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.

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Streaming Video

September 27, 2009

After seeing several red envelopes at a friends house the other day I started to wonder what Netflix‘s cost structure would look like if streaming video replaced sending DVDs by mail.   Mindful of Andrew Tanenbaum’s adage about never underestimating the bandwidth of a station wagon full of tapes hurtling down the highway, I thought it might make sense to do a cost model and see if streaming DVDs would be as cost effective as shipping them. This is a very simple model that does not take into account several crucial factors such as the First Sale doctrine, licensing for streaming,  partnering with studios instead of sourcing DVDs etc.  Leaving those aside and focusing on the technological aspect of the cost modeling is still quite illuminating.

The model is based on the NETFLIX INC (NFLX) 10-Q filed 7/31/2009. The results were quite surprising.

The article was improved thanks to contributions by Ben Black, Randy Epstein and Alex Pilosov