Cloud Computing and Shorting

February 27, 2011

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.