The Case For And Against An Alibaba/Netflix Deal

| About: Netflix, Inc. (NFLX)

Summary

Alibaba denied rumors that it was looking to acquire a stake in NFLX.

An acquisition makes sense for BABA in some respects, and NFLX would likely be open to a deal.

But BABA would be better served spending directly on content rather than acquiring it through NFLX.

Alibaba (NYSE:BABA) denied rumors sparked last week that the company was looking to acquire a stake in Netflix (NASDAQ:NFLX). The speculation of a possible business combination drove up shares of both companies close to 5% last week, and while a deal seems off the table for now, we don't think BABA is shutting the door on NFLX entirely. We explore some of the reasons why a Netflix acquisition would make sense for Alibaba, and also present the case against a BABA/NFLX merger.

Alibaba is attempting to build an online-video streaming service in China comparable to Netflix in the US. China's online streaming market is lucrative and has massive growth potential: In 2015 the market was worth $5.9 billion and analysts estimate that it could reach $214 billion in just a few years. BABA has leveraged its considerable financial resources to establish a footprint in this growing market. In 2014 Alibaba partnered with Lionsgate to provide streaming video in China, and last year the company launched its own subscription-based streaming service, Tmall Box Office, to compete with rivals such as Youku Todou and Sohu.com. Much like in the US, competition for content in China has increased significantly, driving up the price. The problem with the Lionsgate partnership is that the firm had no experience in the online streaming space when BABA acquired it, and therefore has limited relationships with content providers. Similarly, the recently launched Tmall Box Office lacks the content breadth of its US peers. BABA will have to spend heavily on new content in order to enhance its offering and keep users engaged, and a Netflix acquisition would allow BABA to significantly expand its content offering in one large purchase. It would also drive down the cost of content acquisition thanks to the overlap with Tmall Box Office. Furthermore, the strength of the Netflix brand and the massive worldwide user base would make BABA more competitive in online-streaming and accelerate market share gains. Netflix might be interested in an acquisition, given that it would be the easiest way for the firm to gain access to China's market and offset slowing organic growth in the US. In order to operate in China, foreign players must partner with Chinese companies (they can't simply launch their services directly in China), and BABA's financial resources would come in handy for Netflix, given the rising costs of content and international expansion.

But Alibaba also has good reasons not to go after Netflix. BABA's own streaming service, Tmall Box Office, is becoming more established, and the company has strong relationships with media companies and government officials. The marginal benefit of adding Netflix may not justify the huge asking price that such a bid would command, and there is always a risk that Netflix would cannibalize sales at Tmall Box Office. Netflix won't be a threat to BABA until it is allowed to compete directly in China, or it partners with one of BABA's rivals. NFLX trades at a forward P/E in excess of 100, and the takeover premium would make the purchase considerably more expensive. BABA has the resources to make such a purchase, but it is hard to make the argument that BABA could extract enough synergies by integrating NFLX to make an acquisition worthwhile. Rather than pay a huge premium for NFLX's portfolio of content, the company might be better served purchasing content directly and not risk losing Tmall Box Office customers to Netflix.

Conclusion:

A Netflix acquisition makes sense for Alibaba in some respects, especially if BABA wants to significantly expand its footprint in the online-streaming space in a short time-frame. If you believe the argument that there are meaningful first mover advantages in online-streaming, you could see how BABA would benefit. But we don't think this is the case, as the divergence in domestic subscriber growth between Netflix and Amazon's streaming offering suggests. Customer switch costs are nonexistent, and we don't think the access to NFLX's customer data would provide a huge benefit. Netflix is not yet a threat to Alibaba, and we think BABA would be better served spending directly on content acquisition.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.