Friday, February 11, 2011, 10:42 AM ET|Posted by Will RichmondLess than 2 months ago investor Whitney Tilson gained a lot of attention explaining his short position in Netflix stock. Now, with Netflix stock about 27% higher than where it was when he wrote his analysis, this week Tilson threw in the towel, closing out his short position. While Tilson made a couple of interesting points around margin compression due to Netflix's escalating content costs, and also potential competition, the short sale was flawed by Tilson's near total misunderstanding of Netflix's value proposition and why it resonates so powerfully with consumers, which is what helped Netflix add 7.7 million new subscribers in 2010. That, combined with Netflix stock's darling status, made Tilson's short bet an almost certain loser.
The central problem with Tilson's conclusion was that Netflix's streaming content library was weak. It was based on him comparing Netflix's library to movie download sites like iTunes and Amazon, and pay-TV's more expensive monthly subscription services. By these standards Netflix's selection does look thin. However, the fact that subscribers can watch all they want for around $10/mo gives Netflix streaming huge appeal relative to one-off download sites and increasingly pricey pay-TV services, especially for non-sports fans. All of this was borne out in a SurveyMonkey questionnaire that Tilson fielded of 500 Netflix subscribers (why he did this AFTER shorting the stock is yet another head-scratcher).
Now, awake to the fact that Netflix is a superb consumer value, Tilson believes Netflix is in a "virtuous cycle," echoing many of the points I made over a year ago in "It's Official: Netflix Has Entered A Virtuous Cycle" (which also begs the question whether Tilson did any Googling around for analyst opinion before he embarked on his short). Over the long term, Tilson's points about Netflix's rising content acquisition costs and intensifying competition will start to bear out. But a final mistake that Tilson made was his exquisitely bad timing, shorting Netflix in the holiday fourth quarter. The signs were very visible that connected device sales would be strong in the quarter (the Sunday Best Buy flyers alone underscored their emphasis on these products), and that Netflix was going to be a primary beneficiary. This led me to be the first (I think) to speculate that Netflix would add over 3 million subscribers in Q4 to end the year with over 20 million (which is what happened).
For now, Netflix's fundamental appeal is very strong and it's riding a huge consumer shift to streaming content. As I've suggested, in 2011 Netflix is going to start reckoning with its own success, and it will be interesting to see how it does so. I'm not a Wall Street analyst and have never suggested anyone buy Netflix's stock, but betting against it in the current market environment is a fool's errand. Tilson can now attest to that.