And the Winner Is – Netflix!!

Last week's earning's announcements gave us some big news.  Looking around the tech industry, a number of companies reported about as expected, and their stocks didn't move a lot.  Apple had robust sales and earnings, but missed analyst targets and fell out of bed!  But without a doubt, the big winner was Netflix, which beat expectations and had an enormous ~50% jump in valuation!

My what a difference 18 months makes (see chart.)  For anyone who thinks the stock market is efficient the value of Netflix should make one wonder.  In July, 2011 the stock ended a meteoric run-up to $300/share, only to fall 80% to $60/share by year's end.  After whipsawing between $50 and $130, but spending most of 2012 near the lower number, the stock is now up 3-fold to $160!  Nothing scares investors more than volatility – and this kind of volatility would scare away almost anyone but a day trader!

Yet, through all of this I have been – and I remain – bullish on Netflix.  During its run-up in 2010 I wrote "Why You Should Love Netflix," then when the stock crashed in late 2011 I wrote "The Case for Buying Netflix" and last January I predicted Netflix to be "the turnaround story of 2012."  It would be logical to ask why I would remain bullish through all the ups and downs of this cycle – especially since Netflix is still only about half of its value at its high-point.

Simply put, Netflix has 2 things going for it that portend a successful future:

1. Netflix is in a very, very fast growing market.  Streaming entertainment.  People have what appears to be an insatiable desire for entertainment, and the market not only has grown at a breathtaking rate, but it will continue to grow extremely fast for several more quarters.  It is unclear where the growth rate may tap out for content delivery – putting Netflix in a market that offers enormous growth for all participants.
2. Netflix leadership has shown a penchant for having the right strategy to remain a market leader – even when harshly criticized for taking fast action to deal with market shifts.  Specifically, choosing to rapidly cannibalize its own DVD business by aggressively promoting streaming – even at lower margins – meant Netflix chose growth over defensiveness.

In 2011 CEO Reed Hastings was given "CEO of the Year 2010" honors by Fortune magazine.  But in 2011, as he split Netflix into 2 businesses – DVD and streaming – and allowed them to price independently and compete with each other for customer business he was trounced as the "dunce" of tech CEOs. 

His actions led to a price increase of 60% for anyone who decided to buy both Netflix products, and many customers chose to drop one.  Analysts predicted this to be the end of Netflix. 

But in retrospect we can see the brilliance of this decision.  CEO Hastings actually did what textbooks tell us to do – he began milking the installed, but outdated, DVD business.  He did not kill it, but he began pulling profits and cash out of it to pay for building the faster growing, but lower margin, streaming business.  This allowed Netflix to actually grow revenue, and grow profits, while making the market transition from one platform (DVD) to another (streaming.)

Almost no company pulls off this kind of transition.  Most companies try to defend and extend the company's "core" product far too long, missing the market transition.  But now Netflix is adding around 2 million new streaming customers/quarter, while losing 400,000 DVD subscribers.  And with the price changes, this has allowed the company to add content and expand internationally — and increase profits!!

Marketwatch headlined that "Naysayers Must Feel Foolish."  But truthfully, they were just looking at the wrong numbers.  They were fixated on the shrinking installed base of DVD subscribers.  But by pushing these customers to make a fast decision, Netflix was able to convert most of them to its new streaming business before they went out and bought the service from a competitor. 

Aggressive cannibalization actually was the BEST strategy given how fast tablet and smartphone sales were growing and driving up demand for streaming entertainment.  Capturing the growth market was far, far more valuable than trying to defend the business destined for obsolescence. 

Netflix simply did its planning looking out the windshield, at what the market was going to look like in 3 years, rather than trying to protect what it saw in the rear view mirror.  The market was going to change – really fast.  Faster than most people expected.  Competitors like Hulu and Amazon and even Comcast wanted to grab those customers.  The Netflix goal had to be to go headlong into the cold, but fast moving, water of the new streaming market as aggressively as possible.  Or it would end up like Blockbuster that tried renting DVDs from its stores too long – and wound up in bankruptcy court.

There are people who still doubt that Netflix can compete against other streaming players.  And this has been the knock on Netflix since 2005.  That Amazon, Walmart or Comcast would crush the smaller company.  But what these analysts missed was that Amazon and Walmart are in a war for the future of retail – not entertainment – and their efforts in streaming were more to protect a flank in their retail strategy, not win in streaming entertainment.  Likewise, Comcast and its brethren are out to defend cable TV, not really win at anytime, anywhere streaming entertainment.  Their defensive behavior would never allow them to lead in a fast-growing new marketplace.  Thus the market was left for Netflix to capture – if it had the courage to rapidly cannibalize its base and commit to the new marketplace.

Hulu and Redbox are also competitors.  And they very likely will do very well for several years.  Because the market is growing very fast and can support multiple players.  But Netflix benefits from being first, and being biggest.  It has the most cash flow to invest in additional growth.  It has the largest subscriber base to attract content providers earlier, and offer them the most money.  By maintaining its #1 position – even by cannibalizing itself to do so – Netflix is able to keep the other competitors at bay; reinforcing its leadership position.

There are some good lessons here for everyone:

1. Think long-term, not short-term.  A king can become a goat only to become a king again if he haa the right strategy.  You probably aren't as good as the press says when they like you, nor as bad as they say when hated.  Don't let yourself be goaded into giving up the long-term win for short-term benefits.
2. Growth covers a multitude of sins!  The way Netflix launched its 2-division campaign in 2011 was a disaster.  But when a market is growing at 100%+ you can rapidly recover.  Netflix grew its streaming user base by more than 50% last year – and that fixes a lot of mistakes. Anytime you have a choice, go for the fast growing market!!
3. Follow the trend!  Never fight the trend!  Tablet sales were growing at an amazing clip, while DVD players had no sales gains.  With tablet and smartphone sales eclipsing DVD player sales, the smart move was to go where the trend was headed.  Being first on the trend has high payoff.  Moving slowly is death.  Kodak failed to aggressively convert film camera customers to its own digital cameras, and it filed bankruptcy in 2012.
4. Dont' forget to be profitable!  Even if it means raising prices on dated solutions that will eventually become obsolete – to customer howls.  You must maximize the profits of an outdated product line as fast as possible. Don't try to defend and extend it.  Those tactics use up cash and resources rather than contributing to future success.
5. Cannibalizing your installed base is smart when markets shift.  Regardless the margin concerns.  Newspapers said they could not replace "print ad dollars" with "on-line ad dimes" so many went bankrupt defending the paper as the market shifted.  Move fast. Force the cannibalization early so you can convert existing customers to your solution, and keep them, before they go to an emerging competitor.
6. When you need to move into a new market set up a new division to attack it.  And give them permission to do whatever it takes.  Even if their actions aggravate existing customers and industry participants.  Push them to learn fast, and grow fast – and even to attack old sacred cows (like bundled pricing.)

There were a lot of people who thought my call that Netflix would be the turnaround tech story of 2012 was simply bizarre.  But they didn't realize the implications of the massive trend to tablets and smartphones.  The impact is far-reaching – affecting not only computer companies but television, content delivery and content creation.  Netflix positioned itself to be a winner, and implemented the tactics to make that strategy work despite widespread skepticism. 

Hats off to Netflix leadership.  A rare breed.  That's why long-term investors should own the stock.

Sell Microsoft NOW – Game over, Ballmer loses

Microsoft needed a great Christmas season.  After years of product stagnation, and a big market shift toward mobile devices from PCs, Microsoft's future relied on the company seeing customers demonstrate they were ready to jump in heavily for Windows8 products – including the new Surface tablet.

But that did not happen. 

With the data now coming it, it is clear the market movement away from Microsoft products, toward Apple and Android products, has not changed.  On Christmas eve, as people turned on their new devices and launched their first tweet, Surface came in dead last – a mere 2% compared to the number of people tweeting from iPads (Kindle was second, Android third.)  Looking at more traditional units shipped information, UBS analysts reported Surface sales were 5% of iPads shipped.  And the usability reviews continue to run highly negative for Surface and Win8.

This inability to make a big splash, and mount a serious attack on Apple/Android domination, is horrific for Microsoft primarily because we now know that traditional PC sales are well into decline.  Despite the big Win8 launch and promotion, holiday PC sales declined over 3% compared to 2011 as journalists reported customers found "no compelling reason to upgrade."  Ouch!

Looking deeper, for the 4th quarter PC sales declined by almost 5% according to Gartner research, and by almost 6.5% according to IDC.  Both groups no longer expect a rebound in PC shipments, as they believe homes will no longer have more than 1 PC due to the mobile device penetration  – the market where Surface and Win8 phones have failed to make any significant impact or move beyond a tiny market share.  Users increasingly see the complexity of shifting to Win8 as not worth the effort; and if a switch is to be made consumer and businesses now favor iOS and Android.

Microsoft's monopoly over personal computing has evaporated.  From 95% market domination in 2005 share has fallen to just 20% in 2012 (IDC, Goldman Sachs.)  Comparing devices, in 2005 there were 55 Windows devices sold for every Apple device; today explosive Apple sales has lowered that multiple to a mere 2! (Asymco).  Universally the desire to upgrade Microsoft products has simply disappeared, as XP still has 40% of the Windows market – and even Vista at 5.7% has more users than Win8 which has only achieved a 1.75% Windows market share despite the long wait and launch hoopla. And with all future market growth coming in tablets, which are expected to more than double unit volume sales by 2016, Microsoft is simply not in the game.

These trends mean nothing short of the ruin of Microsoft.  Microsoft makes more than 75% of its profits from Windows and Office.  Less than 25% comes from its vaunted servers and tools.  And Microsoft makes nothing from its xBox/Kinect entertainment division, while losing vast sums on-line (negative $350M-$750M/quarter).  No matter how much anyone likes the non-Windows Microsoft products, without the historical Windows/Office sales and profits Microsoft is not sustainable.

So what can we expect at Microsoft:

1. Ballmer has committed to fight to the death in his effort to defend & extend Windows.  So expect death as resources are poured into the unwinnable battle to convert users from iOS and Android.
2. As resources are poured out of the company in the Quixotic effort to prolong Windows/Office, any hope of future dividends falls to zero.
3. Expect enormous layoffs over the next 3 years.  Something like 50-60%, or more, of employees will go away.
4. Expect closure of the long-suffering on-line division in order to conserve resources.
5. The entertainment division will be spun off, sold to someone like Sony or even Barnes & Noble, or dramatically reduced in size.  Unable to make a profit it will increasingly be seen as a distraction to the battle for saving Windows – and Microsoft leadership has long shown they have no idea how to profitably grow this business unit.
6. As more and more of the market shifts to competitive cloud businesses Apple, Amazon and others will grow significantly.  Microsoft, losing its user base, will demonstrate its inability to build a new business in the cloud, mimicking its historical experiences with Zune (mobile music) and Microsoft mobile phones.  Microsoft server and tool sales will suffer, creating a much more difficult profit environment for the sole remaining profitable division.

Missing the market shift to mobile has already forever tarnished the Microsoft brand.  No longer is Microsoft seen as a leader, and instead it is rapidly losing market relevancy as people look to Apple, Google, Amazon, Samsung, Facebook and others for leadership.   The declining sales, and lack of customer interest will lead to a tailspin at Microsoft not unlike what happened to RIM.  Cash will be burned in what Microsoft will consider an "epic" struggle to save the "core of the company." 

But failure is already inevitable.  At this stage, not even a new CEO can save Microsoft.  Steve Ballmer played "Bet the Company" on the long-delayed release of Win8, losing the chance to refocus Microsoft on other growing divisions with greater chance of success.  Unfortunately, the other players already had enough chips to simply bid Microsoft out of the mobile game – and Microsoft's ante is now long gone – without holding a hand even remotely able to turn around the product situation.

Game over. Ballmer loses. And if you keep your money invested in Microsoft it will disappear along with the company.   

Related articles

Mobile Overtakes Desktops in 2013: Microsoft Be Warned

The iPad and the Surface: a tale of two tablets

Microsoft Sold 1 Million Surface Tablets During 2012's Q4

Why Jeff Bezos is our greatest living CEO

The Harvard Business Review recently published its list of the 100 Best Performing CEOs.  This list is better than most because it looks at long-term performance of the CEO during his or her time in the job – with many on the list in service more than a decade.

#1 was Steve Jobs.  #2 is Jeff Bezos – making him the greatest living CEO.  It is startling just how well these two CEOs performed.  During Jobs' tenure Apple investors achieved a return of 66.8 times their money.  During Mr. Bezos' tenure shareholders achieved a remarkable 124.3 times return on their money.  In an era when most of us are happy to earn 5-10%/year – which equates to doubling your money about once a decade – these CEOs exceeded expectations 30-60 fold!

Both of these CEOs achieved greatness by transforming an industry.  We all know the Apple story.  From near bankruptcy as the Mac company Mr. Jobs led Apple into the mobile devices business, and created a transformation from Walkmen, Razrs and PCs to iPods, iPhones and iPads – to the detriment of Sony, Motorola, Nokia, Microsoft, HP and Dell. 

The Amazon story is all the more remarkable because it has been written in the far more mundane world of retail – not known for being nearly as fast-changing at tech.

Lest we forget, Amazon started as an on-line seller of books frequently unavailable at your local bookstore.  "What's a local bookstore?" you may now ask, because through continuous upgrading of its capability to build on the advances in internet usage – across machines, browsers, wi-fi and mobile – Amazon drove into bankruptcy such large booksellers as B.Dalton and Borders – leaving Barnes & Noble a mere shell of its former self and on tenous footing.  And the number of small bookshops has dropped dramatically.

But Amazon's industry transformation has gone far beyond bookselling.  Amazon was one of the first, and by most users considered the best, at offering a complete on-line storefront for any retailer who wants to sell goods through Amazon's site.  You can set up your inventory, display products, provide user information, manage a shopping cart and handle check out all through Amazon – with minimal technical skill.  This allowed Amazon to bring vastly more products to customers; and without adding all the inventory or warehousing cost.

As digital uses grew, Amazon moved beyond the slow-paced publishers to launch the Kindle and give us eReaders displacing paper books and periodicals.  But this was just the first salvo in the effort to promote additional on-line buying, as Amazon next launched Kindle Fire which at remarkably low cost gave people a tablet already set up for doing retail shopping at Amazon.

As Amazon launched its book downloads and on-line services, it built its own cloud services business to aid businesses and people in using tablets, and doing more things on-line; which further reinforced the digital retail world in which Amazon dominates.

And make no doubt about it, Kindle Fire – and the use of all other tablets – is the WalMart and other traditional brick-and-mortar retail killer.  Amazon is now a player in all pieces of the transition which is happening in retail, from traditional shopping to on-line. 

Demand for retail space in the USA began declining in 2009 and has not stopped.  Most analysts blamed it on the great recession.  But in retrospect we can now see it was the watershed year for customers to begin looking more, and buying more, on-line.  Now each year growth in on-line retail continues, while demand at traditional stores wanes.

Just look at this last holiday season.  To (hopefully) drive revenue stores were opening on Thanksgiving, and doing 24 and 48 hours of non-stop staffing and promotions to drive sales.  But it was mostly in vain, as traditional retail saw almost no gains.  Despite doing more and more of what they've always done – trying to be better, faster and cheaper – they simply could not change the trend away from shopping on-line and back into the stores.

For the last year the #1 trend in retailing has been "showrooming" where customers stand in a store with a smartphone comparison pricing on-line (most frequently Amazon) to the product on the shelf.  Retailers were forced to match on-line prices, despite their higher overhead, or lose the business.  And now Target has implemented a policy of price-matching Amazon for all of 2013 in hopes of slowing the trend to on-line purchasing.

Circuit City went bankrupt, which saved Best Buy as it picked up their lost business.  But now Best Buy is close to failure.  Same store sales at WalMart have been flat.  JCPenney recruited Apple's retail store wizard as CEO – but he's learned when you have to compete with Amazon life simply sucks.  Nobody in traditional retail has found a way to reverse the on-line shopping trend, which is still dominated by Amazon.

We all can learn from these two CEOs and the companies they built.  First, and foremost, is understand trends and align with them.  If you help people move in the direction they want to go life is easy, and growth can be phenomenal.  Trying to slow, stop or reverse a trend doesn't work, and is expensive. 

Second, don't ask customers what they want, instead give them what they need.  Customers may be on a trend, but they will frame their requests in the old paradigm.  By creating new trend-promoting products and solutions you can capture the customer and avoid head-to-head competition with the "old guard" titans selling the increasingly outdated solutions.  Don't build better brick-and-mortar, make brick-and-mortar obsolete.

So, what's stopping you from growing your business like Apple or Amazon?  What keeps you from being the next Steve Jobs, or Jeff Bezos?  Can you spot trends and provide trend-supporting solutions for customers?  Or are you stymied because you're spending too much time trying to defend and extend your old business in the face of game changing trends.