July 21, 2017

Stocks closed mixed yesterday in a session dominated by individual company earnings reports. Industrials were mostly lower while health care issues advanced.

I want to start today and focus on two companies that reported results this week, IBM and Netflix. On Monday, after the close, Netflix reported a greater number of new subscribers than Wall Street had expected. While it lost money and had huge negative cash flow, Wall Street didn’t seem to care. The stock rose by about 10%, on top of substantial gains earlier in the year. Tuesday evening IBM reported. Its earnings per share were above estimates, and it was able to convert 74% of its earnings into free cash flow. But its shares Wednesday morning fell by over 5%. Are investors insane, or is there more to the story?

Let’s start with Netflix. The company was founded in 1997 and for its first dozen years it grew renting movie disks via mail in competition with stores like Blockbuster. Remember Blockbuster? Does anyone still have a VCR? Anyway, in 2010 technology advanced to the point where it could begin to stream a few movies to customers. Not too long after, it separated its disk rental business from its streaming business. You can still rent disks by mail, but today streaming totally dominates. As time passed, the mix of what Netflix rented changed. Original movies gave way to streaming old TV series. With “House of Cards” Netflix entered original programming in a serious way. In a sense, this was a very similar path followed by the premium pay cable channel services like HBO. Original content became the differentiator. This fall, Netflix plans to offer almost 20 new series, and it plans to spend billions of dollars on original content. Via aggressive marketing worldwide, the company now has almost 100 million subscribers, and is signing up new ones at an accelerated pace. The company’s business model is focused on expanding the customer base as quickly as possible to become the largest paid subscription service for video content worldwide. With close to 100 million customers, hopefully someday becoming hundreds of millions if not billions of viewers, the content cost per client will become far lower than its nearest competitor.

Of course, that requires a lot of ifs to translate into reality. Netflix’s original content needs to continue to be must-see. Years ago we all watched NBC, CBS, and ABC. Now many of us only watch them occasionally and only for sports or special events. It also presupposes that it can continue to win the long term battle versus the likes of YouTube and Amazon Prime. Don’t forget Hulu, Facebook#, Apple#, Yahoo and, of course HBO, plus the other premium cable channels. Even the old TV networks now stream content, and they aren’t going to roll over and play dead without a good fight. Someday soon traditional media companies like Disney will also compete online. The day may not be far off when first run movies are offered online at the same time they are shown in theatres. Without dominating volume, Netflix won’t be able to drive cost per customer down to the point where it has a dominating competitive advantage.

In reality, we don’t even know what Netflix will be streaming in 5-10 years. Will video become dominated by short form content, or will we still watch series in hour long segments? Will Netflix segment its offerings into different channels? Will Amazon, that lumps its streaming services with its Prime offerings, be able to provide better value than Netflix? Can Netflix leverage its content and develop other consumer products and services like Disney? Most important, will Netflix ever get to the point that it actually generates excess cash flow? That is a huge number of questions, and I have exactly no answers for any of them. I don’t even know whether Netflix will exist as a standalone entity in 5 years. Many investors speculate that it won’t, labeling it a merger target for several of the largest media companies.

The bottom line is that Netflix is, and always has been, a high risk, high reward investment, teetering on the border between investment and speculation. So far, CEO Reed Hastings has a very high batting average. He is smart and aggressive. Wall Street loves him and his stock. He could become tomorrow’s Bill Gates or Jeff Bezos. Or he could become tomorrow’s Steve Case who sold AOL to Time Warner in what proved to be one of the absolute worst merger deals ever.

Now let’s move to IBM. IBM was a bit late figuring out that the cloud was going to replace standalone corporate data centers. Its business model of services and software, wrapped around a mainframe computer-based complex, isn’t where anyone is headed. CEO Virginia Rometty inherited a 5-year growth plan that she stuck with far too long. Rather than investing aggressively to move the company from the mainframe to the cloud, she cut costs, including R&D, to boost near term earnings. She figured out a couple of years ago that the model couldn’t be sustained, and since then IBM’s message to investors has been about its business transformation to strategic initiatives.

The problem is, however, that while IBM is moving faster than it ever did before, it is still moving much slower than its now huge and emboldened competition. So while IBM proudly touts that it is growing its new business initiatives at a 10-20% annual rate, Amazon, Microsoft#, Google# and Oracle# are growing the same services twice as fast. Just last evening Microsoft, in its post-earnings conference call, said its Azure cloud business revenues grew 97% year-over-year. It is as if IBM is riding a tricycle down the highway trying to chase riders pedaling sleek road bikes. IBM is never going to win this race. The more relevant question is whether it can restructure the company to be a healthy viable force in a very different computing world of tomorrow. Right now, its legacy businesses are going backward faster than its new strategic initiatives are moving forward. As a result, the company has experienced 21 consecutive quarters of declining revenues. At some point, hopefully fairly soon, the old legacy businesses will get small enough, and the new strategic initiatives will be large enough, that the company can grow again, even if it’s only at a low-mid single digit rate.

So what’s the moral of the story? There are several. First, it is hard for legacy companies to compete if too much energy is exerted trying to protect the legacy base. For several years, IBM grew by shrinking. What do I mean? I mean that cash flow was used to buy back so much stock that earnings per share were rising, even as net income was declining. Like it or not, in today’s world, where technology is disrupting so many businesses, companies, both new and old, have to invest whatever is needed to be competitive. If, in the short term, that means dividends or share buybacks have to take back seats, so be it. On the other hand, reckless investment can lead to even worse consequences. A company’s value is the present value of future cash flows. Netflix is thinking very big and, at the moment, Wall Street is enamored with its success to date. But cash flows and revenues aren’t the same thing. The Internet bubble of the late 90s was created as venture investors fed young upstart companies huge amounts of money and told them to get big. Netflix and Tesla are hardly yesterday’s newbies. Both are adored today, but neither is guaranteed to be successful. Yet both are highly disruptive. The 800-pound gorilla, when it comes to disruption, is Amazon. Now when Amazon even hints it might go into a new venture, investors sell the stocks of those who might be attacked with a vengeance. Yesterday, there were hints it might sell Kenmore appliances in concert with Sears. Sears, according to its own SEC filings, doesn’t even know if it will survive the next few months. Nonetheless, investors sold off stocks of Home Depot, Lowe’s and even Whirlpool#. Heck, Whirlpool makes many of the appliances that Kenmore sells. Are we really at the point where we are going to buy washing machines online? Are Prime customers going to get free shipping for a 200 pound washing machine?

The bottom line is the following:
1. The world is moving faster and faster, driven by technology. I don’t want to say no one is safe, but few companies are immune to the winds of change.
2. The chase for revenues at all costs rarely works out well. But when it does, (e.g. Amazon) it works out well in spades. In much the same way, for many years Microsoft Windows dominated computer operating systems, and Google search still has enormous market share. But, as we have seen over the past 20 years, failure to reach and maintain domination can be very painful. The graveyard is filled with technology companies that never earned a dime.
3. Ignoring the waves of change may be the deadliest sin of all. Just ask Eastman Kodak. IBM hasn’t lost the battle yet, but it needs to move into a higher gear if it is going to be a future market leader again. Macy’s is in the same boat.
4. The urge to protect legacy businesses has led to the creation of new leaders every time massive disruptive change happens. The old computer mainframe companies (except IBM) are long dead, as are all the minicomputer companies and most PC manufacturers. This statement doesn’t just apply to the tech world. Look how badly the cereal companies are doing as tastes change. Look at the sad performance of rent-a-car companies since Uber has been in existence. As noted, ABC, NBC and CBS are struggling for relevance. How long will we continue to watch new movies in theatres?

For investors, we need to adapt quickly, while change is taking place around us. We need to be conscious of these disruptors early on. We cannot assume they will be squashed by the power and size of legacy businesses if the new companies have a better business model. Online retailing has a better model than conventional retailing, and Amazon executes it to near perfection. As noted earlier, I have no idea what entertainment product will look like in 5-10 years, or whether Netflix will be a leader or not. It certainly has a good shot. But I don’t have to invest in high risk disruptors if I don’t want. I do, however, have to decide if my long term legacy company holding that is king today is going to remain king tomorrow. Even a company that sells such basics as shaving gear (Procter & Gamble#) becomes susceptible to online competition. So far, P&G is reacting well and defending its fortress. All legacy companies don’t have to lose. What they do have to do is commit the resources to win. In today’s world the disruptors with great business models have the fire in the belly and will be able to attract the capital to fight a very aggressive war. No one said competition is easy.

Today Cat Stevens is 69.

James M. Meyer, CFA 610-260-2220
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors. Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.

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