 to 1942, stocks declined significantly in the aftermath of 1929 crash and the Great Depression.  From 1942 to 1965, prices increased eight-fold.  This was followed by volatile but flat period to 1982.  After that, from 1982 to 2000, prices again went on a tear and increased twelve-fold.  And now, in 2011, the prices are at the level of 12 years ago.

The book “Unexpected Returns” by Ed Easterling tries to provide some explanations for this behavior.  According to the author, company earnings actually grow at a relatively constant rate and increase about three times during an average secular period (either bull or bear) of 16 years (bull markets tend to last longer than bear markets).  But it is the P/E ratio that drives the equity valuations.  During periods of declining interest rates, P/E ratios tend to expand, again by a factor of about three, from an average low of 8 to an average high of 25.  This, together with 3x earnings growth, results in prices increasing roughly ten-fold.  This happened in secular bull markets of 1942-1965 and 1982-2000.

On the other hand, rising inflation tends to compress P/E ratios again by that same factor of 3.  And 3x earnings growth simply means that stock prices are stagnant (with a lot of volatility in between), as was the case during secular bear market of 1965-1982 and is the case today.

There is no denying that we are currently in a secular bear market.  The question is, are we anywhere near its end?  Well, at its beginning in 2000, P/E ratio actually was abnormally high, at 40.  Today, it is about 13.   So we already had a “mandated” 3x compression in P/E.  However, we are still ways off away from an average P/E bottom of 8.  Also, while previous secular bear market had rising inflation, this time it actually declined slightly from the level in 2000.  An optimist may make a case that low inflation justifies higher P/E ratios and thus we should be close to the start of another secular bull.  A pessimist, on the other hand, will argue that prices must swing from that high P/E of 40 to below average.

Of course, no one knows if the next secular bull market is around the corner or if it is still a few years off.  In all likelihood, we won’t even recognize it until several years pass after its actual start.  But the prices tend to be mean-reversing and it is clear that equity valuations today are depressed.  So, it is important to have your portfolio ready for the coming rebound.  It is easy to be a stock investor during secular bull markets — all you have to do is buy an index fund and you would do just fine.  During secular bear markets, however, investors need to pick stocks with extra care.  But this is not mission impossible by any means — just ask Apple investors how they did in the last ten years.  I am here to help.