What's Netflix Hiding?

 | Oct 10, 2011 | 7:00 AM EDT
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Last week, I got invited to co-teach a class on Top Management Teams at the Tuck School of Business at Dartmouth. The subject of the class was Why Smart Executives Fail. It addressed why really talented executives who lead market-leading companies can sometimes get themselves into hot water by making a bunch of deliberate and unconscious strategic moves.

At the end of the class, during a question-and-answer session with the students, one asked me how to spot some of the flaws in a CEO so as to avoid investing in the company they lead. I told him that my favorite approach was to listen to the CEO give a speech in which he had to answer questions on the fly. Another approach was to listen to the quarterly earnings calls and pay special attention to the question and answers.

I explained that CEOs today are typically protected from saying anything on a spontaneous basis. They have a phalanx of lawyers and public relations people who typically scrub any public speech they make, including the prepared remarks during the earnings calls. It's likely that they are also coached on how to answer many possible questions that they get.

However, you cannot prepare for every question. There are going to be some occasions when someone asks a CEO an unexpected question for which he must think on his own. It's in those moments when you truly get to assess a CEO's competence.

Can They Think on Their Own?

I first knew I was going to short Research In Motion (RIMM) when I listened to co-CEO Jim Balsillie answering analysts' questions about 18 months ago. It was simply a hot mess. You couldn't follow Balsillie's thinking after two sentences. He rambled on, ending in a place far different from where he began.

That was important to me as a potential investor because, if I can't make sense of the guy, how is his management team going to do so? How will people five or six positions removed from Balsillie make sense of his orders? By the time the game of broken telephone is applied to Balsillie's instructions, no one will be able to make any sense of them.

After class, another student approached me and asked me what it means then that Netflix (NFLX) doesn't even answer analyst questions. It's a very good point. Every quarter, analysts have a chance to submit their questions in advance. Investor relations collects it, shares it with management to prepare a response, and then Reed Hastings gets to deliver the official response.

The problem with this, of course, is that it gives Reed lots of time to be coached on this. Where's the real Reed? How does this guy form decisions and strategy? We don't know. As such, this policy on the part of Netflix is really a red flag for investors.

Netflix has done some strange things from a communications standpoint in the last 10 months. First Reed decided he wanted to write a Seeking Alpha response to short seller Whitney Tilson, who had posted the short case against Netflix. That Reed was taking time to essentially pump his stock -- and that he was doing it on Seeking Alpha -- was very puzzling. More recently, we saw Netflix's price increases for their customers, followed by a sophomoric apology five weeks later.

So, if CEOs like Reed Hastings are not ready to stand and deliver -- answering legitimate analysts' questions on his feet -- you should be very careful.

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