By Alex Daley, Chief Technology Investment Strategist

We all make stupid investment decisions on occasion. With the impending Facebook IPO looming large over the technology markets right now, the in-vogue meme in popular news media seems to be that a lot of investors will make mistakes hopping into that offering when it debuts. But there’s no real consensus. On the one hand, words like “exuberant” and comparisons to the late 1990s are being tossed around widely; on the other, analysts have been quick to point out that Facebook’s expected valuations are not much different than Google’s were at its debut, with a trailing P/E ratio just over 100. The differing opinions and debate are a pretty good sign that we are not at frothy levels of excitement.

The big mistakes in the market are made when media and pundits turn into a collective echo chamber. When all parties agree something is a good idea, chances are it is not any longer. Tech stocks. Condo flipping. Rare earths. When everyone out there believes the same thing, the majority of people will end up finding out the hard way that conventional wisdom tends to be wrong.

A cacophony of violent agreement is not just dangerous to the decisions we as individual investors controlling our own money make, it affects the decisions made by professionals as well, including fund managers, brokers, and even the management of the companies we invest in. This is why I want to explore some news that has cost technology investors billions of dollars, and highlight the reminder it gives us to analyze before acting.

Should Netflix Have Gone Ahead with Qwikster?

In September of last year, Netflix announced that it would be renaming the DVDs-by-mail portion of its business to Qwikster, in what was largely thought to be an attempt to spin out that aspect of the company via a quick sale to a private-equity firm or prior competitor.

Almost from the moment it was announced, the decision was pounded by critics. Fresh on the backs of a price hike that was communicated poorly, the company had once again made a PR gaffe and announced a confusing change to its services. Why on earth was Netflix going to such great lengths to divide the businesses?

To understand that, we have to look back at the summer price rise first.

DVDs were once Netflix’s sole business. Streaming was what marketers refer to as a “premium” – something extra tacked on top that helps close the sale, but which is not the core product – the icing on the cake. But the premium quickly proved to be wildly popular… popular to the point that customers began pressuring Netflix to offer streaming alone, and not force them to get DVD subscriptions along with it. Seeing a clear market opportunity, Netflix jumped on the strategy and hasn’t looked back.

Just as the company’s advertisements for its DVD-by-mail service were nearly inescapable, it aggressively pursued making access to its streaming service as easy as possible, offering up help to any device maker who wanted to add the feature to its lineup. When offered the chance to add value to their devices beyond just letting that cable wire plug in, electronics manufacturers jumped at the opportunity. Now you can hardly find a Blu-Ray player, game console, or other device without support built right in.

Today, 23 million Netflix customers stream content. Only 10 million receive discs. And just 30% of the latter do that exclusively – the other 7 million also pay separately for using the streaming service.

At least they pay separately now. That was not always the case, as many of us remember quite well. It wasn’t until the summer of 2011 that the company made the decision to charge a distinct fee for the streaming service to those customers getting discs in the mail. For those customers, it amounted to a 60% price hike.

Why would the company make such a huge price hike in one fell swoop, instead of gradually raising rates over time? The reality is, the company had painted itself into a corner. It wanted nothing more than to rid itself of the DVD-renting business – but it couldn’t do that if streaming was to stay.

To Netflix, the Qwikster plan seemed like the perfect solution. Separate the charges. Separate the brands. Then quietly – once the changes had settled in – flip the DVDs to a receptive buyer and use the cash to support growing the streaming business.

But why rid itself of the thing that made Netflix to begin with? Is DVD-by-mail really that bad a business? After all, Netflix did enjoy healthy rental profits for many years and still counts itself as the overwhelming market leader.

It’s not that DVD-by-mail is bad business – it’s that streaming is simply a better business all around.

That difference begins with the nature of content delivery. Netflix’s original model – eschewing itself of the large legacy costs of the retail movie rental agreement, and instead relying on economies of scale at large, central processing facilities – was a brilliant one.

When Netflix first started offering its DVD-by-mail services, the biggest game in town was the retail chain of Blockbuster Video stores. Rentals were $4 each at best, and if you forgot to return them you were penalized for considerably more. Watching four movies a month could cost upwards of $20 with taxes and fees. That was a great deal compared to going out to a theater, sure. But Blockbuster’s business model – renting brightly lit storefronts, stocking them wall-to-wall with videos, popcorn, and pimply teenagers to scoff at your selection of American Pie 9, all in order to rent to you a little one-ounce disc of plastic – was its ultimate weakness. As digital technology evolved to shrink the massive cassettes of old, Blockbuster failed to adapt with it.

Netflix saw the incredible overhead built into the DVD rental market at the time and hit the competition right where it hurt, undercutting the big guys on price by a large margin – you could easily get those same four movies per month from Netflix for just $8, less than half the cost. On top of that savings, it made late fees a thing of the past by creating predictable, recurring revenues per disc out with a customer. Also, its large, centralized warehouses could hold a much larger selection of movies than any retail store could ever hope to stock.

The lack of convenience of not being able to pick up a movie on the way home was Netflix’s only real weakness, but many customers were willing to trade the convenience for lower prices, better selection, and no late fees to worry about. At its inception in 2001, Netflix was able to pick up a few hundred thousand subscribers. Riding its momentum and with cash in hand from a successful 2002 IPO, the company soon grew that number to over five million by its fifth year.

The DVD-by-mail business was booming, and Netflix was the market leader by a long shot.

It was also an expensive business. Customer-acquisition costs grew steadily over Netflix’s first few years, as competition ran wild trying to catch up. Blockbuster Video jumped into the DVD-by-mail game and tried to play catch-up, using the convenience of being able to return to its stores to target Netflix’s weakest point. Ultimately, Netflix’s aggressive marketing, big selection, and low prices proved too much for a chain that couldn’t sustain itself with ever-mounting customer losses.

However, all that competition drew stark attention to Netflix’s biggest flaw, too. Would-be competitors saw that if they could find an equal footing with Netflix on price and beat them on convenience, millions of customers were up for grabs.

One of the biggest competitors to come along was vending-machine company Coinstar. Its Redbox brand movie-rental machines are now a regular feature of the American landscape, with over 35,000 machines at more than 30,000 locations from grocery stores to fast-food restaurants all around the US. These machines require no staff – except for restocking and the occasional maintenance tech visit – but offer the convenience of “pick up a movie on the way home” retail locations, like the Blockbuster of old. The machines don’t require any rent – just a small royalty to the shop owner to cover a few feet of space – and a power hookup. Thanks to good technology on the backend – emailed receipts let the company do preference tracking (What kind of movies do you rent? At what location? How often?) – it can market for repeat visitors as effectively as Netflix does. And thanks to low cost of operation, it can compete on price, at about $1 per night per disc.

Cable companies were added to the mix, too. As they saw the movie-rental business heat up, they saw a way to increase average revenues per customer by a few dollars a month if they could grab a slice of that pie. So they increasingly invested in the burgeoning field of digital cable, in order to increase the number of “video on demand” (VoD) movies available to customers. Providers like Comcast further eroded the selling points that Netflix relied on: There is no wait for a pay-per-view movie… no disc to return, ever. It’s no wonder that VoD revenue jumped 85% in 2011.

Both VoD and vending were starting to eat into Netflix’s disc business in a major way.

As pointed out earlier, Netflix recognized its own Achilles heel. It tried to bandage over the area with a focus on strategic locations of its facilities to keep that wait down to just a day when possible, and with excellent software that helped keep customers satisfied by pointing them to movies they were most likely to enjoy based on their individual tastes.

Still, Netflix needed some way to compete on convenience. Having subjected Blockbuster to the sharp edge of the “innovator’s dilemma,” the company was not about to let itself fall prey to the advances of technology. It was already stocked with one of the best software-development teams in the country, thanks to founder Reed Hastings’ foresight in plastering over the service’s weak spots with excellent technology facing the customers and back at the warehouse. Next, jumping headlong into the streaming business seemed like the logical choice for the company.

With that star development team in house, the company added a steaming feature to its website. At the time, DVD sets of television shows had started to explode in popularity, so Netflix convinced every studio it could find that if it was going to buy thousands of copies of their movies and TV shows, the companies should also license Netflix to let users just click on the “play now” button on its website and watch it instantly. Having seen what digital did to the music business, video companies were a little hesitant to open the floodgates full-bore, but knew they couldn’t ignore it either. So they reluctantly partnered with Netflix, treading carefully so as not to rile their bread and butter – the big cable companies – and soon many of the titles in Netflix’s library were available online as well.

And the rest, as they say, is history. The feature proved incredibly popular – so popular that soon nearly every customer Netflix had was using it, and it was the driver for new subscriptions. Customer-acquisition costs started dropping, and fulfillment costs did too, as people took fewer discs by mail. When customers started demanding disc-free subscriptions, the future became obvious.

Someone was going to kill the DVD-by-mail business. The weaknesses were just too big. Netflix had known that for some time and tried to bandage it over for as long as it could, but in the process it stumbled on something that was going to be bigger and way better than its old business anyway.

That’s because it was a cheaper business. Sending DVDs by mail is expensive… cheaper than storefront video retailing, sure, but it still involves huge warehouses, along with a large unskilled labor force to process all of those physical packages and manage that inventory (and all the potential liabilities that come with that kind of labor force). Not to mention a massive postage bill.

Since Netflix was founded, postal rates have risen more than 35%. With the postal service losing billions of dollars per year in the midst of the biggest budget crunch this nation has ever faced, and with gasoline prices holding at all-time highs, those rates are poised to move up even faster in the coming years.

On the Internet, however, Netflix commands a very different position. The decentralized, private network had already made great strides in driving down the cost to deliver a few megabytes of content to a customer’s house over its 17-year or so popular history. But Netflix – serving up gigabytes of data to 23 million streaming addicts, each watching potentially hours per week of content – sucks up a lot of bandwidth… approximately one-third of all Internet bandwidth these days, according to measurements by network-tracking firms. That gives the company extreme pricing power with content-delivery networks and network-service providers – power it never could have achieved with the postal service.

The bottom line is that it costs Netflix approximately a quarter as much to deliver an hour’s worth of video entertainment to a customer via the Internet than it does via the mail.

Not only is it cheaper, the mix of fixed to variable costs is more favorable to the company. With fewer people and more servers, the company’s savings only increase as it scales larger and larger. Gone are the indirect costs of a low-skill labor force – wage and benefit limitations like the ones Amazon.com suffers from when hiring against competitors in Seattle who don’t have to offer their health plans to warehouse workers (who outnumber by 10:1 the highly paid and difficult-to-recruit software engineers on the other side of the company).

As a streaming company, Netflix is leaner, meaner, and sports lower margins.

The cost of acquiring customers also improved. The company spent a great deal of its gross revenue on advertising in the past. Flyers, inserts, mailers, print ads, digital ads, and more were a big upfront cost for the company as it built its brand. But beyond the benefits of inheriting one of the nation’s most recognized brands, Netflix streaming had another, more direct effect on acquisition costs: it came with partners.

Those electronics manufacturers that built Netflix into their devices… each is providing a valuable advertising service for the company, making it a “no-brainer” for users to give Netflix a try. It is already right there in front of you. No trip to Redbox required. Just click a button on the remote and voilà. Whether it’s Xbox, Playstation, Wii, your television, Blu-Ray, or even a DVD player, chances are you have at least one Netflix-ready device in your home. The result has been a dream come true for Netflix: accelerating growth of digital subscribers, coupled with plummeting acquisition costs.

Graph by SplatF

The concern with any subscription business, of course, is “churn” – the number of subscribers lost each period. In order to keep revenues steady and predictable and to get the value projected from a customer over time, a company must keep its churn low, so that more money goes to finding new subscribers and less to replacing the ones who left. These net acquisition costs for Netflix, despite dropping rapidly, are not what they could be because of losses in the DVD business.

DVD subscribers have fallen from a peak of nearly 15 million to just 10 million today. Better options on the market for getting much of the same content now exist for a large part of Netflix’s market, and thus the number of DVD subscribers the company has is falling quickly. Redbox, Comcast, Verizon, and Netflix’s own streaming service are all grabbing a share of the market. The prognosis is so grim that CEO Reed Hastings put it simply in January’s earnings call when he said, “We expect DVD subscribers to decline steadily for every quarter, forever.”

Only those who don’t get what they want from streaming or can’t yet be reached by its services will remain loyal – but costly – customers of the DVD-by-mail service.

Obviously, Netflix’s DVD business is holding the company back. The finances of the business are constraining key metrics that drive profitability and cash flows. But why try to spin off the business in its entirety with the Qwikster move? Why not just put it into maintenance mode and milk the cash cow until it’s dry?

With streaming subscriber acquisition beginning to flatten in the United States, Netflix faces two very expensive challenges over the coming few years.

First, the company has to keep churn low, lest those net acquisition costs start to rise dramatically again. And the only way to do that is by maintaining and expanding its library of videos. The moment you can’t find something you want to watch on Netflix is the moment it loses you as a customer.

Second, to keep growth numbers up it has to expand to more markets outside the United States. With streaming, this is much easier than it would have been with DVDs, where the postal services of other countries might not have been as affordable or accommodating – i.e., those countries might not be willing to burn billions of dollars per year losing money to help deliver movies to Netflix’s customers’ doorsteps. But with streaming, the answer is as simple as lining up some content-delivery network partners in the region, and immediately you can reach every home with broadband (the penetration rate of which is higher in most other developed nations than the US, thanks to their smaller sizes and denser populations).

In both cases the biggest barrier is access to content.

In this area, Netflix has been the architect of its own problems. The company’s runaway success – as by far the leading streaming service with over 23 million paying downloaders – has awakened the sleeping giants of the cable industry. The increasing availability of large libraries of streaming movies and TV shows does not just threaten the pay-per-view revenues of the big cable companies, it also threatens their core business. Cable companies around the country have been shedding subscribers, collectively losing more than four million subscribers to other media over the past two years, including the so-called “cord cutters” who rely solely on Internet streaming content for their video entertainment.

At the same time, content providers like Hollywood studios and major television networks find themselves dealing with a much larger and more diverse set of potential licensees: cable companies; expanding satellite providers; new fiber-optic networks like FiOS and Uverse; Internet-based providers from major-studio-owned Hulu to Walmart’s Vudu subsidiary to Amazon.com’s Prime Video to Netflix; and a dozen other well cashed-up suitors to boot. This increased demand has allowed content providers to charge higher rates overall and leverage their highest-demand content to incredible heights, as they negotiate exclusive deals for certain providers – for a few months, weeks, or even just days.

Netflix saw these higher prices coming, like a freight train headed its way. You see, Netflix’s largest content deal – a license piggybacking on the Starz channels’ agreements with multiple content providers – was due to expire this past year. The company did not just need to prevent itself from losing a large portion of its content, it also needed to increase the total content available to keep current customers happy with the service – managing the churn level. And it was going to have to start licensing entirely new sets of content for new markets. That train carried a load of new expenses.

With those daunting costs looming on the horizon, increasingly bad economics in the core DVD business, and its future so clearly tied to the streaming business as its DVD customer base continued to shrink, the right thing to do must have been obvious: spin off the DVD business and raise some cash.

By ridding itself of the DVD business, Netflix would not only have acquired the money it needed to sign long-term licensing deals and get it over the costly content hump ahead, but fundamental business metrics like gross margins would have improved in the process. For a company that had seen its stock sink from a high of $300 down to around $155 just before the Qwikster change was announced, that must have seemed like a win-win. Netflix could avoid dipping into cash flows and reserves to license content and improve the make-up of its business (and the attractiveness of that languishing stock) at the same time.

How to do that? Step one: separate the pricing of the two products. Stop using one business to support the other, and make a clean break. But that has to be carefully managed. You can’t discount the value of the DVD subscribers lest you make the business less attractive to a suitor. Plus, a dichotomy of pricing for old and new customers post-split would just anger full-paying customers on both sides of the business… hence last summer’s pricing debacle.

Step two? Well, there is really no reason why the company could not have sold off its DVD business right then and there. Why it chose to first rename it I can only guess at. Large companies tend to get very attached to their brands, and the fear of a founder-executive suddenly putting that innovative, well-loved name into the hands of some cost-slashing, private-equity bankers (Netflix was rated as the brand with the highest customer satisfaction) may well have played a role.

So, had Netflix been aiming to maximize shareholder value, especially in the short term – i.e., drive up the stock price – the Qwikster spinoff actually might have been the best move. It would have yielded better margins and all the cash they needed to get through Q1’s big licensing push, without dropping out of profitability for the first time in years. Now, the company isn’t projecting to make a profit at all during 2012, as its customer-acquisition costs increase from entering new markets for the first time and as its content-licensing costs rise sharply. Had it successfully finished the Qwikster transition and sold off the DVD business (as many analysts suspected was the eventual plan), Netflix shareholders might have been in a very different spot than they are today.

[As chief technology investment strategist for Casey Research, Alex Daley is often sought for media interviews. Here’s one he did on the Financial Sense Newshour, where he discusses robotics, biotechnology, and the effects of disruptive technology.]

Bits and Bytes

123D Make (Apple)

Cool app. 123D Make lets you turn 3D models into real-world creations made out of any flat material that you can cut. Convert any 3D STL or OBJ file into a physical object using automatically generated 2D build plans and animated assembly instructions.

Computer Gets a Driver’s License (eWEEK)

You’ve probably seen footage of Google’s driverless car. Well, in a huge step for the program and enthusiasts of autonomous vehicles everywhere, Nevada has just become the first state to approve a license for a driverless vehicle. Skynet: winning.

Zuckerberg Hoodie: Mark of Immaturity? (Bloomberg)

According to Michael Pachter of the financial services and investment firm Wedbush Security, “Mark and his signature hoodie: He’s actually showing investors he doesn’t care that much. He’s going to be him. And he’s going to do what he’s always done. And I think that’s a mark of immaturity.” To which we would reply, “No kidding, buddy; the guy is in his 20s.” We’re not bullish on Facebook’s stock prospects at IPO based on the current lofty valuations, but we’re willing to admit that Zuckerberg is a genius. And analysts shouldn’t let his wardrobe get in the way of their opinions of the company. Steve Jobs wore the same terrible outfit for years and built a $500-billion company.

Will Google and Facebook Disappear Soon? (Forbes)

Can you imagine a world without Google and Facebook? We tend to think that the school of thought known as “organizational ecology” is pretty much crap. Our take is that the evidence overwhelmingly shows the power of the individuals in an organization to succeed regardless of the circumstances. But we’re not too closed-minded to think that a different point of view isn’t worth consideration. This is a pretty interesting article that suggests companies like Google are becoming obsolete.

Amazon’s Cloud Carries 1% of the Internet (Wired)

Most people still consider Amazon just an online shopping mall of sorts. But the Amazon of today is much more than a low-cost, online retailer. It’s now part Walmart, part Apple, part Netflix, and part Rackspace. In fact, since the introduction in 2006, the company’s cloud-computing infrastructure has grown to the point where it is now on the sending or receiving end of 1% of all the Internet traffic in North America, according to Craig Labovitz, cofounder of DeepField Networks.