A Capacity to Suffer and Setting the Right Expectations

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“If you owned a business all by yourself, you wouldn’t care at all about maximizing reported numbers. ” — Tom Russo

Who the heck would want to watch movies on the Internet?

The year is 2012 and Netflix (NFLX) is coming off a banner year where it reported record operating income and EPS ($376mm and $4.28 respectively) on the back of a declining yet still healthy DVD by mail business.  The previous few years had seen Netflix deal a death blow to its primary competitor -Blockbuster Video. With healthy profits and competition out of the picture, what better than milk the business for its cash flow and ride out the wave of juicy profits for several years to come.

This is a move that shareholders might have applauded at the time but it is precisely what Reed Hastings (CEO of Netflix) didn’t do.  Just one year later (2012), operating income declined to ~$50mm and EPS took a nosedive to $0.31.  The driver?  A significant, several hundred-million-dollar investment in content to support the newer streaming business.  Rather than milk the profits of the DVD business, Hastings decided to pour everything and then some into the future- the streaming video business.  Yes, sure – the success of Netflix is very obvious with the benefit of hindsight some 7 years later but at the time it wasn’t so obvious to the Street and investors.  As a result, the stock got punished.  It went from a high of $40 in July 2011 to languish in the $10 to $15 range from late 2011 through the end of 2012.

I tell this tale about Netflix not because I am practicing my Harvard Business School case writing skills but because this decision by Hastings to reinvest for the future gets at the crux of the “capacity to suffer”. Let’s delve a bit deeper.

Source: Data sourced from Netflix public filings”

Consistency is wonderful unless it masks an intolerance for “pain” or complacency

A straight line that is “up and to the right” is a beautiful sight when it comes to a graph of a company’s revenue, earnings, free cash flow or any other financial metric that matters.  I get excited when I see that a company has performed so well that everything looks so perfect.  More often than not, that excitement is quickly tempered by a dose of skepticism.  How is it that Company X has managed to grow its earnings and cash flow so consistently over that many years?  What has the management team forsaken in the pursuit of that perfectly consistent growth and line graph?

As an investor – yes – I generally like consistency and predictability in the businesses that I buy an ownership stake in, but I don’t like when that consistency and predictability is artificially manufactured.  I don’t like when management teams dial back marketing investment or any other important investment because they want to hit an arbitrary 10% earnings growth target that they committed to a year prior.  In other words, I don’t want earnings consistency at the expense of activities that widen the moat.  I’m ok if earnings take a hit because the company wants to make an investment that has the potential to bear fruit later.  This is more or less the core idea behind the “capacity to suffer” or the “capacity to reinvest” –  It’s an idea that’s been popularized by value investor Tom Russo over the years and one that I’ve become quite enamored with after hearing him speak about it on a few occasions like below.

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