22 December 2010

is Netflix sustainable ?

Several people have recently asked me if I thought Netflix had a viable business model. To be honest, I never thought much about that question until this month when Fortune magazine annointed Reid Hastings CEO of the year. The stock has been on a tear in 2010 – so it got me thinking, is Netfix sustainable?

Netflix is type of company I love to root for. It’s the nimble smart company that takes market share from slow incumbents despite all the odds stacked against them. Blockbuster, Walmart, and Amazon all went after the fledgling company. Coinstar’s Redbox inked deals with all of the chain stores to put their DVD kiosks in their establishments. Netflix was no match for these industry insiders and deep pockets. But they all pulled back or lost the battle to the startup (blockbuster = ch. 11). Kudos Mr. Hastings.

Now they are at it again. They are completely revamping their business model to lead the charge to real-time streaming content. 2/3 of Netflix subscribers already use streaming - a figure expected to rise rapidly. It’s a risky bet to gamble their entire DVD business, but probably a smart one. Like DVD’s in the mail, they are moving aggressively hoping to gain a critical mass of content and subscribers to give them a sustainable first mover advantage. So the question is can they beat the odds again ?

At first blush, it seems like they can. They inked deals with many of the movie and TV studios such as Disney. They cornered the hardware providers like blue-ray, smart phone, and the numerous media center offerings with “Netflix inside”. Like they did with DVDs, they no doubt have the widest array of streaming content compared to their competitors like Apple TV. Unlike the first time around however, the price to play has gone up considerably.

Netflix claims that they only need $9 / subscriber to make a profit. In a world of cheap or free content, I tend to agree. But that’s not the case anymore. They paid $1B over 5 years to MGM and other movie studios for their content. Sure they are padding their libraries with cheap second tier content online such as ABC family, but the good stuff costs a lot more now. The “28 day” delay rule is still in effect in which they can’t offer premium content from the top movie studios. HBO and the other premium providers still refuse to work with them. Bottom line, content costs are going up not down. $9 per subscriber works great in a cheap acquisition cost model but not when the big boys start charging real dollars.

It all comes down to bargaining power (remember Porter’s 5 forces?). Netflix has distribution and a growing customer base. Warner Brothers and NBC have the content that people want. Disney embraces Netflix. Warner despises them. How much is an “entourage” show or “harry potter” movie worth? That’s the million dollar question. How much can a distributor command versus the manufacturer (studios)?

How much would you pay for entertainment content? That’s the key to Netflix. In a $9/month world, Netflix wins. That means the content is more commodity priced which tips the scale to Netflix who has established strong distribution. If it’s more along the lines of your $50/month traditional cable bill, then the content guys win.

Times are different now. Back when music was free (Napster), Apple was successful in convincing all the studios to allow them to charge 99c per song in its Itunes store. They all feel robbed now – they will never get to the levels of sales as they did during the peak of compact discs. Bestselling Ebooks go for $20; not much cheaper than their hardback predecessors. The NY times and WSJ charge monthly subscription fees now to access their website. Content providers are no longer timid to charge as they once were in the net infancy days.

There are many parallels going on right now in business, particularly with this week's net neutrality ruling. How will YouTube and Pandora fare in negotiations with Comcast and AT&T? What about mobile content providers as they wrestle for airtime on Verizon and AT&T's networks (surprisingly the net neutrality compromise excluded wireless networks since that't the wave of the future)?

I'm still rooting for the boys in red. As respectful as I am of what Netflix has accomplished over the years, I think that online content distribution becomes ubiquitous over time (much like the movie houses which all filed for bankruptcy in the 90s while the studios thrived). Netflix will definitely survive; I just don’t think their $9 nut will net them as much as they think it will in the future.

14 December 2010

The upcoming tax hike no one is talking about

There's heated debate going on right now about the compromise bill on what taxes are fair and what groups should (or should not) be subject to tax hikes if the Bush cuts are rolled back. There's another tax creeping up on us that will hit each of our pocketbooks more directly since it's tied to consumption.... the internet commerce tax. As much I hate giving more money to the government, I think its fair, especially if you take into consideration the hidden economic costs of the status quo. And get ready for it folks, its coming soon to a computer near you.

Consider this situation - Atmabus is looking to buy a Dyson vacuum for $399. It's the same price at both Best Buy and Amazon. At a 9% sales tax rate, my purchase is roughly $36 higher if i patron my local Best Buy - a no brainer for me. The way the tax rules work - internet commerce is not taxed, historically because its been difficult to establish jurisdiction. These sales have been viewed as interstate commerce; sales tax is governed by state and local authorities. Advantage: Amazon. Just today, Best Buy announced terrible earnings citing market share losses. Certainly their offline and online competitors are running faster than them; but the tax arbitrage situation has added fuel to the fire.

All things being equal, we're dissuading people from shopping at their local stores - a big economic cost to cities. It's one less sale to justify a new employee for Best Buy, and one less sale that circulates money locally (real estate, restaraunts, etc...). Also - the likes of Best Buy create more jobs than Amazon since their retail model is more labor intensive than ecommerce companies. So what is the cost ?

Amazon had sales of $25B last fiscal year (and growing), much of which had no sales tax applied to it. Assuming 90% of their sales were untaxed a 9% average sales tax rate, that would have generated $2B for state economies. Not enough to plug the CA budget hole, but not pocket change either. And this is just one ecommerce company, imagine applying this logic to all online sales.

Best Buy generated $50B last year. They employeed 180,000 full time employees. Amazon, which had half of Best Buy's revenue, employed a meager 25,000. For every dollar of revenue created by Amazon, it translated into 1/4 of the jobs than it did at Best Buy. Applying this ratio to Amazon's sales, this means 65,000 less jobs created. 65,000 less people with disposable income, paying payroll taxes, and circulating money locally. I know this is a bit of a generalization, but you get the point. Again, this is one example, imagine if you apply it more broadly.

I'm not saying that we should end ecommerce and source everything locally, but it doesn't make sense to give Amazon a competitive advantage when they clearly do not need one. Why should i have to pay $36 to my local Best Buy who employs people versus Amazon which does not ? Given the pressure on local government agencies to find new sources of revenue, they will no doubt jump at ecommerce. Many states have already done so and many are planning on it.

So as i blogged about earlier, i told everyone to take advantage of the short-lived free services the net currently affords due to its nascency. I'd now also load up on all your christmas gifts for the next several years to save another 9% that will hit in the years to come.

07 December 2010

Endeavor - update to microfinance

A quick update to my MicroFinance in Marco Economies article -- I read an article in the WSJ this weekend that chronicled 13 year old non-profit Endeavor, which provides VC-like services to entrepreneurs in poor countries and communities. They leverage their Ivy league educations, business connections, and savvy to incubate successful businesses. They focus on building larger, scalable entities (as opposed to microfinance which focuses on the $1/day market) such as the "Latin America etrade" and a Turkish version of Cisco. They've had IPOs, and their entrepreneurs accounted for 135,000 jobs and $3.5B in sales last year (the bulk in Argentina).

Kudos to Linda Rottenberg and her team. This is a great effort that leverages capitalistic methods to complex societal problems. It also illustrates that free market philanthropy doesn't only work on the "bottom of the pyramid", but can work to build large startups and could even work in mature economies like the US.

03 December 2010

America the Oligopoly

One of the things most concerning in the business landscape is the rise of big business and the fall of choice in America. I’m the biggest free market capitalist out there, but I don’t like the trend of the fat getting fatter and barriers to entry rising. We're inundated with chain restaurants, box retailers, and product differentiation based only on price. While conglomerates give us some advantage in terms of reach, they tend to focus on defending their market positions instead of creating value and providing customers what they want. Defense is not a great offense.

Every industry you look at is primarily dominated by one or two players. Consumer staples like diapers and razors – Kimberly Clark and P&G; Our services at home – one electric provider, 1 cable, 1 telephone, 1 gas company. Banking has become Chase or B of A. Even the next generation tech industries are now ruled by the chosen few – Oracle and Microsoft with enterprise software, Cisco with networking, Google and Facebook rule online eyeballs. America has done a great job of building scalability, consolidating industries, and homogenizing society. You can't blame Cisco for their aggressive acquisition strategy and monopolistic-like market share. But is this good for the US in the long run?

Not in my opinion. Big business creates fewer jobs than smaller companies (in aggregate), capture less of people’s talents, and reduce the workforce to merely caretakers versus innovators. I also think there is a societal cost of less worth to individuals who merely punch in and punch out. So how do we buck this trend? Not through regulation which creates artificial winners and losers (and unintended consequences). But there are ways that I see we can bring local business back.

-VCs: I gave them a hard time in an earlier post for not being innovation centers, but they have the deep pockets and smarts to level the playing field against the oligarchs. They can give new businesses scale, bring new ideas to market, and love to find “white space” opportunities that displace incumbents. Groupon (a huge payday as Google reportedly is paying $6B for them) is competing head on with NBC and Mint.com provides an alternative to high priced financial advisors.

-Keep our borders open for business: Toyota and Honda brought true value to consumers by giving quality at a better price. We should force the oligarchs to compete not only with the small businesses at home, but the big businesses abroad. Open markets force big business to remain honest and focus on consumer needs. This also opens market opportunity for small business (with the rise of the internet) in which entrepreneurs will find a niche. Four Hands has proven to be a formidable competitor against the big North Carolina boys by leveraging open markets.

-End government tax breaks: The richest companies hire the best tax firms to get them out of paying taxes. There’s a reason why Singapore is becoming a business hub – 5% corporate tax rate. Multinationals can park profits there. We need to simplify the tax code and end tax breaks. Small business is at a disadvantage in this area.

-Teach business in Schools: We need to teach students basic finance, marketing, and accounting just as we do basic science and English. Last week I heard a terrible stat – 70% of doctors ten years ago were non-employees (ie. entrepreneurs in their own private practice), now its 30%. It’s gotten so complicated to open a business now that doctors, auto repair shops, and other generally local business providers are falling to prey to becoming franchise employees. There would be no Monarch Dental or NTB if local experts were better educated in business.

-Make the patent process more accessible: I love the James Dyson story of how he tried to sell his unique designs to the large vacuum companies. They basically said no and tried to copy him. Dyson spent all of his life savings in the courts against the big guns (experienced personal bankruptcy, but eventually won). Most people don’t have the will, money or time to fight the battle that Dyson did. And let’s face it – nothing beats the suction and ball technology of a Dyson vacuum.

I like that Walmart has added more dollars to everyone's pocketbook by passing their significant cost advantages to the masses. There is certainly a place for this level of efficiency (and I'm glad walmart actually passes their cost savings to the public versus other big boys), but I don't think that should be the face of US business. Small businesses create better jobs, more choice, and a level of diversity that equals the US population. I think if small businesses get can better organized, tap into resources that create efficiencies, they will be well poised to give us the next bagless vaccum.