The Lesson of Netflix and Reed Hastings

Netflix is the best performing stock on the S&P 500 in 2013 -- up more than 135% in four months. It's a different story from a year ago, and the complete opposite of what was happening around summer 2011. Coming up on two years since the complete disaster that was Netflix's policy changes and DVD spinoff, the company has now soared to new heights and is likely to be bound for more. While it was not the actions of any one party, there is an important lesson for businesses and investors to learn. As demonstrated by Reed Hastings, here is how to make a full recovery from a serious case of business idiocy.

Dream come true
For the value-conscious and technological skeptics among us, it was a joyous time when Netflix plunged from its $300-per-share days to near $50.

"We told you! Sky-high valuations have no place in the reality of investing."

The thing is, it wasn't a market correction of Netflix's valuation and an understanding that paying 100 times earnings for a company is completely absurd. It was punishment. When Reed Hastings decided to shed the company's DVD delivery business and push up prices on streaming, nearly everybody got ticked off. Eight hundred thousand subscribers fled in the fourth quarter of 2011, according to a recent New York Timesarticle. It wasn't a quick lashing, either, as the stock shed value for more than a year and Hastings was lambasted again and again for poor leadership skills. He took the criticism graciously and admitted quickly the errors of his ways. That was step one.

Step 2
Admitting failure is, for some, an already impossible task. And the worst part is, it's not nearly enough when you run one of the most closely followed tech companies in history. But Hastings didn't stop at "I'm sorry." He embarked on a multi-year mission to regain his disenchanted customers. With 2 million new subscribers in the first quarter of this year, we know now that it worked.

Netflix quickly reversed course on the Qwikster move, even if long-term it was probably the right thing to do. But, again, that wasn't enough of an effort. The company needed to show us it was worth redemption. The best example of doing so, in my opinion, was the original series House of Cards. Not only did it bring in millions of customers and help it pass HBO in subscriber count, but it also showed us that Netflix was actually a really cool, adaptive company. Content costs are a tremendous cash-suck for Netflix and cable operators alike. A rational response is to make your own content. House of Cards, though, was anything but a conventional show. It had the writing, violence, and sex of an HBO series, and the watchability of West Wing. It opened the company up and showed investors, analysts, and, most importantly, customers, that its ability goes far beyond streaming nature documentaries and past seasons of 30 Rock.

A buy?
Now that I've stroked Hastings' ego and laid my coat in a puddle for Netflix to step on, I'll go ahead and say buying the stock is not a good idea. My reason is not because of Hastings, content costs, competitors, or any complaint about the business. It's my original complaint -- valuation. Netflix is trading at 70 times this year's projected earnings. If you were to buy a taxicab that generated $10,000 a year in revenue, would you pay $700,000 for it? If you were in New York, probably, but that's not the point. Ever the penny-pincher, I can't stomach paying 70 times anything.

Reed Hastings and Netflix have shown something rare in the corporate world -- the ability to say "I'm sorry," and the talent to move forward. Expect bigger and better things from this company, but don't pay Rolling Stones scalper ticket prices for it.

The tumultuous performance of Netflix shares since the summer of 2011 has caused headaches for many devoted shareholders. While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why The Motley Fool has released a premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. The report includes a full year of updates to cover critical new developments, so make sure to click here and claim a copy today.

The article The Lesson of Netflix and Reed Hastings originally appeared on Fool.com.

Fool contributor Michael Lewis has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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