Netflix's Newest Bull Whitney Tilson Explains Why He Got Long Yesterday

T2 Partners' Whitney Tilson took a royal shellacking by being short Netflix NFLX during its ridiculous run up in the last year. Eventually, he was forced to cover when the stock was trading at around $230. The stock eventually topped out above $300 in July and has since imploded in spectacular fashion. During Wednesday's session NFLX shares are trading at $80. For Tilson and other short-sellers who lost their shirts during the run-up and subsequently covered their shorts, this experience is obviously frustrating. Basically, they were right and took heavy losses, nonetheless. That is never fun. Now that the stock has crashed, however, Tilson has become a Netflix bull! There are a number of ways that investors could interpret this latest news. Depending on your level of cynicism, you might be inclined to say "Tilson got steamrolled on the way up and now he is going to be a bagholder on the way down," or you might look at it from the perspective that he was right on Netflix all along, despite his poor timing, and knows a lot about the company. If you take the latter view, you might want to look into the Netflix saga a little closer and see if the market has overreacted in recent weeks. In any case, below is the letter that Tilson sent to general partners at his hedge fund outlining his revised thesis on the stock in light of its implosion. Dear Partner, We established a position in Netflix yesterday after the stock crashed 35%. We will discuss it at greater length in our monthly letter next week, but in case you read about it before then, we wanted to assure you that we haven't lost our minds. We simply think it's a good company and that the market has over-reacted to all of the recent negative news, thereby providing us the chance to own it at a cheap price. Given our unsuccessful timing of being short this stock – a highly frustrating experience – we'll admit that it was hard to overcome the emotional baggage and think about Netflix with a fresh perspective, but as we wrote to you in last month's letter, for every investment decision, we simply ask ourselves: if we were starting our fund from scratch today and held only cash, what would we do? In this case, the answer is that, at this price, we'd own Netflix. Netflix today reminds us of BP 16 months ago (and we all know how well that worked out): the company, its CEO and the stock are all universally hated right now, with endless headlines of furious customers and shareholders. We love situations like this – as long as we're convinced that there's a good company and a cheap stock once you cut through all of the noise. And we do think Netflix is a good company – even when we were short it. The problem wasn't the company, but rather the extreme valuation of the stock – but now that it's down nearly 75% from its peak less than four months ago, the valuation is downright cheap in our opinion. The article below captures many of the reasons we're bullish. In addition, we'd add the following:

• We think Netflix can earn $5-6 of contribution margin per customer per month (a bit less than half of average revenue of approximately $12.50). This translates into $1.3-$1.7 billion of operating profit (excluding Netflix's nascent international operations), for a company with a market cap today of just over $4 billion.
• With 23.8 million subscribers (again, excluding 1.5 million international ones), Netflix is being valued at $175/subscriber, a very low figure relative to other media companies.
• We think Netflix was smart to raise its price – our only quarrel is how Reed Hastings communicated it. We wish he'd send the letter below to them, explaining the reasons for this action. Note that the price increase only affected subscribers who were getting both the streaming and DVD services (they were paying $9.99 and now have to pay $7.99 for each service, a 60% price increase). Streaming-only and DVD-only customers didn't see a price hike and these subscriber numbers are growing quickly, especially the streaming-only, which is the future of the company. Based on the company's guidance and our own estimates, we think that the number of streaming-only customers will rise 29% from 9.9 million at the end of Q3 to 12.8 million at the end of Q4, due to both new subscribers as well as current streaming and DVD customers dropping the DVD portion. The net result is that the total number of subscribers will remain roughly flat in Q4, but the mix will shift to more streaming and fewer DVD customers (who will be far more profitable, thanks to the price hike). We think these trends bode well for the company over time.
• Its shrunken market cap means that Netflix would be a bite-sized acquisition for any number of much larger companies like Apple ($370B market cap), Google ($188B), Amazon ($93B) or Disney ($64B).

Please let us know if you have any questions. Sincerely yours, Whitney and Glenn PS—Our fund is up 7.8% this month through yesterday.