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We’ve been bombarded with emails asking for a follow-up post on Netflix (NFLX) since recomminding a long position in late December and early January when the stock was in the low $70′s. As is typical, many of you are seeing the stock in the $125 range and wondering if now is the time to buy the stock. If you didn’t think it was a buy at $70, why do you want to chase it at $125? However, for those of you that put the trade on, we’re not yet considering letting go of a single share of our core position other than to increase it by trading around major moves like last weeks sudden $10 decline after a straight line run to $125 from $70. This offered both a profit taking opportunity as well as an opportunity to leg into additional shares. I reitirate the first major target remains $150 for no reason except the fact that $150 is a round number. However, in the next 5 years, ask yourself where you think NFLX is going to be trading, without taking into account the potential for splits. We’ve asked ourselves that and even fed the numbers into our models every which way you can possibly imagine. The range of price potential remains between $350 and $425. That’s only a 5 to 6 bagger when I prefer 10 baggers. However, I do expect the stock to split, or perhaps even spin off one of its business lines to be called “Quickster”. This will create tremendous value for long-term shareholders and that value will make up the difference. Ultimately, this long position is destined to be a 10 bagger.

In the near term, a great deal of market chatter and color regarding Netflix has hit the wires recently. The Deal, Businessweek and The Wall Street Journal all the way down to the blogosphere are making noise. An executive decision by Reed Hastings, Founder and CEO, announcing a whopping 60% price hike while simultaneously announcing his intention to spin off the DVD rental division has taken a heavy toll on the stock. Not to mention an unknown inquiry by the SEC. After choosing to name the spin-off “Qwikster”, the company has justifiably endured the wrath of online ridicule and become the butt of sarcastic financial reporting. A plethora of synonyms for Qwikster, the most popular being a quick, painless death of the company’s main cash cow: its mail order DVD business. This business runs on auto-pilot requiring very little human intervention and has historically been a cash cow for the company. NFLX realized early on that less human intervention equates to higher productivity. Here was Reed Hastings announcing to the world he was separating the golden goose from the main company and renaming it, and not only that, for the main company under the moniker of “Netflix”, he was instigating a price hike of 60%. Two shocking blows to send investors fleeing, the trend and momentum traders to hit the bid, and the bears to start coming in. We’ll get to the reason in a second.

First, the recording industry taught us that although they knew their model’s broken, they entrenched their positions in order to maintain the status quo for as long as possible instead of embracing rapid change, as is the dogma of high tech companies. Until this decade though, music was not considered a “high tech” business. In fact, it was quite the opposite. The delivery device was always the technology, the music the product being delivered. Today, the delivery mechanism is ubiquitous: The Internet. So music is now multimedia and often “enhanced” by software. They realized in 2004 during the Atlanta CIAA wireless conference their model was based on fooling their customers and in the 21st century, this model wouldn’t fly with informed consumers. The idea of taking a CD with 2-3 good songs, and stacking it with another 10-12 songs to sell the final product for $15+tax was no longer acceptable to the almighty consumer. Change or get downloaded for free until your industry is forced to change. That’s what happened in music. Reed Hastings, NFLX, and a few other Hollywood connected companies decided to get ahead of the problem before it became one.

Paying for packaging, distribution, the retailer’s cut, and the artist’s royalty; the last item being the most important, while getting the smallest percentage of the pie was a broken model for an interconnected world. This was a no brainer to me! Artists deserved at least 75% of the revenues in a digital world where distribution needn’t go through the old channels but instead should get to the customer digitally, the way iTunes was invented, and at a price point where the consumer didn’t think twice about downloading their favorite single without paying for unnecessary overhead. Although the illegal downloads would continue even with iTunes and the demise of Napster, in Atlanta I had an epiphany which I shared with my partner who was an attorney that represented big name artists. I told him the industry was shifting to the single (remember, this is 2004 and the RIAA was still suing teenagers publicly to set an example while Metallica was the spokesperson of the evil corporate machine, making things much `worse). My advice to my colleague, from a global macro long-term perspective, was that the single and all the pirated downloads were going to become de facto marketing for the artists to go on tour, which is where they would make their money. This to me was a no brainer but to my colleague was a total game changer and almost gave him a heart attack. The manager made 10% of tour revenues while the attorney made 10% of album sales and sponsorships. Therefore, it was time for him to change his entire business model and to do it right away before the managers, which tended to be drugged out “enablers” of the artists, figured out the new game in town.

I explained singles and online music sharing was in fact the panacea of marketing a band’s tour. Release the singles in low quality all over the P2P networks or give them away as free downloads by putting those little cards in every Starbucks within the marketing zone of the band’s next concert. I’m glad to say my colleague took my advice and is now showered with praise for figuring out the new model years before anyone else did. No worries, I don’t need the credit. I went there for him. However, the RIAA fought this for so long instead of creating a new model they lost over $100 billion in gross revenue for the same people they were supposed to be lobbying for. Rage Against the Machine, Chili Peppers and many new bands have caught on and are actually releasing their new work free on their own websites, or selling the singles without iTunes as the middleman for a price less than iTunes can handle. Moreover, they maintain all rights and trademarks, all masters, and have the flexibility to offer significant incentives for fans to buy merchandise. Those that have tapped into the social networking world, and I don’t mean a Musical MySpace account, are able to reach out to fans in specific cities and offer them concert tickets as a package deal with merchandise, music and anything else. Using Google print and radio ads, along with social networks like Facebook, bands can localize their advertising and marketing rather than rely on corporate carpet bombing, group marketing, random interviews, fliers, posters, commercials and hope the music catches (the best example is Tom Cruise’s role in “Tropic Thunder”).

The answer lies in what Joseph Schumpeter referred to as Creative Destruction, originally written about by Karl Marx in the Communist Manifesto. This brings us back to Netflix and why Reed Hastings is going crazy in the eyes of the blind. First, let’s put to rest one fact, which is that Netflix is an extremely “intelligent” company with Intellectual Property that borders on artificial intelligence at the speed of light. The algorithms that run Netflix’s suggestion tool based on perceptions of what you like according to what you’ve watched, how you’ve organized your cue, how you’ve altered that cue, how quickly you return your movies, how you prioritize your cue, etc… you get the picture. Netflix offered a $1mm prize to the first team that improves this algorithm by a very modest percentage. After several rounds, many teams realized they didn’t have the manpower or the combined skill sets to improve what Netflix had created, so the most unexpected occurred: the top teams began to partner up and the longer the race continued, the larger the clusters became, with members all over the world from hackers to top scientists at IBM to Astro-Physicists at CERN joining forces in a show of human determination rather than human greed. Programmers who had never met became overnight best friends in a coordinated attack on the problem from multiple angles, communicating only over the web, the winning team members had never even met until the day of the award. The true winner was Netflix as it harnessed the programming world’s best of breed to do all the heavy lifting for an advanced behavioral analysis and recommendation engine, all for a measly $1 million dollars. Seriously, if you paid salaries to just the winners, you would far exceed labor costs of $1mm. That’s literally a song for a company whose stock was trading at almost $310 before Reed Hastings came out and “stumbled” or “tripped” or “blew a gasket”, depending on who you watch and listen to. The programmers weren’t doing it for the money but as engineers do, they did it for the challenge and recommendation. That’s why CEO’s are rarely engineers and it’s a rare engineer who runs a company.

Now the stock is hovering at $70 after reaching $300 in mid-2011 and the chart looks exactly like the dot com bubble of 2000. This is another indication of overwhelming manipulation followed by a bear raid, both sides of which the public paid a heavy toll. As this is being written, the stock closed up over $4 (6.33%) on unimportant news regarding BBC content being made available in the UK and Ireland. The announcement triggered a short squeeze more than anything, and I would use this as an opportunity to hit bids on the stock to build a short line until at least the gap is closed near $67, although this isn’t the intended point of this editorial. The downtrend hasn’t even begun the early phases of a base, let alone indications of a bottom, so the trend remains down and the stock should continue to be sold on spikes like the one that occurred on Tuesday. Although the stock is 1/4th it’s recent high, until . Netflix was a high flyer net stock favored by the fast money monkeys who are generally referred to as “day traders”, with their keyboard hotkeys and arcade like set ups, trading discretionary strategies at a time when discretionary is the equivalent of tape players as opposed to iPod’s. Nonetheless, the stock was flying, but that’s the rub. Netflix is notorious for paying employees with stock options, and the 1999-2003 vintages were so far under water the company repriced them to hold onto their most prized employees, their brain power. The only thing that keeps Netflix worth what it is. Aside from the fact that Netflix is working fast to transition to a world without DVD’s, where Blu Ray and Hi-Def 3D can be delivered over the net, or over PS3 or the Xbox. Ultimately, the writing’s on the wall and Netflix will adapt as nimble Silicon Valley companies do or they end up in the vast cemetery of has been’s like Excite, The Globe, World Com and hundreds of other companies. But not Netflix. They are too smart and Reed Hastings is too shrewd to let that happen to his company. By splitting the company in two, he is detaching the future from the past. Qwikster is probably a rub on how quickly the company will disappear, following the footsteps of Blockbuster. When Netflix acquired Starz and other media content holders, they were preparing for this day. The day when all things are delivered over the web.

Where this leads us to is interesting from both a trader’s perspective as well as long-term investors. First, Netflix is a screaming buy at these prices but I wouldn’t load the boat or back up the truck. Slow and stead accumulation is the way to go about this play. There is nothing to light a fire under this market until February of next year, when the election year goes full throttle. Let’s return to why Reed Hastings announced a massive 60% price hike AND a division of the company all at the same time when he could have not only spread the announcements out, but could have raised the prices gradually, or using different type plans, like the phone companies. But this is not the point of this article. The point is that there was a strategic incentive for the stock price of the company to come down in the near term. No company with long-term ambitions likes to see their stock go parabolic like NFLX did. It creates a bubble and we all know bubbles burst. But once the fast money monkeys had this stock in their sights, the fight was lost. The company couldn’t issue new stock, if they split it would make matters worse by allowing smaller investors to join in the party, so what do they do? They take a page out of Microsoft’s playbook, which many companies have done so because of the advice of Wilson Sonsini, the heavy weight lawyers to a large majority of major tech companies.

Microsoft in the early days of its rise to the top of the world and masters of the universe, quickly learned that one doesn’t just get out in front of the analysts and say whatever is on their mind, like the CEO of Overstock.com, who was branded “crazy” and “delusional” for ranting about the conspiracy to short his company into a death spiral, although it eventually went in the opposite direction and followed the lead of Priceline.com, hitting triple digits and not looking back. What Bill Gates and Steve Balmer figured out was that the script has to be designed to in a special sequence. Not withhold information or provide false or misleading data, as that would violate too many securities laws. The idea was to move sections of the presentation around in order to have the effect most desired. Good news, when there was any, was at the top of the list and bad news, as always, went to the bottom of the script. Why? Because more analysts are tuned in at the beginning of the call than at the end. But when there’s bad news, even one analyst is enough to damage the stock considerably. Most tech companies eventually realized that the weapon of choice, stock options, which got them to where they were by lowering their cost of labor, and tax footprint, was just a way of putting off the inevitable. Because it created the classic “Innovator’s Dilemma”. Their use of such tools helped propel the stock to new heights, however, eventually employee’s would eventually vest and exercise their stock options, which meant flooding the market with new shares. New shares equals a lower EPS as the new stock dilutes earnings without lowering it. So the magic potion was to “sterilize” this new stock by having the corporate treasury buy it back in open market activities without tipping its hand to the market. The whole point of issuing options was to save money, but being forced to buy that stock back at or near its highs was a nightmare for many companies. But the choices were few and far between. Either you buy the stock back and reduce your cash on hand, or you face a declining EPS which “green”, fresh out of college analysts would construe as declining revenue. Although it was true that shareholder equity was being diluted, the value of the company was not. If you’re a company in the privileged position of Microsoft, who kicks off approximately $137,000,000 PER DAY in free cash flow, then you do what’s called sterilization which means removing that excess stock from the market, which ended up there due to employees exercising their options. The tax savings, the savings in cost of labor, the deferred compensation, all came around at once to hit the company like a freight train. Which is really all an ESOP (Employee Stock Option Program) is. A way to push forward the inevitable. However, Microsoft, being the pioneers and brains behind the explosion in technology in the 1980′s and ultimately the mid 1990′s, figured a way to beat this fiasco. When it was time for the Treasury to kick into gear and buy the excess stock off the market, Bill and Steve would have an analyst meeting and near the end, they would vaguely say something about uncertainty in the future. In those days, cellular phones were the size of lamps so not many analysts carried them. Instead, the would rush out the door before Bill even finished his sentence, so that they could contact their companies, whether an Investment Bank, a Brokerage, or the Wall Street Journal, to proclaim that the invincible “Softie” was talking about uncertainty. Now, what exactly does uncertainty mean? It means an unknown which could go in either direction, or be nothing at all. However, it achieved the goal of Bill and Steve, to where they were quoted in a book as saying “this is too easy”. In no way am I implying they were intentionally manipulating the stock, but they had figured out that the human factor, the behavioral mechanism which resulted in a Nobel Prize in Economics in 2006 for research on Behavioral Economics and Finance, was always inclined to brace for the worst. It appears we, as human beings, are pessimists when it comes to our money. One word and we jump. Or, looking at it another way, one word and the Bears raid. Thus allowing the company treasury to purchase the stock back at a discount to where it had been trading the weeks prior. Just a 5% decline saves the company hundreds of millions in capital, so a 15% decline hits the billion dollar mark for a company the size of Microsoft. The final act in this game is to have the treasury retire the newly acquired stock in order to reduce the number of shares and thus increase EPS or keep it going in the trajectory they wanted. This was not illegal. This was not against any moral or ethical guideline. This was a smart company having figured out how to use the emotions of uninformed analysts who slept through most of the meeting, and only caught the last few paragraphs which were negative, to their advantage. The only company that does this but does NOT retire their stock is Exxon/Mobile. The reason they do this is because they trade their own stock. When the stock is high, the treasury issues new shares and keeps feeding the market for as long as it will take it. Thus raising capital and using their high-valued paper to acquire assets. On the other hand, when their stock is down significantly, the treasury authorizes a multi-billion dollar buyback program but doesn’t retire their acquired stock, instead, they park it, as if they invested in their own company, so that when the stock inevitably rises again (the energy complex is cyclical of course), they use that stock to either raise massive amounts of cash or as I said, they use the stock for highly advantageous acquisitions that saves the company billions in taxes.

This brings us back to Netflix and the recent, out of character and abrupt announcements from the CEO indicating the company was taking two extraordinary measures which they knew would hammer the stock down. If I was Reed Hastings and playing the long game, I wouldn’t want my stock in a parabolic frenzied rally that eventually becomes a short squeeze as bears get in and get squeezed out by the momentum daytrading monkeys that are nothing but fast money. Google stays at lofty levels for the same reason Berkshire Hathaway does, in order to keep the fast money out. But Netflix hit some serious lows after the crash and became a heavily diluted stock. So when the trend was established, every trend following money manager with a momentum derived system had the stock on their radar and buying on classic 3 step declines. In the case of NFLX, after their stock took a beating like all net stocks did, they adjusted the strike prices of their employee stock options to bring them in line with what other tech companies were doing in order to hold onto their best and brightest. But unlike the others, NFLX saw its stock soar to new, unexpected heights. Does anyone really think the company is worth $ The last thing a corporate treasurer wants to do is “top tick” or even pay dearly for this forced stock sterilization. So they would talk down the price of the stock and the company would commence massive stock buybacks without having to pay way over the top for the stock.

Is this what Netflix just pulled off.

Taking a page out of Bill and Steve’s playbook, in the early days of the company’s history, as was written extensively about in several books and magazines, the two were notorious for providing a room full of analysts with accurate information pertaining to the company, including negative news. The trick was, they would save the bad news for the very end so that the analysts had a chance to rush out of the room and make the phone calls they needed to make, to clients, to Head Analysts, to Sector Analysts, to Clients even, that the two highest ranking officers of Microsoft just made some comments that may be construed as negative by the press or by some lone nut job that decided to hammer the company for. Hedge funds, as we all know, are notorious for building large short positions in a company, then releasing multiple press releases to get the story out and the analysts, as well as other hedge funds to listen. Obviously hoping to attract aggressive sellers to help push the stock down. Little did they know they were playing right into the hands of Bill and Steve, because by pushing the stock down, it permitted the company treasury to buy back or sterilize the excessive stock floating around because of the millions of shares in exercised options. Rather than pay dear, the treasury could buy lower, preserving the tax advantages that accompany a typical tech company ESOP and saving the company hundreds of millions of dollars, each and every time. It always focused on top line revenue growth being “foggy” as was once said by John Chambers, the CEO of Cisco, another heavy issuer of stock options.