Thursday, May 22, 2008

Netflix, Inc. Shareholder Meeting, May 21, 2008

Netflix (NFLX) had one of the shortest and strangest shareholder meetings I've ever been to. I am now realizing the time and day a company sets its meeting is important in analyzing whether they even want people to show up. Netflix had its shareholder meeting on a day other than Friday; in addition, the meeting was held at 3:00PM, too late after lunch, and too early before getting off work for most people to attend. It looked like less than 10 non-employees appeared at the meeting. While short interest in Netflix is quite high, the stock has done very well compared to the rest of the market. You would think that Netflix would want to show off its comparative stock performance. You'd be wrong. There was no presentation whatsoever. Only the Netflix logo appeared in the background of what appeared to be an auditorium. The food--well, there wasn't any real food. Some sodas and cookies were on a table with napkins. Take all this together, and you've got a PR campaign opportunity missed for what is basically a media company.

The meeting was in Los Gatos, CA, NFLX's HQ. This is not a distribution center, so don't bring your DVDs to the building and expect them to take it. The CEO is Reed Hastings, and he went up to the podium, said that Netflix was a company that offered media content online and through a DVD subscription service. After that short statement, he immediately launched into the Q&A session.

One person asked how Netflix intended to grow, given that all the people she knew already had Netflix. Mr. Hastings replied that in the Bay Area, they had good penetration in the market. 20% of the people in the Bay Area were signed up already. However, in other cities, such as Chicago and Boston, market penetration and brand recognition were still not at high levels. Therefore, there was plenty of room to grow.

The CEO pointed out that NFLX had won a customer satisfaction award.

Another person asked how many distribution centers Netflix had, and their location. Mr. Hastings replied that they had 50 centers located in about the 50 largest cities in the U.S., covering 95% of their current subscribers.

The CEO pointed out that although the company has been around for about a decade, it named itself Netflix, not "DVD-by-Mail" because it knew that eventually, the real market would be online. Nevertheless, the DVD format is still very profitable for companies, who aren't yet completely on board with the online streaming media format. (The underlying current, as I interpreted it, was that media companies make so much money on DVDs that they have no incentive to change their business model.) As a result, Mr. Hastings said that the DVD market should remain in place and be profitable for the next 10 to 20 years. (This would be good news for Toshiba and its Blu-ray format; however, the CEO never mentioned Blu-ray at all.)

NFLX has 100,000 movie titles. One interesting question was about how Netflix would adapt to globalization in an age where anyone could relocate to a lower-cost locale and set up a competing company. This dove-tailed with a later question about whether Netflix had considered selling its service to other countries' citizens because of the scalability of delivering online content. The CEO said that to use each film, each country has to provide you with authorization and rights to use it; in other words, it's a "country by country" analysis, and NFLX was planning on staying in the U.S.

I asked two questions. One, what did Netflix think about the potential merger between Circuit City and Blockbuster, and how did it plan on responding to it? This caught the CEO somewhat off guard, and he said that I knew as much as he did about it, and that when and if it happened, he would take a look at it. My second question was what the company planned on doing with captions as it moved to more online delivery (most online delivery lacks captions, and on many older films, captions are non-existent, even on DVD--if someone is hearing impaired, they wouldn't be able to really enjoy the online delivery service without captions). The CEO replied that the caption was basically another file that had to be incorporated into the online delivery, but that the media companies hadn't yet focused on delivering that file. He expected that the media companies would eventually provide such files for online delivery, but given his earlier statement about media companies being happy with the status quo of DVDs, I'm not sure online content delivery will be accessible to older and/or hearing impaired persons anytime soon.

Almost right before the shareholder meeting, Netflix received publicity for its set-top box player, which allows its subscribers stream videos from the NFLX website into their TVs. This was a device developed with Roku, another company that was apparently founded by some NFLX ex-employees. 10,000 films and TV episodes will be offered for this service at this time. But NFLX may lose money the more people use its box and online service because it probably has to pay a fee or a higher fee to the media companies the more views its online films receive. With a DVD, once NFLX buys it, it belongs to NFLX and there's not much--at least under current laws--that the media companies can do to prevent NFLX from offering it to others. These would be good questions to ask at next year's meeting: Isn't it less profitable for NFLX to move its viewers into its online services? How is the fee structure set up between NFLX and the copyright owner of a film in terms of how the copyright owner gets paid for online delivery? Is it a one-time fee?

After the meeting, the CEO looked very uncomfortable talking to the remaining shareholders but humored us for a while. His main comments related to piracy, and how international expansion would be difficult because of all the piracy outside of the U.S. (However, a shareholder mentioned that online delivery was harder to steal because encryption could be more complex--you can't download an encrypted movie file as easily as you can copy a DVD--and that the encryption could have several layers that were constantly changing.) Another question was how NFLX was going to work with the X-Box and Microsoft. The CEO was very vague on that response. Once he was out of the auditorium, he practically bolted away, even cutting someone off in mid-sentence. I don't mean to say that Mr. Hastings is abusive or mean-spirited. He actually appears quite the opposite, i.e. he appears to be a good-humored, good-natured person, and went out of his way to make an older shareholder who wasn't a subscriber and who didn't quite understand the business feel comfortable.

All in all, a very strange experience. I got to thinking perhaps this company was going to be bought out and needed to keep mum. But given the recent alliance with Roku, a smaller company, and the level of short interest, that appears to be less of a sure thing. Still, a company like Netflix will definitely be one to watch, if only because they appear focused on their business--so focused, in fact, that they don't seem to want to have any shareholders show up and see what they're up to, at least not in person.

Update on May 25, 2008: I read the company's 10K. Here are some interesting highlights:

1. Netflix says it is calculating the value of options under a "lattice-binomial model" rather than the more popular Black-Scholes model. I have no idea what this means, but it's definitely interesting--is NFLX trying to hide something, or does it have cutting-edge economists on its staff?

2. From 2006 to 2007, Netflix grew from 5,083,000 subscribers to 6,718,000 subscribers.

3. Netflix settled some litigation with Blockbuster and received 7 million dollars. I would have liked to see more about the content of that litigation, but it's settled, and so the parties probably have to stay mum.

4. See page 12 of the 10K for some information on the online delivery payment format. "Our ability to provide our instant-watching feature...depends on studios licensing us content specifically for Internet delivery...Unlike DVD, Internet delivered content is not subject to the First Sale Doctrine [where you can do whatever you like with a DVD once you buy one of them]. As such we are completely dependent on the studios providing us licenses in order to access and distribute Internet delivered content. In addition, the studios have great flexibility in licensing content. They may elect to license content exclusively to a particular provider...For example, HBO licenses content from studios like Warner Bros., and the license provides HBO with the exclusive right to such content against other subscription services, including Netflix."

It looks more and more like Netflix has to be bought out by a major producer of content to move towards its goal of being primarily an Internet delivery company.

Update on May 26, 2008: looks like Netflix's meeting wasn't always so brief. See

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