Barron's Streetwise - Reed Hastings on Netflix's Secret Sauce

Episode Date: September 18, 2020

Plus, Jack talks cars and small cap stocks. Learn more about your ad choices. Visit megaphone.fm/adchoices

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you know, there's really a tremendous opportunity ahead for Netflix. Welcome to the Barron Streetwise podcast. I'm Jack Howe. The voice you just heard is Reed Hastings. He's the co-founder of Netflix, a service so popular that it accounts for over 12% of the planet's internet traffic, even more than this podcast. Reed has a new book out on Netflix's workplace culture. We'll look at that and hear from Reid on the streaming competition and the future for movie theaters, plus his words of consolation for long-suffering Netflix bears.

Poor things. Listening in, as always, is our audio producer, Metta. Hi, Metta. Hi, Jack. We've gotten a lot of requests since last week's podcast about my singing to never do it again. All of them. So we're not going to do a song special where you just sing answers to reader questions. I'm not sure that's what the people are looking for. I guess they're not. Meadow, what does the phrase be kind rewind mean to you? Absolutely nothing. You've

not heard that? No. It sounds kind of like self-help book advice. Be kind and relax, you know? I love it. I want to start writing that book. Well, those words used to come printed on video cassettes from movie rental stores. It was a drag if you went, you rented a copy of Beetlejuice, you popped it into the VCR, then you see the end credits playing because that meant that you had to hit rewind and then wait a few minutes to watch your movie. And some stores would charge you like a dollar if you didn't rewind. And some stores would charge you like a dollar if you didn't rewind. That might sound like a long ago tale of primitive society,

but just 20 years ago, video cassettes were still the market leader for home movies. At the time, in 2000, DVDs had been on the market for about four years. And there was a two-year-old company called Netflix that was bringing together the small size of DVDs and the reach of the United States Postal Service to deliver movies by mail. There's a better way to rent movies, as many as you want for only $17.99 a month

and no late fees. Go to netflix.com, make a list of the movies you wanna see, and in about one business day, you'll get three DVDs. And it was starting to get some attention. Here's the title of an October 2000 story in the Charlotte Observer newspaper. Easy Online DVD Rental is just a few clicks away. The writer explains how to set up a rental queue online and return discs in the same envelope they came in, and says he's been using the service for six months and hasn't made a single trip to the video store. Rewind this tape all over and it's blank.

Really? Be Kind Rewind is also the title of a 2008 movie starring Jack Black and Mos Def, also the title of a 2008 movie starring Jack Black and Mos Def, which I think drives home just how quickly Netflix upended the home entertainment business. The movie's about a video store owner who's losing his business because he refused to make the switch from video cassettes to DVDs. He becomes magnetized. I don't mean that metaphorically. We're magnetized! He accidentally erases his cassettes. You erased these tapes! And he needs something for the remaining customers he has to watch. So he takes an old camcorder and he creates his own low-budget remakes of famous movies.

And you see a little ghost. What you gonna do about Ghostbusters? What is that? That's the Ghostbusters theme song. No. I'm pretty sure it is. Customers like them and they want more. Hilarity and a 65% fresh rating on Rotten Tomatoes ensues. What's noteworthy about the movie is that a year before it came out, Netflix introduced a service called Watch Now, which allowed subscribers to instantly watch some shows and movies on their personal computers.

In other words, between the time a Hollywood studio said yes to the script for Be Kind Rewind and the time the movie hit theaters, the premise was out of date. DVDs by mail were no longer the main existential threat to movie rental stores. Streaming was. threat to movie rental stores. Streaming was. Netflix by then was already making deals to stream movies through consumer devices like the Xbox 360 video game console. To put the pace of change differently, Blockbuster Video, the movie rental giant, it peaked in size four years before Be Kind Rewind hit theaters. It went bankrupt two years after the movie. What followed, of course, was shocking growth for Netflix. In 2005, the year before launching that Watch Now service, it had reached 5 million subscribers. It took five years after that to quadruple its subscriber base

to 20 million. It's now 10 years later, and Netflix is expected to hit 10 times that number of subscribers, ending this year at more than 200 million worldwide. I had a chance to chat recently with Netflix founder Reed Hastings about the company's success and what's next. Hi, Reed. It's Jack Howell from Barron's. How are you? Jack, what a pleasure. Hi, Reid. It's Jack Howell from Barron's. How are you? Jack, what a pleasure. Thanks for having me. I asked what the company's main key to success has been. Netflix has had wildly successful shows of its own, like Stranger Things, and shows at licenses from outside studios like Orange is the New Black. Is the company's hit-making ability the key? It's also a sleek, easy-to-use service. Are the software

interface and the movie recommendation algorithms the keys? This is a good time to tell you the title of Reed's new book, No Rules Rules, Netflix and the Culture of Reinvention. Reed says culture has been the key. Well, I think at the deepest level, it's culture, which then manifests itself as better shows, better product experience, being more nimble and adapting to new things. Netflix's approach to managing its workers was summed up in an internal slide deck that got published online back in 2009. Hiring well is a key, of course, but so is firing well. The slide said workers that were merely adequate got let go. It mentioned the keeper test. If a worker comes to you today and says he or she is leaving for a similar job at a rival company,

would you fight to keep that worker? If not, fire them. Other slides discussed the importance of always giving honest feedback and how Netflix's vacation policy was that there is no policy. When I first saw the slides, they looked to me like Silicon Valley chest thumping. The sort of shark tank workplace ethos that companies can get away with for as long as their shares keep soaring. For the book, though, Reed brought on a university professor named Erin Meyer as a co-author. I like that she quickly dismisses the slides as, in her words,

workers aren't at their best if they're constantly worried about being fired. And not having a vacation policy sounds nice, but in practice, it means the most competitive workers just won't take time off and they'll get burned out. I suspect the motivation for the book was to explain that Netflix's culture is a bit more livable than that slide deck suggested. Basically, the company seeks to hire top people and pay them well, to weed out underperformers, to promote candor, and to minimize controls, like decision-making approval. That process has allowed it to move past mistakes quickly and respond well to change. The book also has some interesting stories. It opens with the time 20 years ago that Reed tried to get Blockbuster to buy Netflix for $50 million. Blockbuster to buy Netflix for $50 million. Blockbuster balked at the price, and Netflix today is valued at more than 4,000 times that much. Oopsie. I asked Reed if he thinks the

streaming landscape has gotten too crowded now that all the media conglomerates have services. There's Disney+, CBS All Access, Peacock, HBO Max, and more than 100 other services, including niche ones. Reed says he wouldn't be surprised to see more consolidation, like how Disney bought TV and movie assets from Fox, but that he thinks there's room for plenty of services. I think consumers want a lot of choices, and we each have different content. You know, there's Disney's Mandalorian show, and then there's Stranger Things. So, you know, there's tremendous choices in that, and people will subscribe to multiple services as they, you know, when they subscribe to multiple magazines. I think all those companies, if they can do excellent programming, will have a great future.

I asked about the future of movie theaters. Now that Netflix is producing its own movies, would it ever open one in theaters? Reed says no, because subscribers are paying to get that content first. But he thinks theaters can survive even without exclusive windows for movies before they go to streaming. Well, we can cook any food we want, and yet we often go to restaurants. and yet we often go to restaurants. We can listen to any music we want and yet we can go to any concert. We can watch sports live on TV and yet we go to stadiums. So the in-person experience, whether it's restaurants or concerts or sports stadiums or films, it's just a different experience. It's a compliment. But movies don't need an exclusive window. Theaters can exist great just as a choice because they're a great venue, just like sports

stadiums, music concerts, or restaurants. I asked about the rising cost of Hollywood talent now that so many streaming services are vying for shows. Reid says that's just the cost of success. I asked if he views a video sharing service like TikTok as a competitor. Here's Reid. There's a number of successful competitors, including TikTok, YouTube. There's all of video gaming like Fortnite. There's social media. There's social media.

So there is a lot of competition, even beyond a Disney Plus and HBO Max, which is much more similar to us. Disney's Bob Iger has explained to me that the company can make money off its movie characters and stories through merchandise sales, theme park visits, and more, and that that de-risks the decision of whether to spend a lot of money on a new movie. I asked Reed if Netflix will push into merchandise as it controls more of its storytelling. He said, yeah, to a degree. Yeah, I think those are great areas and consumer products is something that we're ramping up and the Disney is well ahead of us on. But the core is producing great shows. That's what we're mostly focused on. And then we'll add in consumer products and other things to be able to support those shows. I asked how much room Netflix has to grow and Reed mentioned 800 million

pay TV customers outside of China, or four times as many subscribers as Netflix has, which suggests plenty more room to gain customers. I asked if Reid has any words of consolation for those long-suffering Netflix stock bears, if there still are any. You know, the internet is hard to bet against because it opens up so many new opportunities. So I think if you put a traditional lens on it, you can get burned pretty badly, as the shorts have on Netflix, given that we went public about 20 years ago at about a dollar a share. And now we trade at about $500. Reed says investors who want to understand Netflix's secret sauce should, and you'll never see this one coming, read about its culture and innovation in the book.

I agree that investors should read the book because Reed is one of the great business creators of our day. Again, it's called No Rules, Rules. It kind of reminds me of the old Outback Steakhouse slogan, No Rules, Just Write. I used to see that in a commercial. I'd think to myself, who are these people for whom the rules at casual dining chains have become too burdensome? I mean, are there people out there who resent having to wear a shirt at Applebee's or not being able to wheel their own beer keg into a TGI Friday?

They just want to consider other options because I'm pretty sure Outback has those rules too. Anyhow, what I can tell you about No Rules Rules is that the second instance of rules is a verb, not a noun. Because in the book, Reed writes, Netflix is different. We have a culture where no rules rules. I want to mention one other milestone Netflix will likely hit this year, apart from 200 million subscribers. The company's on pace to generate free cash flow for the first time in many years. Just a little bit, and just for a little while, mostly by accident. And I think that's closely related to the company's success. You see, Netflix,

the service, has long been an excellent deal for consumers for a simple reason. The company has charged customers less than it has paid to run the business, including creating and licensing shows. A lot less, in fact. Over just the past three years, free cash flow has been negative by a total of $8 billion. That was like giving each subscriber back $50 more than they paid during those years. How can a company afford that? Well, it has to raise money, which companies can do in one of two main ways. By borrowing, including issuing bonds, and by selling part ownership, including issuing shares. Netflix lately has raised money by borrowing. It owes about $15 billion in long-term debt. Last October, it issued $2.2 billion worth of bonds that were just a smidgen into junk territory in terms of their credit

rating, but at rates that consumers with mediocre credit ratings would be happy to borrow at. but at rates that consumers with mediocre credit ratings would be happy to borrow at. 3.58% for a portion denominated in euros, and 4.78% for a dollar portion. One reason investors have been happy to lend to Netflix is that the company's rapid subscriber growth suggests it will generate free cash in the future. Netflix says it will begin consistently producing free cash in a few years, but it might temporarily produce a little free cash this year, in part because the pandemic has shut down movie and show production. That's given Netflix less to spend on, much the same way the rest of us aren't spending much now on restaurants and long-distance trips. There's another reason I

suspect investors have been happy to lend to Netflix. The stock has risen so high in price that Netflix was recently valued at $218 billion. That's not far from the stock market value of Disney, even though Disney in its best years has generated $8 to $10 billion in free cash. And Netflix isn't expected to approach that level until later this decade. Lenders take comfort in all that investor demand for Netflix's stock, because it means in an emergency, the company could issue stock to raise money. In other words, the soaring stock price has helped Netflix raise the money to run the losses to offer a better deal than its rivals. The good deal it offers keeps the subscriber base growing, making future free cash flow more likely. And that growth, it keeps investors buying the stock. It's a circular relationship, but one that has benefited

from the backdrop of ultra low interest rates and a raging bull market for stocks, especially tech stocks. Netflix is already well past the riskiest part of its growth, and the company could be only a few years away from being able to fund its own growth without borrowing. It's one thing to have no rules and to think that not having rules rules. But I asked Reed, what gave him the confidence to spend all those billions of dollars over the past five years on the belief that the subscribers and free cash flow would come. The Internet is very big. Entertainment is a core human need.

There was absolutely a large opportunity to serve Internet families all over the world with great entertainment. internet families all over the world with great entertainment. So it was our core belief in the size of the opportunity that gave us confidence to invest so much. Medha, I think it's time for a listener question. Let me get emotionally prepared with a deep breath. Okay, I think I'm ready. Let's hear one. That's the be kind, rewind stuff I was talking about earlier. Exactly. So we got a question from Brian from Baton Rouge, Louisiana. All right, let's hear it.

I plan to pay cash for my next car. Would it be financially advantageous instead of paying cash to invest that money in an index fund and use the growth in income to pay for a car lease? Basically like an endowment fund for my car. It seems like it would be smart because then you'd have the money and the car, but am I missing something? Thanks, Brian, and congratulations for having accumulated the savings to give you some choices on your next car and for thinking it through so carefully. Now, I've never heard of a car endowment. I suppose if you wanted to cover, let's say, a $500 monthly car expense and you were to assume a long-term withdrawal rate of

3%, you could set aside $200,000 in investments to cover your car. But I think of a car as being part of general expenses, not something that warrants its own accounting facility. I think the heart of your question is whether you should buy a car in cash or leave the bulk of that money invested in the stock market and lease a car instead. Now, I'm not a personal finance expert. I feel like every personal finance advice giver I've ever heard has said that the best value is to pay cash for a three-year-old car with about 45,000 miles because that's old enough for the price to have gone down a lot, but young enough to still have plenty of useful life. The worst value might be leasing, but that doesn't mean

it's the worst choice for you. Are you someone who has plenty of room in your budget, but not much room in your schedule, so it's important to avoid trips to the garage for repairs? Do you have kids and you want the latest safety features every few years or just a fresh car that doesn't have french fries lost down the seat cushions or chocolate milk spilled on the carpet? Only you know how you feel about these things and how you feel is important. Maybe you're someone who doesn't mind driving, say, a seven-year-old car, but only so long as it's your rear end that's been sitting in it for the past seven years or the rear end of someone you love. If so, you might want to consider buying a new car and keeping it for a long time.

I'll just tell you two things, Brian. First, I don't think future potential stock returns on your unspent car funds should play a big role in your decision whether to lease. Stock valuations look high today, so my guess is that returns over the next decade will be lower than average. They might be more than offset by the extra money you pay to lease cars every three years. Whatever you do, be sure to keep enough emergency money in cash. And second, be aware that the pandemic has turned some car pricing screwy, and I'm not talking about deep discounts. New car prices have been pretty steady, but I've seen examples of popular models that have

been put in short supply by production interruptions and are now selling for thousands of dollars over sticker price. The larger effect is on used cars. They've risen in price at the fastest pace in more than a half century, according to the U.S. government department that tracks inflation. Some people that used to use Uber and Lyft or public transportation have decided to buy cars, and they're turning to used cars to save money. How long prices stay like this depends on how long the pandemic lasts. Did I answer your question, Brian? Not really, I know, but cars are such a personal thing. Okay, here you go. If you truly can't decide, buy a three-year-old Honda minivan for $25,000 and keep the leftover money in the bank or in a stock index fund if

you already have enough money in the bank. Now I don't know if that advice is the right fit for you personally, but minivans are for winners and if you do find a french fry stuck way down in the seat, it might be one of mine. Meta, how about one more quick question and I'll provide a quick answer. You know what? I'll abbreviate to save time. One more Q and I'll provide an A. Yeah, we've got a short Q from Nathan who lives in Dana Point, California.

Let's hear it. Hi, Jack and Meta. For years, I have made the max contribution to my IRA and invested that money in a low-cost S&P 500 index fund. Recently, I was talking to a financial advisor who said that was a mistake and that I should invest in a low-cost total market index fund. I looked at the historical performance and both funds were pretty much neck and neck. But I wanted to ask you if the total market index is a better way to go. Thanks for a great show. Thank you, Nathan.

Now, I'm glad to hear about the IRA, but that part is beside the point. That's the type of account. And your question is really about what to put in the account. You have an S&P 500 fund, which means you're invested in large U.S.-based companies. Your financial advisor says you should invest in a total market index fund, which will include large, mid-size, and small companies. He says it will outperform your S&P 500 fund.

Let's put aside for the moment other decisions, like whether to diversify outside the U.S. Is your financial advisor right that you should have some small company exposure and that it might increase your returns? I say yes. A total market index fund is a good idea as long as the fee is as low as the one you're paying now, which hopefully is laughably low. And the switch won't give you a big tax bill, which it won't because it's inside that tax-deferred IRA. There's something called the small company effect. It refers to the tendency of small company stocks to outperform large company ones over long time periods.

It was first described by a researcher named Rolf Banz in a paper published in 1981 in the Journal of Financial Economics titled The Relationship Between Return and Market Value of Common Stocks. But lately, Nathan, as your return comparison suggests, the small company effect is nowhere to be seen. Over the past five years, the S&P small-cap 600 index has returned

a cumulative 40%, including dividends. Its large company sibling, the S&P 500, has returned more than twice as much, over 90%. Some people think the small company effect is broken. What's clear is that a handful of massive tech companies like Apple, Amazon, Microsoft, Alphabet, and Facebook have run ahead of other stocks and now make up a massive portion of the stock market. The pandemic has amplified that effect in part because big companies with deep capital resources have been in a better position to weather the shutdown than small companies. So the question is, will this trend continue forever, or will conditions revert to the way they were? Any attempt to answer that question would have to get into issues of market dominance, entrepreneurial opportunity, even antitrust action. But when in doubt, I tend to

guess in favor of reversion to the mean, because things that get out of whack tend not to stay out of whack forever. But keep in mind, even if I'm right, things can stay out of whack for a long time. You might also be comforted by the fact that small companies, having been exceptionally poor relative performers lately now look exceptionally cheap relative to large caps. If we go by S&P 500 indexes, small company stocks were recently almost 30% cheaper than large company ones relative to last year's earnings. That's not necessarily a reason to load up on small companies, but a total index fund comes pretty far from loading up on them. It weights all companies according to size, so the giants still dominate the portfolio.

For example, the S&P 1500 Composite Index, which is a total market index, has a market value of around $30 trillion, and of that, $28 trillion is made up of the large companies in the S&P 500 index. So buying a total market index fund is a more subtle change than it might seem, Nathan. It's not an urgent matter, but I think it makes sense. Thank you, Brian and Nathan, for sending in your questions. And everyone, please keep the questions coming. Just tape on your phone using the voice memo app.

Send it to jack.how, that's H-O-U-G-H, at barons.com. Thank you for listening. Meta Lutzhoft is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's at Jack Howe, H-O-U-G-H. See you next week.