Why Google Should Buy Netflix

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 |  Includes: GOOG, NFLX
by: Dana Blankenhorn

At first glance the whole idea sounds silly. What would Google (NASDAQ:GOOG) want with Netflix (NASDAQ:NFLX) when it already has YouTube? The real question is why Netflix should sell, right?

Right.

Because Netflix should sell. Because Netflix has a problem. As it transitions from a business that mails discs to one that delivers movies online, its costs at some point stop falling and start rising. The more movies people see online, the more this costs. And you can see a lot more movies a month when they're available for streaming than you can if you're waiting for a DVD to arrive in the mail.

As Netflix scales its video service, those costs become less than minimal. Yet Netflix is under intense pressure from a variety of sources, including YouTube, to keep its prices down. This crunch can't go on forever. At some point it will have to raise its prices, at which point the stock tanks.

So why would Google buy something that sells at 77 times earnings? Here's why. Netflix has two things Google needs badly. It has a fee-based business model. It has access to social networking skills through CEO Reed Hastings. These are things Google needs. Advertising is just a billboard. An ad is unlikely to lead to a sale. It is merely the presentation of a brand or offer to an unwitting (sometimes unwilling) consumer. It does very little to take you down the sales funnel.

By contrast, the whole business model of social networking is to take you down the sales funnel. Groupon and LivingSocial present merchants with customers, not prospects, and certainly not suspects. Networks like Facebook lead suspects down the sales funnel, through their friends, turning them into prospects and then into sales.

Combine its existing +1 system with Netflix reviews, add text to those reviews, and you get a powerful marketing tool. You get a way to drag people down the sales funnel, something mere advertising doesn't do. Plus there's real revenue.

Oh, and almost any acquisition of Netflix would be accretive. Because Google has the lowest costs around for storing data, handling queries, and moving data in the internet industry, and by a lot, it would drop Netflix' costs immediately and bring more of its revenue to the bottom line.

Google could store Netflix' most popular movies in servers closer to customers. It could deliver those movies over its own fiber, reducing Netflix' core internet costs. It could handle transactions as Netflix seeks to get better pay per view windows from the studios.

Then there are the revenue upsides.

Instead of fighting with Netflix in other words, Google should buy it. It's a Fred-and-Ginger deal. Google gives Netflix cost controls. Netflix gives Google commerce. I don't think Netflix is worth a premium over its present price-earnings multiple of 77, but when the cost squeeze hits, when the bear run rolls, Google can be Netflix' white knight.

Disclosure: I am long GOOG.