Lately there seems to be an the endless parade of articles about how (insert Apple (AAPL), Google (GOOG), or Amazon (AMZN) here) will acquire Netflix (NFLX). When I see articles like this, I have to assume that the author completely misunderstands Netflix. Usually the argument goes something like this: "Netflix used to be a $15 billion company, now its a $6 billion company and (insert company here) can acquire it for $8 billion and get it for half price!"
The idea that any company, let alone really smart companies like Apple, Google, or Amazon, will pay $6 billion or anything close to that for Netflix is ridiculous. There are many reasons why it's absurd, but let's start with the basics.
First off we have to ask what exactly an acquirer would be buying. Netflix would have to add value to an acquirer, right? So what exactly makes this company worth its market cap of $6 billion, let alone a takeover premium price of, let's say $8 billion?
When it comes to streaming, Netflix owns nothing. Period. It pays for licensing deals to stream movies it doesn't own over the internet. It also sends DVDs through the mail, which will actually remain a fairly profitable business until the U.S. postal system figures out how to deal with its huge budget deficit, which will almost certainly impact the Netflix bottom line. When Netflix was a DVD-only company, the stock traded between $25 and $50 a share. The streaming side, however, would be a massive liability to any acquirer.
But to get a better idea of the assets, let's take a look at the Netflix balance sheet from the last 10-Q, year-to-date June 30, 2011.
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Notice that the two biggest assets are the short-term asset "Current content library, net" for $499.4 million and the long-term asset "Content Library, net" for $425 million. Those numbers are for the current and non-current portions of streaming content deals, explained on page 26 of the 10-Q:
When the streaming license fee is known or reasonably determinable for a specific title and the specific title is first available for streaming to subscribers, the title is recognized on the consolidated balance sheets as current content library for the portion available for streaming within one year and as non-current content library for the remaining portion.
In other words, 59% of Netflix's total assets are streaming content deals. To be clear, these are deals where Netflix buys the rights to show someone else's content to its customers for a specific amount of time. On top of that, the only exclusive deal it has is the Epix deal (go to the Epix website and tell me if you've heard of any of the movies). Everything else is non-exclusive and readily available to anyone with a big enough checkbook, so if Apple, Google or Amazon wants the same content streaming rights that Netflix has, it just has to make a phone call and write a check.
To be fair, Netflix also has a mountain of used DVDs and sorting machines, which are most likely included in the "property and equipment" line, along with $175 million in cash, $201 million in short-term investments (page 7 of the 10-Q, its corporate bonds and government securities). It also has some other minor items as well, making up the rest of the $646 million in assets after the content deals.
Now, let's look at the liabilities and off-balance sheet debt. The balance sheet is above, and here's a look at the off-balance sheet obligations for streaming content deals.
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Let's hit the highlights of the liabilities. Accounts payable increased by 250% in just the first 6 months of 2011 and total liabilities doubled in the same period. Off-balance sheet streaming content obligations due in less than a year are $624 million, with another $1.3 billion due between 1 and 3 years, as well as $440 million due between 3 and 5 years, totaling $2.4 billion in off-balance sheet debt-- just for streaming content rights.
However, since these numbers were released, Netflix has inked a few more deals. There's the Dreamworks deal for $30 million per movie (that's 50% more than HBO was willing to pay) starting in 2013, the AMC deal for "Walking Dead" (costs to Netflix not disclosed), and finally, the CW deal for a cool $1 billion over four years. For anyone not familiar, the CW deal is a non-exclusive deal for reruns for such TV gems as "Hart of Dixie," "The Vampire Diaries," "90210," and "Gossip Girl" among others. So even if we ignore the Dreamworks and AMC deals, we now have at least $3.4 billion due within 4-5 years in off-balance sheet debt, but we'll know next week when we get to see the next 10-Q.
So in summary, as far as assets go, Netflix has roughly $400m in cash or cash equivalents and about $1 billion worth of intangible, non-exclusive streaming content deals that have expiration dates. Then there's $1.2 billion in liabilities on the balance sheet, and another (very conservatively assessed) $3.4 billion off the balance sheet. It also owns zero intellectual property and no patent portfolio. So as an acquisition target, where is the value in Netflix in the balance sheet?
It's important to remember that Netflix is no longer a growing company. It released revised earnings estimates last month projecting a 1 million subscriber loss. This is not a company that is worth a premium based on its growth, future cash flow (it's had very little in the last 3 years due to the enormous buyback program), or profitability. The deteriorating income statement has been addressed elsewhere and does not need to be re-hashed here. It will have to grow revenue aggressively to meet the content obligations, and considering it is losing customers, it's very questionable if that can be done.
What about some other reasons to buy this company? The acquisition theorists like to point to a few things. First, Netflix has a subscriber list of tens of millions of people willing to pay for their service, and that's certainly true. But what value does that list have to Apple, which already sells movies, music, tv shows, and apps to hundreds of millions of people worldwide? What about Google? I can only imagine how big its user list is. Then Amazon, same thing, massive customer list of people who have bought from it. To say that there would be major overlap between the Netflix list and the lists of these three titans is an understatement. Making things worse, Wal-Mart (WMT), which owns Netflix competitor VUDU, already has the entire Netflix list that it finagled in the lawsuit against Netflix, diluting the value. So I just don't see the value there to any capable acquirer.
Netflix does have a big head start in having its software included in wifi blu-ray players, TVs, and game consoles. No question there, that's an advantage. But it's not a permanent advantage, evidenced by Microsoft's (MSFT) announcement that the Xbox will soon get a smorgasbord of new streaming options free for Xbox Live Gold customers ($5 a month). Furthermore, HULU is already on lots of devices, and Amazon's Prime streaming service will stream to its Kindle Fire and most likely elsewhere in the near future. How would an acquirer value the big installed base of Netflix-ready devices? I'm not sure, but I think it's safe to assume this is a rapidly deteriorating advantage that Netflix has been enjoying.
The bulls also like to point to the strength of the brand name and that, as a streaming video pioneer, Netflix enjoys brand loyalty. That might have been true 5 months ago, but the value of the brand has been seriously tarnished in recent months by one massive PR debacle after another. The management would also probably be an impediment to any deal; what acquirer would want Reed Hastings around after the last few months? Netflix has angered so many customers that it's hard to imagine anyone thinking that the brand name has value. Netflix is not the "Apple" of streaming video, even if some people think it used to be.
Moving on, there are many other reasons why no one is going to buy Netflix. The most obvious reason is simply that Netflix does not do anything that can't be replicated easily. Its entire streaming product is just a marriage of software and licensing deals. Why exactly would Apple, Google or Amazon pay up for that, especially when Apple and Amazon already have a streaming infrastructure and their own content deals? It does not make sense, nor would it add value; it'd be a huge waste of money.
The takeover theoreticians love to argue that Netflix is somehow a good value for the tech titans. But they forget that Apple, Google and Amazon are top-tier companies, run by really smart people. Does anyone honestly believe that Tim Cook, Larry Page, or Jeff Bezos don't know how to value a company?
Let's also not forget that Apple and Amazon do not do many takeovers, and Apple is legendary for being incredibly stingy with its cash. Why would it burn 10% of its cash hoard on a company that adds no value to its ecosystem? Google likes acquisitions, but it likes takeovers that put Google into new frontiers to reach more people in different ways. Buying a streaming video company that has no intellectual property or even a sustainable business model doesn't really fit with the Google mantra.
Finally, we know Amazon definitely doesn't want the DVD side of Netflix due to sales tax issues, and Apple just launched the iCloud which will replace the need for physical DVDs. It's hard to imagine Google integrating a mail-order DVD rental service into its high-tech portfolio. Yet even if Google did want Netflix for some reason, it'd be stupid to not just wait 6-12 months for the stock to keep falling and scoop it up far cheaper than would be possible today.
Let's pretend for a second that some other random non-tech company wants to buy Netflix and it doesn't already have any software, content deals, or massive email list. For example, let's say that Caterpillar (CAT) wants to get into the online streaming video business and acquiring Netflix looks like an easy way in, even with the projected subscriber losses. The problems would arise as soon as it started digging below the surface and actually looked at the details. What if Caterpillar thinks that $1 billion is too much to pay for reruns of 90's teen sitcoms, or that $30 million per Dreamworks film is a waste of money? Would it really consider paying even the $6 billion market cap when 59% of Netflix's assets are non-exclusive content deals that Caterpillar can go negotiate on its own? What if it wants just the streaming infrastructure but can't buy it without taking on billions worth of content liabilites? What if the Netflix management decisions in recent months would be an embarrassment to Caterpillar's shareholders and current customers? Any one of these issues could be a serious roadblock for any acquirer.
The bottom line here is that there simply is nothing at Netflix that makes the company even worth the current market cap, let alone a takeover premium for an acquirer. The fairy godmother of corporate takeovers is not going to show up and bail out the Netflix longs with a $150/share offer. There is simply zero chance of that happening, or any legitimate acquirer showing up to buy Netflix. Once the share price gets to $20-$30 a share, then we can have conversation. Maybe somebody will get lazy and pick Netflix up for $1 or $2 billion. But no one will pay even close to the $6 billion market cap, let alone a premium to that. There's nothing there to buy, the liabilities are massive, and Netflix is losing customers. If you are long Netflix, don't hold the stock thinking someone will buy it, just sell it and get short while you still can.