Netflix: The Best Logistics Is the One That Eliminates the Object Being Moved

Netflix announced a small convenience for subscribers today. That is probably what the market will call streaming: convenience. A domestic, harmless word, fit for analysts who see functions but not displacements.

I do not see a function. I see an assassination.

The company built an admirable operation around red envelopes, distribution centers, title queues, mail, inventory turns, and logistical discipline. It won not because it had better stores, but because it removed the store from the path. Blockbuster rented physical space. Netflix rented time. The consumer no longer had to drive to a shelf. He only had to choose, wait, and return.

That was brilliant. And, like almost everything that was brilliant, it is condemned.

Streaming is inferior today. Few titles. Uneven quality. Dependence on connection. Use trapped on the computer. Technical friction. The DVD catalog is vast; the online catalog is anemic. DVD is tangible, reliable, familiar. Streaming is a promise with a buffer.

That is exactly how disruption usually enters: too small for the incumbent to respect, too ugly for the ordinary consumer to idolize, too limited for the analyst to model correctly.

The wrong question is: "Will streaming replace DVD now?" It will not. The correct question is: "Which system improves faster and reduces marginal friction every year?" DVD depends on atoms. Streaming depends on bits. Atoms have cost, weight, delay, loss, inventory, envelope, truck, human hands, and human error. Bits have their own problems, but they compress with scale, software, bandwidth, and time.

The best logistics is the one that eliminates the object being moved.

Netflix is not merely adding a button to the site. It is adding an emergency exit to its own business. The market may look at this and see self-sabotage. In a sense, it is. But there are two kinds of self-sabotage: the fool's destruction of what works out of vanity, and the rational operator's sacrifice of a known margin to buy a chance at monopoly in a better model.

Mature companies protect their past. They say they are "listening to the customer," when in reality they are listening to last quarter's income statement. The store manager defends the store. The fleet owner defends the fleet. The DVD executive defends the DVD. Each calls his private incentive strategic vision.

Reed Hastings seems to understand something colder: if someone must kill the DVD, it is better that Netflix do it. Internal cannibalization is ugly in a spreadsheet, but elegant in evolutionary theory. The species that changes before the environment does not receive applause immediately. It receives suspicion. Later, it receives the territory.

The market likes simple narratives. Netflix will still be treated as a movie-rental-by-mail company. Streaming will be seen as a free extra, a defense against Apple, a technical experiment, or entertainment for early adopters. That reading interests me because it reduces the chance that the optionality is fully priced.

The company has an advantage that looks banal and is not: a direct relationship with the subscriber. Hollywood has content, but not necessarily habit. Cable companies have distribution, but sell bloated and slow packages. Netflix knows what the customer chooses, abandons, rates, waits for, repeats, and forgets. That is not merely a catalog. It is behavioral memory. In streaming, that memory can become invisible programming of demand.

But I do not want to romanticize. There is enough poison here to kill the thesis.

First, content. When the user clicks and watches, the owner of the content wakes up. And when the owner of the content wakes up, he charges. Second, competition. Apple, Amazon, cable, and studios can try to capture the final interface. Third, economics. Streaming is not magic. Servers cost. Bandwidth costs. Licenses cost. A company can win the format and lose the margin.

So how would I position?

I would not buy this as one buys a beautiful story. Beautiful stories are expensive because they comfort. I would buy it as an imperfect option on a change in distribution. I would prefer common shares, not excessive leverage. The thesis needs years, and short-dated options are an elegant way to be right and lose money.

My operation would be small at first, built in layers, financed by other people's impatience. A long position in NFLX, sized to survive falls of 40%, 50%, or more, because the market will punish any quarter in which churn, content, or streaming costs look out of control. I would not use margin. Margin turns volatility into a boss.

If liquidity were adequate, I would consider complementing with longer-dated calls, out of the money only enough to capture convexity, but not so far that they become lottery tickets. The serious part would be equity. The speculative part would be optionality. Confusing a thesis with a bet is like confusing surgery with a stab wound.

I would also evaluate a relative pair: long Netflix, short Blockbuster, if cost, liquidity, and squeeze risk allowed. The logic is simple: if physical distribution loses relevance, the company born digital has more ways to survive than the company born in the store. But shorts in wounded companies require humility. A corpse can still move.

The center of the thesis is not that Netflix will dominate entertainment. That would be arrogant in 2007. The center is that the company is trying to migrate from wait-time logistics to instant logistics. When a company removes waiting from a recurring behavior, it does not merely improve convenience. It changes frequency.

And frequency changes value.

DVD forces the user to plan. Streaming permits impulse. DVD turns entertainment into a queue. Streaming turns it into availability. DVD has enough friction to protect scarcity. Streaming destroys scarcity and creates another problem: excess. In that excess, recommendation becomes infrastructure. Whoever helps the user choose when there is too much to choose captures power.

I would not pay any price for this. A correct thesis bought at an absurd price becomes moral punishment. The investor must resist the addiction of turning technological inevitability into stock-market inevitability. Streaming can win and the shareholder can still suffer if content cost, competition, and expectations crush return on capital.

But in January 2007 the asymmetry exists because most people are still discussing the envelope.

The envelope is symbol. The button is destiny.

The traditional rental store asks: "How do I deliver the movie?" Netflix seems to be starting to ask: "Why does delivery still exist?" That difference is small in the sentence and enormous in present value.

I do not need streaming to be good today. I need it to become less bad faster than DVD can become less physical. That race is unequal. DVD can gain catalog, improve distribution centers, reduce delays, negotiate better postage. All of that helps. None of it changes the nature of the object. The object still travels.

Streaming improves with forces Netflix does not control alone: broadband, compression, better computers, better screens, consoles, connected televisions, online payments, and falling infrastructure costs. When a thesis benefits from many tailwinds that do not appear in the current income statement, the market tends to underestimate it.

That does not make the company safe. It makes it interesting.

The correct position, for me, would be long with suspicion. The size must respect the possibility of error. The price must respect the possibility of euphoria. The patience must respect the possibility that the market will only understand the thesis after it has already become obvious.

Today, Netflix looks like a DVD company adding streaming.

Perhaps it is the opposite.

Perhaps it is a streaming company using DVD to finance its own crossing.

Leo Bentier