Cloud Computing and Shorting

Reed Hastings, the CEO of Netflix is one of the smartest folks around in my book. His article on why Tilson should cover his Netflix short position strongly reinforces that belief. The entire article is a great lesson on how to think clearly about business but here, I want to focus on the relevant excerpt for cloud computing quoted below:

We will be working to improve the FCF conversion trend in 2011. On a long term basis, FCF should track net income reasonably closely, as it has in the past, with stock options as an offset against small buildups in PPE and prepaid content. Nearly all of our computing is through Amazon (AMZN) Web Services and CDNs, which are pure opex. [emphasis mine]

The key part is bolded above. Nearly all of Netflix computing is on-demand based, which is pure opex. Is it more expensive than building it in-house on a per-unit of compute? Almost certainly. However as Reed mentions in the paragraph above, he is pushing to improve control over Free Cash Flow (FCF) and bring it in on a quarter by quarter basis. Not having large capital costs is key to that. He specifically calls out that “Management at Netflix largely controls margins, but not growth.”

With minimal capital costs acting as drag and Netflix computing almost entirely opex based, moving FCF management into the quarter by quarter range is a lot more feasible, with the attendant ability to fine-tune his margins.

Cloud computing is already here – it’s just unevenly distributed. Reed Hastings is ahead of most.

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5 Responses to Cloud Computing and Shorting

  1. Chris says:

    This is a tough one; I’d normally have a knee-jerk reaction to the prospect for a company of Netflix’s scale – outsourcing that amount of CPU and CDN traffic can’t be cheap – there’s the balancing force of the bulk discounts on that opex that NFLX’s scale brings. It’s a question of whether the cost of depreciation (if they build their own data centers and CDN) is more than the outsourcing premium.

    I will ask – how are they able to manage their compute cost so closely when the cycles and bits needed are entirely driven by their user base? Drop the bitrates by a few percent if revenue is dragging?

    • John Curran says:

      Actually, managing variations in compute costs when you are truly “in the cloud” to their extent is almost automatic… A revenue decrease means less traffic and lower compute bills. Instead of managing month to month or quarter to quarter, you truly are managing the economics of the business, and fining the unit-cost-model and unit-revenue-models. Reed shows a fine understanding of exactly what drives this model, and betting against a CEO with this level of understanding of their company finances seems rather risky.

      • Chris says:

        That’s a valid point, assuming the revenue-to-cost ratio is stable and predictable. For example, more users choosing HD streams over SD will raise bandwidth costs with no corresponding rise in revenue. This probably is something that can’t be managed quarter-to-quarter, although trend analysis will help for predicting future costs. But this can swing greatly and unpredictably (for example, let’s say they get the rights to stream Avatar…)

  2. John Q says:

    While I don’t disagree with the main point here, something doesn’t pass the sniff test.

    First and foremost, Netflix is now giving that opex revenue to their main competitor (Amazon).

    Second of all, in the grand scheme of opex costs (content is opex, as you don’t own it – you license it for a period of time), there are publicly announced content deals that will cost them $1B this year. If we think about the cost of building these resources in-house, there’s no way that the cost would even remotely approach the cost of content. Sure, cash is king, however it seems like an error to direct their energy at this key juncture (with Amazon nipping at their heels) towards making their applications work “In the cloud”, versus making them better and more popular by adding user friendly features and more devices and formats.

  3. Yuri Yankovski says:

    Netflix CEO is smart riding on the Cloud not only because he improves FCF, but also because most likely he is buying Megabits-per-second priced for the general internet traffic, while in fact Netflix pushes video.

    video traffic != mix of web/mail/chat

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