Reed Hastings and the Myth of the Great Man
A warning sign for poor governance
When one thinks of the influential billionaires of the day, a few names spring to mind: Elon Musk, Jeff Bezos, Warren Buffett, Mark Zuckerberg are the top names. Some day there will be a Zuckerberg University and Medical School. The name Zuckerberg won’t likely be associated first with Facebook, just like the name Vanderbilt doesn’t summon images of Railroads and Steamships today.
Myth-making and legacy have long been the stated goal of the extremely wealthy and powerful. From the Gilded age boom to the onset of World War II was identified as an era of the extremely wealthy: think the Vanderbilts, Rockerfellers and Carnegies. In the post WW2 era, the richest men were not unknown by any stretch, but the luster seemed to have faded. Howard Hughes, Daniel Ludwig and Sam Walton are notable as the richest men of the day, but an average American today, in 2022, is more likely to recognize the name of Gilded era tycoons rather than their 1970s counterparts.
As the 1990s rolled into a new century, the era of the great rich man came back in style and it continues on today. Starting with Bill Gates and Larry Ellison, to the iconic Steve Jobs, and this decade’s “hot names.” Enough ink is spilled about the big three (Zuck, Bezos, Musk) to dominate a huge amount of mind- and media-space to the point at which it becomes tiresome. That’s, of course, forgetting our favorite recent Ex-president, who is much more powerful than he is rich. Heck, I’m guilty of focusing too much on them. The greatness of these men, promoted by the Myths they propagate about themselves, is furthered on by the reactionary and often important pushback against them as they consolidate power, riches and influence. The saying “There’s no such thing as bad news” comes to mind.
With that setup out of the way, I’m going to talk about another Billionaire, who doesn’t get enough negative attention; Mr. Reed Hastings, CEO and Founder of the Streaming Service Netflix. Netflix’s stock is cratering, down nearly 40% as I’m writing this, after releasing horrifyingly bad earnings. Year to date, the Company has lost over $200 billion in market capitalization, despite the service itself being more or less unchanged. Growth looks to have plateaued and what remains is a service with very poor unit economics. They pay too much for content and don’t have enough viewers at the current price point to make money on a steady state basis.
The Reed Hastings Origin Story
Now, Mr. Hastings doesn’t have the fabulous story that many of his peers share. He didn’t come from a broken family or spend late nights cranking out code and soldering PCB boards in a garage. He also isn’t nearly as wealthy (having peaked at ~$7 billion late last year) and he thankfully doesn’t start slapfights on Twitter. But the Reed Hastings’ myth is such an interesting story, and in keeping to the theme of this blog, it’s important because it really impacts corporate Governance of Netflix, Inc.
In 2010, middlingly average hedge fund manager Whitney Tilson announced he was short selling Netflix’s equity. At the time, NFLX was trading at $30 per share and their Streaming service, the replacement for DVDs by mail, was in the process of gaining some steam. Even after the recent rout, NFLX is up 900% from the time of the announcement by Tilson. It was, in retrospect, a bad trade.
But the myth of Reed Hastings comes about because shortly after Tilson’s call, he wrote a personal letter, posted publicly, to Mr Tilson. The letter says, to the effect, “I think you are a nice human being, but you got this trade wrong and you should close your short position.” Rebuttals to short sellers are often angry, defiant and spiteful so at the time this letter was newsworthy for its civility and candor. But the Myth of Reed Hastings doesn’t come about because he was polite to a short seller, it’s because he was right and the market proved it. Or did it?
Whitney Tilson went on to close his short position and often cites the letter as the reason he did so, long after he shuttered his fund. But, here’s the thing: Netflix’s stock indeed levitated in the months that followed up to $38. But in July 2011, the equity cratered by 75% to below 10 dollars per share. It languished there for a year and a half before going on a nearly decade long trajectory of “up and to the right.” Tilson, had he ignored the letter and kept the position on, would’ve likely pulled a lot of money out once the stock got gutted a few months later and booked a big trade.
But today, the story is akin to a fable: the generous, 21st century different breed of CEO brought his critics in and calmly dispatched them using logic and a forward thinking vision of the future. Netflix has since proved that streaming would become “the thing,” and the number of copycat services indeed bolsters this view.
Reed Secured his legacy, his own “How many Rockets have *you* landed?” A CEO of the future, a business savant, and a kind and thoughtful man at that.
The Reed Hastings Myth is Nonsense
I would write tomes on the topic of how silly the unit economics of the company are, but in the service of brevity, I think this tweet sums it up nicely:
When Disney pays for a new Avengers movie, the $300 million or so in production cost is spent largely as CapEx. That cost, when calculating profits, is spread out over a few years.
Let’s say the newest movie, Avengers: The Avengening, costs $300 million and it’s released this summer. It brings in $400 million in sales this year, including all streams, tickets, licencing etc.
The Gross Margin for the second half of the year isn’t just (400-300) = $100 million. It’s the sales against the portion of that $300 million spend that gets depreciated this year. Hollywood typically depreciates about 80-90% of the value in the first year. So in this example, the accounting cost of goods sold (COGS) for Avengers:The Avengening for the second half of 2022 is something like $130 million, leaving a gross profit of closer to $270 million.
This is a severe simplification, but it’s illustrative of what Netflix innovated being financial more than anything. In the case of the above tweet, the Netflix movie Bright, a Will Smith film about a cop who teams up with an Orc to fight fantasy creatures in a fantasy Los Angeles, cost approximately $100 million to make. Netflix, somewhat famously, doesn’t follow the “traditional” rules of Hollywood accounting. The money they spent making Bright (which is a truly terrible film) was pushed to the expense (COGS) line in the way Netflix does with all their properties: equally divided over a set term.
Here’s a crude illustration I made in MS Paint using a laptop touchpad:
Disney recognizes a bulk of the expense early on and Netflix’s approach is completely different: it’s very hard to make a like for like comparison between two media companies. Netflix probably got a good slug of new customers right around the release of Bright. Same goes for other hits like Squid Game and Bridgerton. Those new customers aren’t showing up to watch Will Smith’s Fantasy Police Film now in 2022. But a good portion of the $100 million spent on Bright has to be written down this year (or per the tweet above, roughly 20% of the cost every year for 5 years).
This was the Reed Hasting innovation. Kicking the can down the road and counting on future growth to keep the dream alive. The buy now-pay-later method of running Blue Chip megacaps.
Reed Hastings also famously aschewed traditional and boring metrics for calculating the ability of a company to take on debt. From 2014:
"At $900 million of total longterm debt, we will have an extremely modest debt-to-equity ratio," CEO Reed Hastings said in the company's fourth-quarter letter to shareholders
What might sound like a reasonable metric to a lay person is actually completely insane. Debt and leverage is evaluated, traditionally, as a function of tangible assets. You can issue more debt if you own more Intellectual Property, Factories or Real Estate. Your creditors can use the factory you own, as an example, to back the loan in the event of default.
Mr Hastings would continue to use the term “debt-to-equity” ratio for the next 8 years. The debt, being Junk Bonds with a higher coupon payment and the equity being the stock price. Stock prices, unlike bonds, are not typically known for their stability or even tangible connection to real world economics.
Netflix, with a sky high stock price would continue to issue junk bonds (now totaling nearly $30 billion today) instead of issuing more stock to pay for their content spending orgy (closing on nearly $90 billion to date). Junk bonds come with coupons and give holders priority spot in line in the event of reorganization. Stock dilution has no coupon but it risks making the stock go down. Reed Hastings wealth is largely in Netflix stock, which he has been selling consistently for years.
Once growth ends (and we might be there today!) those content spends from years past will continue to weigh on the company.
Reed Hastings and Governance
Like many of his tech brethren, Netflix is run at the whims of a single man. There is nominally a board of directors and shareholders get to vote on proposals. But Hastings, the great innovator, was showered with praise non-stop over the past 7 years as a business genius. Netflix, at the direction of Hastings, specifically went against the accounting standards that every other media company uses. This allowed them to show profits while burning eyewatering levels of cash year after year.
I can’t for sure what goes on during every Netflix board meeting, but it looks like no one, who by all accounts should know better, ever challenged him. That, in and of itself, is a failure of GOVERNANCE, the often forgotten “G” in ESG. That autonomy was a product of the Reed Hastings Myth and further the ongoing and incessant “Myth of the Great Billionaire” that doesn’t seem to be going away anytime soon.
As the brilliant Francine McKenna put it in her latest story about Musk’s lack of accountability:
Dennis Howlett, a Twitter early adopter and retired co-founder of Diginomica, is fed up. “The SEC needs to rein in this man’s child-like behavior. His actions have made Twitter toxic. No right-minded investor would try to buy it now.”
As for me, I agree with historian and culture critic Ruth Ben-Ghiat, who said in a recent interview that there’s only one way to stop a personality cult that repeatedly ignores the rule of law. “It takes prosecution and conviction to deflate their personality cults.”
The same applies for Mr. Hastings; I think we’ll be hearing more of his name in the months to come.
My man is cold 🔥
I think Netflix was often treated as a growth stock too which inflated it's valuation when in reality its just a media company/studio with vertical integration of content delivery. Warner Brothers or Sony might be better comparisons, but it's hard because these companies exist within larger conglomerates.
I suspect Netflix might become a target for acquisition if their stock keeps tanking