Mad Hedge Technology Letter
August 6, 2018
Fiat Lux
Featured Trade:
(NEXT STOP IS $2 TRILLION),
(AAPL), (AMZN), (MSFT), (NFLX), (FB), (GOOGL), (TWTR), (CRM)
Another win for big tech.
Apple (AAPL) is the first company in America to have a trillion-dollar market cap and won't be the last as Amazon (AMZN) is close behind.
This also opens up the door for one of our favorite companies Microsoft (MSFT), which will shortly cross the $1 trillion threshold as well.
The milestone underscores the reliability and power of the tech sector that has propped up this entire market in 2018 as we continue the late stage cycle of the nine-year bull market.
Apple has entered into a hyper-charged expansion phase, and I will explain how this will boost shares to new heights.
The Mad Hedge Technology Letter has been hammering away on the software and services narrative since its inception.
As legacy companies are pummeled in the financial markets, the cloud has enabled a revolutionary industry catering toward annual subscriptions of all types.
Users no longer have to store gobs of data on computers. The cloud allows the data to be stored on remote data servers giving access to the information from anywhere in the world with an Internet connection.
A plethora of modern hybrid apps boosting productivity integrated with the cloud offers business a new-found way to collaborate with coworkers around this increasingly multicultural, multilingual, and globalized world.
Apple is perfectly placed to take advantage of the current technology climate and will wean itself from the image of being a hardware company.
Investors wholeheartedly approve of the conscious move to bet the farm on service and subscriptions.
After Apple's earnings came out, the stock traded up whereas in past quarters, the total sales unit was the crucial number investors hung their hat on and the stock would dip.
Apple missed iPhone total sale units registering 41.3 million compared to the expected 41.79 million units.
This slight miss in the past was enough for the stock to sell off on and instead the stock rose 3%.
This is the new Apple.
A software services company.
Investors can feel at peace that iPhone sales aren't growing. It's not that important anymore.
Apple's software and services segment pocketed $9.55 billion in revenue, a 31% jump YOY from $7.27 billion.
This has been in the making for a while as software and services has been a five-star performer for the past few quarters.
However, the performance is material now and the pace of improvement will take Apple into the next phase of hyper-growth.
This is all good news for the stock price.
Software and services revenue now comprise 17.9% of Apple's total revenue.
By year-end, this division could topple the 25% mark.
In the earnings call, Apple CEO Tim Cook was smitten with the software and services growth saying this particular revenue will double by 2020.
In the next few years, software and services will eclipse the 40% mark, all made possible inside an incredibly sticky and top-quality ecosystem.
The iPhone continues to be the best smartphone the market has to offer. If you marry the best hardware with top-quality software, this stock will chug along to higher share prices unhindered.
As the technology sector matures, the flight to quality becomes even more glaring.
The inferior platforms will be found out quickly heightening the risk of massive intraday sell-offs and revenue-depleting penalties.
Facebook and Twitter have seen 20% sell-offs hitting investors in the mouth.
These platforms have issues rooting out the nefarious elements that seek to infiltrate its operations and manipulate the platform for self-serving interests.
Apple does not have this problem. Neither does Microsoft, Amazon, Netflix (NFLX) or Salesforce (CRM), and I will explain why.
When you offer services for free such as Facebook (FB) and Twitter (TWTR) do, you get the good, bad, and ugly bombarding the system.
Even though it's free to use these platforms, Facebook and Twitter must spend to make it useable for the good forces that made these companies into tech behemoths.
Instead of rooting out these rogue elements, they turned a blind eye describing their businesses as a distribution system and were not accountable.
Then sooner or later one of the evil elements would get these companies in hot water. It happened.
Big mistake, and the chickens are coming home to roost.
The flight to quality means avoiding public tech companies that only offer free services.
You pay for what you get.
Alphabet also has seen its free model penalized twice in Europe with hefty fines, and it probably won't be the last time.
Play with fire and you get burned.
It also offers Cook the moral high road, allowing him to non-stop criticize the low-quality platform companies, mainly Facebook, because it makes the whole tech sector look bad.
The bite back against technology in 2018 is largely in part due to these low-quality free platforms manipulating user data to ring in the profits.
Amazon has been public enemy No. 1 for the Washington administration but not to the public because the loathing of Amazon is largely a personal issue.
Amazon improves the lives of customers by giving users the best prices on the planet through its comprehensive e-commerce business.
Apple now constitutes 4% of the S&P 500 index.
Investors have been waiting for Apple's Cook to sweep them off their feet with the "next big thing."
Even though nearly not as sleek and sexy as a smartphone, the software and services unit are it.
Apple doubling down on high quality that I keep mumbling about shows up in average selling price (ASP) of the iPhone, which destroyed estimates of $694, coming in at $724 per unit.
The bump in (ASP) signals the high demand for its higher-end iPhone X model over the lower-tiered premium smartphones.
The iPhone X is the best-selling iPhone model because customers want the best on the market and will pay up.
The success of the iPhone X lays the pathway for Apple to introduce an even more expensive smartphone in the future with better functionality and performance.
If Apple can continue innovating and producing the best smartphone in the world, the price increases are justified, and demand will not suffer.
Perusing through some other parts of the earnings report, cloud revenue was up 50% YOY.
Apple pay has tripled in the volume of transactions YOY surpassing the billion-transaction mark.
China revenue has stayed solid even with the mounting trade tension. I have oftentimes repeated myself in this letter that Apple is untouchable in China because it provides more than 4 million jobs to local Chinese directly and indirectly through Apple's ecosystem.
This prognosis was proved correct when Apple announced revenue in China of $9.55 billion, a spike of 19% YOY.
Even though much of Apple's supply chain remains in China, Beijing isn't going to take a hammer and smash it up risking massive social upheaval and public fallout. In many ways, Apple is an American company masquerading as a Chinese one.
As for the stock price, the explosion to more than $208 means that Apple is overbought in the short term.
If this stock dips back to $200, it would serve as a reasonable entry point into this record-breaking hyper-growth software and services company.
And with the $234 billion in cash planned to be deployed in Apple's capital reallocation plan, the biggest hurdle is the federal daily limit Apple has in buying back its own stock according to Apple CFO Luca Maestri.
Even the problems Apple has right now are great.
Apple's Path to $1 Trillion
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Quote of the Day
While the Diary of a Mad Hedge Fund Trader focuses on investment over a one week to six-month time frame, Mad Day Trader, provided by Bill Davis, will exploit money-making opportunities over a brief ten minute to three day window. It is ideally suited for day traders, but can also be used by long-term investors to improve market timing for entry and exit points. Read more
Global Market Comments
August 3, 2018
Fiat Lux
Featured Trade:
(DON'T MISS THE AUGUST 8 GLOBAL STRATEGY WEBINAR),
(SHAKING THE HAND THAT KILLED OSAMA BIN LADEN)
The team fought their way up two flights of stairs in pitch-blackness, dispatching several Al-Qaida fighters along the way.
A tall figure emerged in the green glow of the night vision goggles. It hesitated. Two shots were fired, and the body hit the ground.
That was how Navy Seal Team Six member, Mark Owen, described the last seconds of Al-Qaida leader, Osama bin Laden, in the raid on his Abbottabad, Pakistan compound.
I can't tell you how I met Owen, except that the circumstances are classified, and it took place at an undisclosed location. A number of terrorist groups are seeking retribution for the raid, making Owen and his teammates prime targets.
He and his family now live in the witness protection program buried deep somewhere in the U.S.
Owen isn't his real name of course, but a nom de guerre. In fact, I can't even tell you what he looks like. His prosthetic makeup and wig were so convincing, I doubt his own mother could recognize him.
But there was no doubting the bone-crushing handshake of a Navy Seal.
Spending an hour with "Owen," I learned several fascinating details about the raid. Just before launching, the team was told there was a 70% chance the Pakistani Air Force would shoot them down on the way in.
There was also the possibility that their top-secret stealth helicopters would crash on a ground-hugging flight through the mountains on the darkest night of the month. Every man was given the option to pass on the mission.
Not one did.
However, that didn't stop them from joking among themselves about the suicide aspects of their assignment.
What guts!
What was the inside story of the raid? The most wanted man in the world, the author of the 9/11 attack that killed 3,000 at the World Trade Center, used "Just for Men."
That was the brand of the hair-coloring agent the Seals discovered in the world's greatest terrorist's bathroom, used to make him look younger than he appeared.
Some of the seals speculated he did this to cut a more threatening figure in his online propaganda diatribes. Others said it was because he had two wives at the site.
The discovery of bin Laden's secret fortified compound was the result of a decade of tireless investigation by CIA analyst, Maya Lambert. Her role was portrayed in the 2012 film, Zero Dark Thirty, with much embellishment.
The U.S. torture of suspects probably slowed down the hunt, rather than accelerate it, because a glut of false information obscured valuable tips. People will say anything to stop the water boarding, right?
I would.
In the end, it was a junior CIA analyst's trolling through 10-year-old archived data gathered in Morocco that uncovered the crucial clue. That was the name of Ibrahim Saeed Ahmed, who turned out to be bin Laden's personal courier to the outside world.
Constant National Security Agency monitoring of his mother's phone line in the Persian Gulf led to Ahmed's location in Pakistan. He was then discretely followed to the mysterious compound in Abbottabad.
Bin Laden successfully hid for so long because he had fallen far off the grid of modern civilization. He never left the building, and didn't use cell phones or the Internet. Trash was burned on site.
His sole means of communication was via flash drives and DVDs physically carried by Ahmed on an infrequent and unpredictable basis. Bin Laden had effectively jailed himself for five years to stay under the American radar. How ironic.
Since there was no means to verify the identity of the compound's occupants before the raid, the Seals were the only option. Maya Lambert personally saw them off on their departure from an Eastern Afghanistan base. She too was committed to the mission to the very end.
Even when the helicopter in which Owen was riding crashed because of freak lift conditions, the mission went ahead. Since their carefully crafted and much practiced plan fell apart, they improvised on the spot, a mandatory Seal quality.
They professionally and methodically breached the compound's outer wall and blew some steel doors off their hinges before they reached their third-floor destination.
Owen went to great lengths to explain how the civilians on the site, including bin Laden's own family members, were kept out of harm's way.
After dispatching their target, the Seals quickly photographed him, took a DNA sample, and uploaded it via satellite link to Washington D.C. Confirmation came back in minutes.
They had gotten their man.
Before the team cleared out, they bagged every possible item of intelligence value. There was so much material that they ran out of bags to carry it. Computers were smashed open and the hard drives pried out to save on space and weight.
Analyzed back home, this data revealed that several new attacks on the United States were in the planning stages.
After blowing up the remains of the crashed helicopter, the entire team piled into the remaining operational one, with only minutes of reserve fuel left. A much-feared counterattack from the Pakistani military never appeared.
After further identification, bin Laden was buried at sea from a U.S. aircraft carrier in the Indian Ocean.
The success of the raid has done much to alter the discussion on the future of military forces, in the U.S, and around the world.
It turns out that it is strategically and tactically advantageous, and much more cost efficient to field a small number of super warriors, such as the Seals, than a large number of cannon fodder.
Every general and admiral I know, and there are quite a few, would love to junk expensive, antiquated Cold War weapons systems whose sole benefit is that they create jobs in battleground congressional districts.
The Army still buys useless, unprotected, IED vulnerable Humvee's because they are built in Florida, a major swing state in the past six presidential elections.
The Air Force has more wheezing, ancient, fuel-inefficient C-130's than pilots to fly them (we're now on upgrade number 22) because they were assembled in Georgia, the home state of former Speaker of the House, Newt Gingrich.
Oh, and the manufacturer, Lockheed Martin (LMT), made sure to buy parts supplied by all 50 states to make it politically "kill proof."
Better to spend money on training, cyber warfare, drones, and Special Forces, which will be essential to fight the wars of the future.
"The greatest threat to national security is wasting money in the defense budget," one brass hat told me, with some irritation.
In fact, the Seals, and the Army's Delta Force are so effective and destructive that they could well replace entire divisions of the past. It's a matter of hundreds doing the job of tens of thousands.
Owen went into great detail to explain the incredible difficulty of Navy Seal training. Only a small fraction succeeds at the 24-week Basic Underwater Demolition/Seal (BUD S) program.
The majority "ring the bell," give up early, and are reassigned elsewhere in the military, without shame.
Owen says he was trained to "eat the elephant one bite at a time," and described how he struggled to get through a half year of torture a half day at a time. "You wake up hoping to make it to lunch without quitting. Then at lunch you focus on getting to dinner without giving up. You then repeat this every day until you graduate."
Owen spoke of being dumped a few miles offshore and told to swim home in the icy Pacific. Classes would link arms and lie in the surf for eight hours to get accustomed to hypothermia.
They were tied up and thrown in a swimming pool for "drown proofing." For good measure they would then have to push a bus uphill, or repeatedly hoist a telephone pole over their heads.
Modern Seals cannot only jump out of a plane at high altitude and blow up anything, they can also hack into computers, disassemble cell phones, and track you down online, no matter where you are.
Spurred on by my Dad's tales of the old Underwater Demolition Teams (UDT), with whom he had experience during WWII, I once thought about applying to the Seals myself. But in the end, I passed. I didn't think I could make it through the training. There are not a lot of things I won't try, but this was one.
Because of their prolonged and extreme training, the Seals always get the toughest missions. Owen also participated in the rescue of Mark Phillips, the captain of the containership, Maersk Alabama, kidnapped by Somali pirates.
The cost of these accomplishments is high. Owen held up his cell phone and said it still contained the numbers of 40 close friends killed in action. He will never delete those contacts.
The Seals' focus on teamwork and leadership is so legendary that it has become an area of interest by American corporate management. Seals will volunteer for once unheard of 10th, 11th, and 12th tours to Iraq and Afghanistan, not because of any extreme patriotism, but because they want to be there to support their buddies.
Unsurprisingly, the divorce rate among Seals is about 90%.
Because of this spectacular record, the Seals are shouldering an ever-larger share of our defense burden.
Their numbers have expanded greatly in the past decade. I can't tell you how many Seals are in action today because it is classified, but it is a much larger number than you think.
One of the greatest honors I have received in writing this letter is when I was invited by Seal commanders to attend a BUDS graduating class in Coronado, Calif.
Despite receiving many medals and commendations, Owen comes across as humble and self-effacing. It turns out that the braggarts and big talkers don't make it through BUDS training.
The son of Christian missionaries in Alaska, Owen is now retired from the forces and is trying to get his life back together.
On complaining about neck pains after his helicopter crash, Owen said the Veterans Administration sent him home with a one-year supply of Motrin. After a hedge fund manager friend volunteered to pay for a private specialist, he was told his neck was "broken" and sent into surgery the next day.
That sheds some uncomfortable light on the recent VA scandal.
When my precious hour was up, I thanked Owen for his service and wished him well.
Owen has published his amazing account of the Abbottabad raid in his book "No Easy Day." It is a real page-turner, partially ghost written by a journalist friend. To purchase the book at discount Amazon pricing, please click here.
It's All About Discipline and Teamwork
While the Diary of a Mad Hedge Fund Trader focuses on investment over a one week to six-month time frame, Mad Day Trader, provided by Bill Davis, will exploit money-making opportunities over a brief ten minute to three day window. It is ideally suited for day traders, but can also be used by long-term investors to improve market timing for entry and exit points. Read more
While the Diary of a Mad Hedge Fund Trader focuses on investment over a one week to six-month time frame, Mad Day Trader, provided by Bill Davis, will exploit money-making opportunities over a brief ten minute to three day window. It is ideally suited for day traders, but can also be used by long-term investors to improve market timing for entry and exit points. Read more
While the Diary of a Mad Hedge Fund Trader focuses on investment over a one week to six-month time frame, Mad Day Trader, provided by Bill Davis, will exploit money-making opportunities over a brief ten minute to three day window. It is ideally suited for day traders, but can also be used by long-term investors to improve market timing for entry and exit points. Read more
Global Market Comments
August 2, 2018
Fiat Lux
NETFLIX SPECIAL REPORT
Featured Trade:
(WHAT'S NEXT FOR NETFLIX?),
(NFLX), (WMT), (AMZN)
In its latest earnings report for Q2 2018 Netflix definitely disappointed. Revenues came in at $3.91 billion compared to an expected $3.94 billion. New subscribers came up short 1 million of those expected.
It also provided weaker guidance, expecting to ad only 5 million new subscribers versus an earlier expected 6 million, with most coming from international.
The stock market noticed, taking the shares from $420 down to $330, a loss of 21.42%. Is it time to bail on Reed Hasting's miracle firm? Or is it time to load the boat once again?
If you have any doubts just ask any former employee of Blockbuster. In 1997, Blockbuster was the 800-pound gorilla in the VHS video rental business, with 9,000 worldwide, a 31% market share, and a $5 million market capitalization.
Today, Blockbuster has only one store left somewhere in rural Alaska. There is but one company to blame for this turn of events, and that would be Netflix.
Not only did Blockbuster bite the dust, so did the entire $8 billion-a-year movie rental industry, including Movie Gallery, Hollywood Video, and the rental operations of Walmart (WMT) and Amazon (AMZN).
That year, Reed Hastings returned his rental of the video Apollo 11 a month late and was hit with a huge $40 late charge. He was struck with a bolt of lightning. "There must be a business opportunity here," he thought.
The next day, he and friend Marc Randolph bought an oversized greeting card, tossed the card, and mailed a CD in the remaining envelope to Hastings' house. It arrived the next day in perfect condition. It was a simple matter of geometry. While the CD sat in the middle of the envelope, the Post Office only stamped the corners. This simple experiment became the basis of a business that eventually grew to $186 billion.
Yes, and now you're all thinking, "Why didn't I think of that?"
Hastings was the scion of an East Coast patrician family, a member of the social register and a regular in the New York Times society pages. His great-grandfather, Alfred Lee Loomis, was an early quant who made a fortune.
He received his undergrad degree from Bowdoin College and then joined the Peace Corps. Following a two-year stint in Swaziland to teach math, Hastings then obtained a master's degree in Computer Science from Stanford University in 1988.
Hastings founded his first firm at the age of 30, Pure Software, which went public in 1995. It then merged with Atria Software in 1996 and as Pure Atria was acquired in 1997. That left him flush with cash and looking for new challenges.
Based on the successful mail experiment Hastings invested $2 million into the Netflix idea, which Marc Randolph ran for the first two years.
Netflix then become the lucky beneficiary of a number of sea changes in technology then underway, none of which it anticipated. Sales of DVD players were taking off. The Internet and online commerce were gaining respectability, and massive overinvestment in broadband led to exponential improvements in streaming speeds.
There was also a crucial Supreme Court decision regarding the Copyright Act of 1909 that protected the right to rent a video that you owned. Hollywood had been fighting rentals tooth and nail to protect their substantial profits from DVD sales.
Hastings assembled a team of former colleagues who managed to build a website and a primitive distribution system. The Netflix website went live on April 14, 1998. The site crashed within 90 minutes, overwhelmed by demand. A rushed trip to the nearest Fry's Electronics brought 10 more PCs, which were quickly wired in as servers. By the end of the first day, Netflix had rented 500 videos.
The DVD optical format first launched in March 1997, creating the DVD player industry. Sales reached 400,000 units by the first half of 1998 and prices collapsed, from $1,100 to $580 in the first year. Netflix was swept up in the tide and monthly revenues reached $100,000 within four months.
Since newly released titles were so expensive at $15, Netflix focused on older, niche films in anime, Chinese martial arts, Bollywood movies, and, yes, soft-core porn. Netflix later exited this market when Hastings accepted an appointment to the California State Board of Education.
The company thrived. The headcount rose from an initial three to more than 100. But it was losing money - some $11 million in 1998.
Then the company caught a major break. The French luxury goods tycoon, Bernard Arnault, CEO of LVMH, was desperate to get into the Dotcom Boom and invested $30 million in Netflix. This attracted another $100 million from other venture capitalists and angel investors.
This allowed the company to experiment with its business model. It launched next-day delivery in San Francisco, which proved wildly popular, new sign-ups, renewals, and customer loyalty soared. Then in a stroke of genius Netflix initiated its Marquee Program, which allowed customers to rent four DVDs a month for only $15.95 a month, with no late fees. DVD player sales in 1999 reached 6 million, but Netflix lost $29.8 million that year.
In 2000, the Marquee Program evolved into the Unlimited Movie Rental service and the price rose to $19.95. It included a free rental, which customers could obtain by entering their credit card data, which then renewed indefinitely. This is common now but was considered wildly aggressive in 2000. Netflix was also an early artificial intelligence user, using algorithms to find movies that both members of a couple would like based on past rental data.
Netflix is a company that did 100 things wrong, any one of which could have wiped out the firm. It was the few things it did right that led it to stardom.
Hastings worked out deals with manufacturers to include a free Netflix rental coupon with every DVD player sold. The move earned it valuable market share, but almost bled the company dry since most didn't return. But a labeling error caused hard-core Chinese porn discs to get sent out instead.
A programing glitch caused members' video queues to be sent out all at once, landing some happy subscribers with 300 videos all at once. Coupon counterfeiting was rife until the company began individually coding each one.
Netflix planned to go public in 2000. Existing shareholders rushed to top up their holdings in expectation of cashing in on a first-day pop in the share price. But the Dotcom Crash intervened, and all new tech IPOs were canceled for years. This episode of greed and attempt at insider trading left Netflix well-funded through the following recession. Netflix lost $57.4 million in 2000.
In the meantime, the installed base on DVD players reached 8.6 million by 2002. Then disaster struck. Hastings learned that Amazon was entering the DVD sales market, the only source of Netflix profits. Hastings flew up to Seattle to sell Netflix to Amazon. But Jeff Bezos only offered $12 million and Hastings walked. It was a rare miss for Bezos. DVD players dropped to $200, and demand for content soared.
An important part of the Netflix story was the self-destruction of industry leader Blockbuster. Hastings offered to sell Netflix to Blockbuster at the bargain price of $50 million. By then, Netflix had 300,000 paid subscribers compared to Blockbuster's 50 million. But Blockbuster charged late fees while Netflix didn't. That difference would change the world. However, CEO John Antioco passed believing that online commerce was nothing more than a passing fad. It was a disastrous decision.
To dress up the company's financials for an IPO in 2002, Hastings fired about 40% of the company's workforce to cut costs. On May 23, 2002, Reed Hastings stood on the floor of wealth manager Merrill Lynch as the stock started trading on NASDAQ under the ticker symbol of (NFLX) at $15 a share. The company raised another $82.5 million in the deal. A year later Netflix announced it had 1 million paid subscribers, and the stock soared to $75 and the stock later split 2 for 1.
Realizing his error, Blockbuster's Antioco launched an all-out effort to catch up with Netflix in online rentals. When that news hit the market, (NFLX) shares fell back to its IPO price of $15. Late in 2004, Blockbuster launched a clunky copy of the Netflix website, but without the magical algorithms in the backend that made it work so well. Blockbuster undercut Netflix on price by $2, offering memberships for $17.95. It immediately captured 50% of all new online sign-ups but continued with its notorious late fees.
Blockbuster Online was plagued with software glitches from the start and every day presented a new crisis. Netflix also fought back with its own price cut, to $17.99. Both companies bled money. Short sellers started accumulating big positions in Netflix stock. Hastings vowed to run Blockbuster out of the online market with a $90 a quarter ad spend.
This Netflix received some manna from heaven. Corporate raider Carl Icahn secretly accumulated a chunk of Blockbuster stock in the market and then demanded that the company pursue an asset stripping strategy. Icahn eventually obtained three board seats and became de facto CEO. So, to say that management time was distracted was a gross understatement.
Netflix received another gift when Walmart finally threw in the towel for online movie rentals. Hastings jumped in and did a deal whereby (WMT) would refer all future movie rental customers to Netflix.
Blockbuster finally decided to dump its despised late fees, costing it $400 million in annual revenues. Hundreds of stores were closed to cut costs. The downward spiral began. The value of Blockbuster fell to $684 million. With 4.2 million subscribers Netflix was now worth about $1.5 billion. Blockbuster lost an eye-popping $500 million in 2005.
DVD sales and rentals reached their all-time peak of $27 billion in 2006. Slightly more than 50% of Americans then had broadband access.
Blockbuster, growing weary of the competition from Netflix, finally decided to deliver a knockout blow. It launched its Total Access program in another attempt to bleed Netflix to death by undercutting Netflix's membership price by $2. It worked, and Netflix was facing another near-death experience. Blockbuster Online's share of new subscriptions soared to 70%, and total subscribers soared from 1.5 million to 3.5 million in months. The Netflix share fell to only 17%, and the company was now losing money for the first time in years.
In a last desperate act, Netflix offered to buy Blockbuster Online for $600 billion, and would have gone up to $1 billion just to eliminate the competition. An overconfident Blockbuster, smelling blood, refused. Movie Gallery and Hollywood Video were already on the bankruptcy trail, so why shouldn't Netflix go the same way?
And then the inexplicable happened. Icahn refused to pay Antioco a promised $7 million performance bonus based on the Blockbuster Online success. Instead, he offered only $2 million and Antioco resigned, collecting an $8 million severance bonus in the process. Icahn replaced him with Jim Keyes, the former CEO of 7-Eleven.
Keyes immediately pulled the plug on the Total Access discount, thus dooming Blockbuster Online. Instead, he ordered that the company's 6,000 remaining stores sell Slurpees and pizzas to return to profitability, in effect turning them into 7-Elevens that rented videos. It was one of the worst decisions in business history. Many of the senior staff resigned and sold their stock on hearing this news. Keyes in effect seized defeat from the jaws of victory.
Reinvigorated and with subscriptions soaring once again, Netflix launched headlong in online streaming. It introduced its set top box, Roku, in 2008. It then got Microsoft to offer Netflix streaming through its Xbox 360 game console that Christmas, instantly adding potentially10 million new subscribers.
And this is what makes Netflix Netflix. Although the company had the best recommendation engine in the industry, CineMatch, Hastings thought he could do better. So, in 2006, he offered a $1 million prize to anyone who could improve Cinematch's performance by 10%. To facilitate the competition, he made public the data on 100 million searches carried out by the firm's customers.
It was the largest data set put in the public domain. Some 40,000 teams in 186 countries entered the contest, including the best artificial intelligence and machine language and mathematical minds. It became the most famous scientific challenge of its day.
After a heated three-year struggle, a team named BellKor's Pragmatic Chaos won, a combination of three teams from Bell Labs, Hungary, and Canada. The copyright for the algorithm is owned by AT&T and licensed to Netflix for a fixed annual fee. AT&T also uses the winning algorithm for its own U-verse TV programming.
When the 2008 financial crisis hit, Netflix subscribers just kept on rising at the rate of 10,000 a day as consumers stayed at home and obtained cheaper forms of entertainment. Total subscriptions topped 10 million in 2009. Those at Blockbuster cratered. A new competitor appeared on the scene, Redbox, with 20,000 supermarket kiosks offering DVDs for 99 cents a day. But Netflix was hardly affected.
By 2012, Netflix subscriptions reached 20 million. Streaming was a blowout success, with half of its customers using streaming only to watch TV shows and movies. Hollywood beat a path to Hastings' door, with Paramount Pictures, Lionsgate, and MGM earning a collective $800 million in Netflix fees. Netflix now accounted for 60% of movies streamed and 20% of total broadband usage.
When Blockbuster finally declared Chapter 11 bankruptcy on September 23, 2010, so did its Canadian operations. That opened the way for Netflix to enter the international market, picking up 1 million new subscribers practically overnight. Next it launched into Latin America, introducing Spanish and Portuguese streaming in 43 countries.
As streaming replaced DVD rental by mail, Hastings attempted to spin off the rump of the business into a firm called Quickster. Customers would now have to open two accounts, one for streaming and one for mail and pay high prices. Customers and shareholders rebelled, taking the stock from $305 down to a heartbreaking $60. This was the last chance you could buy the stock at a decent price.
Hastings recanted on Quickster and let go the 200 staff applied to the unit. Icahn made a reappearance in this story, this time accumulating a 10% share in Netflix. After demanding management changes nothing happened, and Icahn eventually sold his shares for a large profit. Finally, Icahn made money in the video business.
Going forward, Netflix's strategy is finally straightforward. Create a virtuous circle whereby superior content attracts new subscribers, who then deliver the money for better content.
CineMatch knows more about what you want to watch than you do. The immense data it is generating gives Netflix not only the insight on how to sell you the next movie, it also proves unmatched insight into trends in the industry as a whole. It also makes Netflix unassailable in the movie industry.
That has given the firm the confidence to double its original content budget from $4 billion to $8 billion this year to produce Emmy-winning series such as House of Cards and Orange is the New Black.
So, the future for Netflix looks bright. As for me, I think I'll spend the rest of the evening watching the 1931 version of Frankenstein on Netflix.
