Netflix: What happens next

January 9, 2013: 11:31 AM ET

The once-lauded streaming company faces a mountain of obstacles, cranky investors, not to mention persistent takeover rumors.

By Janet Morrissey, contributor

Hastings explains it all.

Hastings explains it all.

FORTUNE -- Video streaming giant Netflix has been on a roller coaster ride -- its shares tumbling more than 80% after a costly pricing debacle in 2011, and then fluctuating wildly up and down over the past year as the company navigated through a series of missteps, tough competition, and pressure from corporate raider Carl Icahn to sell the company. Yet Reed Hastings, the company's chief executive and co-founder, remains undaunted and convinced the company will not only survive, but flourish.

Surprisingly, analysts, many of whom have downgraded Netlix (NFLX) to underperform or sell, aren't placing bets against Hastings. But they are taking a defiant "show me" stand before ratcheting up their ratings again. "He's one of the more imaginative and intelligent CEOs in the country and I have great respect for him," says Charlie Wolf, senior analyst at Needham & Co. However, Wolf, who rates the firm at underperform, said the company has had missteps and he doesn't think the company's earnings stream over the next two or three years justify its current stock price. "There's a lot of uncertainty in what direction Netflix is going to go," concurs Michael Corty, an analyst at Morningstar (MORN), who has a sell rating on the stock.

Hastings insists that the company is in the early innings of a business plan that will reap millions of new subscribers. He contends the company's deep library of movies and TV shows, international expansion, and upcoming rollout of original programming will drive the company's growth. Activist shareholders, like Icahn, trying to push a sale, are a distraction to that goal. "The transition from linear TV to internet TV provides a staggeringly large long-term opportunity," said Hastings, in a recent letter to shareholders. "Internet TV is the future of television, and we are leading the change." Hastings declined to comment for this story.

Hastings, often considered the godfather of video streaming, started and built Netflix from a small DVD rental business in 1987 into the largest video streaming company in the U.S. today. But Hastings was no neophyte to Wall Street before launching Netflix -- he was already a seasoned and successful businessman.

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Born in Boston, the son of an attorney, Hastings honed his business chops early selling vacuum cleaners door-to-door as a teenager. After graduating with a major in Math from Bowdoin College in 1983 and a master's degree in computer science from Stanford in 1988, he took a job at a technology company, Adaptive Corp. In 1991, he launched his own firm, Pure Software, which went public in 1995, and was sold to Rational Software for about $750 million in 1997.

But it was a video rental experience the following year that triggered Hastings' Netflix idea. After renting the film "Apollo 13" from a local video store, Hastings was annoyed when he faced a $40 late fee for being six weeks late on returning the movie. He figured there had to be a better business model, and looked to the local gym as a paradigm, where people paid a flat fee per month to work out as little or as much as they wanted. That's when Netflix was born. A visionary even then -- Hastings named his new firm Netflix, instead of DVDbyMail, because he believed, even then, that the service would someday be offered through the internet.

The startup grew in leaps and bounds, going public in 2002 and beating back competition from Blockbuster and Wal-Mart along the way. He moved into the video streaming sector in 2007 at a time when critics considered it little more than a cyber pipe dream. Rivals, such as Blockbuster that didn't follow suit, were left in the dust.

The company's shares soared, hitting an all-time high of $304 in July 2011, a huge gain from its May 2002 IPO price of $15. Subscribers surged to more than 20 million in 2011 from 600,000 in 2002. Hastings was considered a darling on Wall Street and invited to sit on a number boards, including those of Microsoft (MSFT) and Facebook (FB). Hastings was Fortune's 2010 Businessperson of the Year. It was an investor's dream stock.

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But that dream turned into a nightmare in mid-2011, when Hastings announced a restructuring in which the streaming and DVD businesses would be split into separate services and websites, and subscribers wanting to keep unlimited access to both services would have to pay much more. Hastings misread the public reaction and initially played down the massive consumer outrage that followed the announcement. Cancellations soared as nasty blog postings from angry customers reverberated across the web. Netflix shares tanked.

A few months later, Hastings apologized in a blog, reversing the decision to split the company's businesses, although he maintained the price changes. "I messed up. I owe everyone an explanation," he wrote at the time. But the damage was done and the stock continued its free fall. Lost subscribers triggered earnings shortfalls, which further decimated the stock.

Other missteps followed: Efforts to expand internationally proved costly, where losses were larger than Wall Street anticipated. And the company's goal to add 7 million U.S. subscribers in 2012 was missed, with Hastings ratcheting down that projection to 5 million instead. "It's not a bad number, but it's below the original expectations," says Aaron Kessler, senior analyst at Raymond James.

Last month, Hastings even found himself in hot water with the SEC for disclosing some video viewing statistics on his Facebook page instead of through an SEC filing.

All of this comes as competition heat ups, with Amazon (AMZN) Prime, Hulu, Time Warner's (TWX) HBO Go, Comcast's (CMCSA) Xfinity, cable's TV Everywhere, Google (GOOG), and Verizon's (VZ) Redbox among others jumping into the video streaming space.

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Netflix advocates say that the company's brand, 30-million subscribers, and library of more than 9,500 movies and more than 41,000 TV episodes, make it tough for competitors to challenge. Although much of its library focuses on past, rather than current, season TV programming, its popularity is high. For example, more people have watched "Mad Men" on Netflix than on AMC because many people, who newly discover the award-winning show, go back to watch the earlier episodes on Netflix, says Ted Sarandos, chief content officer at Netflix, while speaking at a UBS conference earlier this month.

Still, the mistakes have cost. Netflix shares tumbled more than 80% from their peak to a low of $52.81 in August 2012. Making matters worse, the company was removed from the Nasdaq-100 on Dec. 24, which could pressure shares further.

In October, corporate raider Carl Icahn indicated in a 13D SEC filing that he had accumulated a 9.98% stake in Netflix (when call options are included) and began pressuring the company to sell itself. Icahn has a history of targeting undervalued companies at bargain basement prices, and then arm twisting or using proxy battles to fight his way onto their boards and turn them around through restructurings or sales.

Amazon, Microsoft, Apple (AAPL), Google and cable companies like Comcast have been bandied about as possible suitors. Word that Hastings recently stepped down from Microsoft's board fueled takeover speculation further. The news triggered a rally in the stock. Netflix shares recently traded at $98.34. "It scared people who were shorting the stock -- and it was a heavily shorted stock," says Corty.

But Hastings, who met with Icahn several times, has no interest in selling, and quickly rounded up other board members to adopt a poison pill to prevent Icahn from buying more shares.

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Hastings remains confident the company can flourish on its own. Although the international roll-out has been costlier than expected and will likely continue to incur losses for the next several quarters, he remains optimistic it will eventually be a home run. The company moved into Canada in 2010, Latin America in 2011, and the UK, Ireland and four Scandinavian countries (Sweden, Norway, Denmark and Finland) last year. In the first three-quarters of 2012, its international streaming operations generated revenue of $186 million, but losses of $284 million. International rampups typically take two years to break even, contends one company spokesman. So far, the losses have been offset by the company's robust U.S. streaming and DVD operations, which generated $2.5 billion in revenue in the first three-quarters of the year and profits of $652 million.

Corty worries the international expansion will generate losses far longer than management believes and wonders how long the company will wait for profits before pulling out. Hastings won't even consider a pullback. "There's little chance of that happening because we've got long-term content deals that we paid," he said. "We are focused on global profitability."

The biggest wild card for potential growth is its original programming, which includes new episodes of the wildly popular Arrested Development series, that will be streamed in 2013. Other original shows slated for 2013 release include David Fincher "House of Cards" starring Kevin Spacey, horror thriller "Hemlock Grove," and "Orange is the New Black."

Creating original shows and resurrecting older popular TV shows have become hot topics of debate for video streaming companies: The runaway success of TNT's modern version of the old "Dallas" TV series in 2012 left many companies wondering what other hit TV series from the past could be resurrected next. For example, is there an audience for the old "Las Vegas" TV series, which ended on a cliffhanger when the plug was abruptly pulled on the show during the writers strike of 2009? Could making new episodes of old shows, whose back catalogs have healthy followings in syndication, bring a new windfall of subscribers?

Even Amazon recently announced plans to produce original content.

Netflix also recently signed a blockbuster deal with Disney (DIS) for exclusive rights to stream its movies beginning in 2016 when Disney's agreement with Starz ends – a deal that's considered a major coup. The Disney deal triggered speculation that Netflix may also be negotiating for similar deals with Universal and Sony, whose contracts all expire within the next five years. "This is a long-term positive for Netflix as it marks the company's first direct Pay TV deal with a top 5 film studio, bypassing traditional premium cable channels such as HBO, Showtime and Starz," says Doug Anmuth, an analyst at JPMorgan (JPM).

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It also inked a deal with Warner Bros Television Group to stream complete seasons of several series produced by Warner Bros, including NBC's "Revolution," USA Network's "Political Animals," and ABC's "666 Park Avenue."

Still, analysts remain cautiously skeptical. While they applaud the Disney deal, they wonder if the company overpaid to steal the deal away from Starz. "We assume Disney was willing to wait unless it received an offer it could not refuse," Corty says. Wolf estimates the company paid about $300 million a year for the deal, which means the company would need to add 4 million new subscribers just to break even on it.

Ditto for the original shows Netfix is producing. "You're betting on TV shows that are going to jack subscribers, and that's hard to do," said one analyst, who did not wish to be named. Kessler is more bullish. "Arrested Development had somewhat of a cult following," that could bring in many new subscribers, he said.

As for Icahn, although he came out with guns barreling at the time of his 13D filing and promised a fight, he's more recently pulled back on plans to launch a proxy battle, at least for now, according to someone close to Icahn. He was impressed with the Disney deal and has watched Netflix stock, which he purchased under $60 a piece, rise to more than $97 a share since his filing, the person said.

Still, Netflix's 30 million subscribers and hefty library of titles could be attractive takeover target for a large entity wanting to jump to the top of the sector in one fell swoop. "I think there could be strategic buyers -- it's a question of price," says Brett Harriss, an analyst at Gabelli & Co. who rates the company at hold. Any potential acquirer would likely have to pay a hefty premium -- at least $150 a share for the board to consider an offer, say analysts. And even then, it might be a tough pill to swallow for investors who bought into the stock when it was close to $300.

But the violent swings in its stock price make it tough for potential buyers to value it. "When a stock moves around this fast, how do you sell it?" said one banker who did not wish to be named. "This hypervolatility makes acquisitions almost impossible. It can be done, but it gets tricky."

Some believe the board would fight any takeover offer at any price. "The board and the co-founder are clearly in control and they're not going to sell for anything less than a very very large premium," said Harriss. "The stock was at $300 in 2011, so it would be tough politically for them to sell for anything less than that."

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