A rumor that Microsoft (NASDAQ:MSFT) is interested in acquiring Netflix (NASDAQ:NFLX) drove the video streaming company up 13% in the latter half of the trading day on Friday. The rumor seems largely unfounded; nonetheless, the market loved the idea. I believe a buyout is a good idea, but is still rather unlikely for the time being.
Earlier this month, Netflix CEO Reed Hastings announced that he would resign from Microsoft's board. Many saw this as a precursor to a potential Microsoft acquisition. Hastings does not officially leave the board until the end of November, when Microsoft conducts its annual shareholders meeting. A buyout will have to wait until then.
So why should Microsoft consider buying Netflix? I believe the market severely undervalues Netflix, even with its recent price hike. Additionally, Netflix would allow Microsoft to compete in the huge market for online video. Finally, Netflix will improve Microsoft's internet business segment.
Netflix is the market leader in internet video streaming. Just 15 months ago, the stock was flying high priced at levels near $300. The fall back down was quick and painful as bad news and earnings convinced more and more investors to sell. Rising costs have depressed earnings significantly in the last year.
Two significant costs affected Netflix's expenses over the past two years. First, content costs rose significantly last year. While bad for Netflix's bottom line, increased content prices create a higher barrier of entry and affect competitors similarly.
Second, Netflix spent significant amounts on expanding abroad. Netflix is now available in all of North America, all of South America, the UK, Ireland, and most recently all of Scandinavia. Spending money to grow the company abroad cut into earnings, but sets up the company for much higher future profits and revenues.
Certainly, Netflix has shot itself in the foot once or twice (a la Qwikster), but it is still ubiquitous with streaming video online. Its most recent earnings report showed better than expected profits and revenue, but the stock fell because of slow subscriber growth. Global expansion will improve growth and earnings, which is why I believe the market is still undervaluing Netflix at $69 per share and presents Microsoft with a good price, even with a premium, to buy a controlling portion.
Online video is one of the biggest markets that Microsoft does not participate in directly. Other large tech companies, Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL), already have strong footholds in video products such as YouTube, GoogleTV, AppleTV, and iTunes instant video downloads. It is also rumored that Apple will release its own television set next year. Both competitors are attacking the video market through consumer gadgets and online services. Meanwhile, Microsoft is sitting on the sidelines, twiddling its thumbs.
Microsoft is already facing competition from them in its stronger products. Google is taking on Microsoft Office with its free Google Drive, which stores everything in the cloud for users' convenience. The Xbox is the market leader in a sector that is shrinking as more people choose to download games to their iOS or Android devices.
Microsoft is one-step behind its biggest competition. A Netflix acquisition may help it close the gap. Last year, Netflix accounted for over 30% of peak downstream traffic in the United States. YouTube took just over 10%. Meanwhile, iTunes did not even make the list. With 25 million subscribers and 80 million broadband connections in the United States, there is still room to increase that number.
Microsoft could use the popularity of Netflix to provide a boost to its other products. Having just released the Surface and new Windows 8 phones on the way, certain Netflix benefits may make the products more attractive to consumers. This worked with the Xbox 360. When the console had Netflix exclusivity for a year, it became the most popular video game system. If Microsoft can provide a Netflix benefit to its new products, it should improve sales.
Microsoft is still struggling to make a profit on its internet business segment. Bing, the biggest component of Microsoft's online business, is still only a blip on the radar compared to Google. Yahoo (NASDAQ:YHOO) is still leaps ahead in popularity as well. In its latest earnings reports, Microsoft showed a loss of $364 million on revenue of $697 million. Meanwhile, Netflix showed a slight profit on more revenue. A Netflix buyout would increase Microsoft's online business by more than 125%.
In order for Microsoft to survive as a software company, it needs to find more profitable online services. Bing and Skype are still running a deficit. Sales of Windows and Office are declining as more people buy mobile devices instead of PCs. Internet use and multimedia are the most popular uses for computers today, and buying Netflix will help Microsoft compete in both.
Microsoft has the potential to make Netflix even more profitable. Hastings abides by the one-size-fits-all philosophy. A flat cost keeps the product simple for both Netflix and consumers. However, one of its strongest competitors, Amazon (NASDAQ:AMZN), offers users a basic streaming package with its Amazon Prime service in addition to a la carte video downloads. This is currently one of Amazon's stronger competitive advantages. Microsoft may implement a similar price structure for a new Netflix service, generating more revenue and minimizing Amazon's advantage.
It appears the recent rumor is just a rumor. Any buyout activity is still at least a month away, and likely much further down the road if it is to happen. However, both stocks could benefit immensely if a buyout came into fruition, and the idea of a buyout seems like a good idea. Microsoft would take a big step in closing the gap between itself and Google and Apple, and firm up its online business segment. It would also, possibly provide added incentive to buy Microsoft devices over Google and Apple products. Additionally, Microsoft has the capacity to make Netflix more profitable and a stronger competitor. Overall, both companies would come out better.
Disclosure: I 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.