AT&T And Time Warner Merger Is A Potential Death Sentence For Netflix

| About: Netflix, Inc. (NFLX)


Why AT&T acquired Time Warner on Saturday and not Netflix.

How AT&T's move is a serious threat to Netflix's long term prospects, especically if other ISP's follow AT&T's suit.

How Netflix has chosen to fight back and why I consider it a permanent "mandatory gamble" forced upon Netflix by its competitors.

I theorize on potential Netflix-Disney synergies, but also why Disney might not pursue it.

Netflix offered $800M in senior notes today. This could be a catalyst for investors to finally begin paying attention to fundamentals again, once Wall Street finishes making its "quick buck".

On Saturday, AT&T (NYSE:T) agreed to acquire Time Warner (NYSE:TWX) (the entertainment company, not the cable company) for $85.4 billion--a 22% premium from Friday's closing market cap of $69.8 billion. With this acquisition (assuming it goes through), AT&T would possess a quality entertainment portfolio and ongoing content-creation capabilities to provide to its wireless/TV customers. If AT&T is a vein, Time Warner is its newfound blood, and in my opinion, there's a lot of strategic possibilities for AT&T in this deal that can combat the rise of media-streaming companies such as Netflix (NASDAQ:NFLX).

What does AT&T gain by purchasing Time Warner?

Obviously, AT&T is purchasing Time Warner for its entertainment portfolio, and its ability to create more quality content on an ongoing basis.

Time Warner's content portfolio includes Warner Bros film studio (Movies such as "Harry Potter"), CNN (news, broadcast), HBO (TV shows such as "Game of Thrones"), TNT (NBA basketball broadcasts), and DC (which includes characters such as Batman, Superman, Green Lantern, Flash, and Wonder Woman--just to name a few.)

The gist of the play is that AT&T can distribute Time Warner's content through its Internet/wireless networks and TV services, where it is a major player, and perhaps gain market share from online streaming platforms such as Netflix.

"Why didn't AT&T just buy Netflix? They could have easily afforded it."

1. Cable providers such as AT&T view Netflix as an adversary. Simply put, if people are watching Netflix, then they're not watching TV, and that dynamic decreases advertising revenues for the TV companies.

2. Netflix doesn't display ads, and if they ever did, it's safe to assume that customers would be outraged or at the very least, perceive Netflix as less valuable. As you know, a big part of Netflix's attractiveness is based on the user's ability to view TV shows and movies without being disrupted by advertisements. So the idea of AT&T buying out Netflix and running ads on it doesn't make any sense.

3. "You can ship an item by plane or by truck, but not both at the same time." That's a metaphor, and what it's pointing out is that AT&T and Netflix are both platforms that facilitate content delivery, so it is natural for them to merge with content companies rather than other platforms.

Furthermore, Netflix is a threat to traditional cable companies

There has been a developing trend of price-conscious consumers choosing to cancel cable TV services and choosing to purchase stand-alone Internet service instead and coupling it with a Netflix subscription. This combo is a cost-effective and time-saving way to entertain a family because Netflix has no ads, and you watch anytime at your pace according to your schedule. At the same time, you can still get your news via the Internet. Aside from every news organization having websites, a simple Twitter account strategically following various news sources who post their content to Twitter can be a great way to receive breaking news without gluing oneself to the TV or being bogged down by frequent advertisements. Another example is using Seeking Alpha rather than watching CNBC, which could work for some independent investors, depending on their trading frequency and strategy.

How the AT&T and Time Warner Merger Can Kill Netflix

By merging with Time Warner, AT&T no longer needs to win the battle of net neutrality (which would have allowed AT&T to cap Netflix's streaming speeds on its data networks, amongst other things.)

Of course, AT&T would like to win that battle, but this merger creates a more palatable strategy: rather than stifle Netflix on their networks by capping data, AT&T's merger with Time Warner could potentially make it less compelling for their customers to own a Netflix subscription (or other variations of media streaming such as Hulu, Amazon Prime Video, YouTube Red, etc.) by simply competing on the basis of content. If customers are busy watching shows and movies created by Time Warner, they have less time to watch Netflix, and over time, may choose to cancel their Netflix subscription.

If other ISP's such as Verizon (NYSE:VZ) choose to collectively implement a similar strategy, it could severely slow down Netflix's growth, or worse.

What can Netflix do to fight back?

Netflix has always known that these mergers between wireless providers and content producers were a possibility from the start, and that's the reason Netflix has been desperately burning through cash to create its own original content--it's the only chance Netflix has to survive in the long run. It is a mandatory gamble Netflix must take, because they will not be able to sustain the business model of solely licensing the content of others and streaming it on their platform. That's because losing one important bid on some popular content to a competitor such as Hulu can mean the difference between subscribers staying or leaving on any given month. By producing its own original content, Netflix can rely less on winning bids for the content of others, and provide a little more stability in their subscriber numbers.

The problem is, Netflix has stepped onto a hamster wheel. They will never be able to stop producing new content without losing ground. For this reason, I do not consider Netflix's cash burn on content an investment as some bulls do, but a permanent cost in operating the business moving forward. To survive in the long run, Netflix would require a merger with another company that produces its own content. Disney (NYSE:DIS) is the most brought-up candidate, so I shall discuss the prospects of a hypothetical merger between the two companies.

Netflix would probably welcome a Disney merger, but would Disney benefit from it?

Disney is not as worried about their movie segment as much as they are worried about their ESPN business, which has contracts with various sports organizations spanning about a decade into the future. With such a far-out time frame, I am guessing that Disney's main priority in any sort of strategic merger is to conclusively secure the future of its ESPN business investments. As far as Disney's movie portfolio, I would imagine that Disney is content with simply selling distribution/streaming rights to the highest bidder, and would prefer more players to be in the game, as it creates competition for its movie content.

In terms of saving its ESPN business via a Netflix purchase, Disney could hypothetically buy Netflix, stream live ESPN sports events on the latter's platform, and allow users to rewind and watch games repeatedly, while serving unique ads each time. Furthermore, this value proposition of all the classic Disney movies and all the content that Disney owns, combined with being able to watch sports on an easy-to-use interface such as Netflix would potentially allow Netflix to raise prices to somewhere around $15 per month over time without much backlash from customers.

People who only have access to the Internet and Netflix for entertainment tend to miss out on sports, and the extra price increase would still be less than having to pay for traditional TV services. If they don't like sports, Disney has a huge portfolio of movies, and ongoing content that's constantly being created.

I am not sure if ESPN's licenses with the sports organizations would allow for multiple Netflix-style viewings complete with pausing and rewinding capabilities, so this is something you would have to dig into yourself if you're interested in building an investment thesis around this scenario.

Between Disney movies and ESPN sports, there would be less eyes to watch other movies and shows on Netflix. This seems like a bad thing, but it could allow Netflix to potentially carve out a new niche for itself, where it can focus on producing more originals, and offering less licensed content. The cash flow freed from spending less on third-party licensed content could be funneled into producing more originals, or can be used to secure streaming rights to third-party movies that are in high demand.

The biggest problem here is that Disney might simply not want to commit over $50 billion to merge with Netflix, especially if they believe that there are other, less-capital intensive alternatives to bolster their ESPN businesses. Since Disney's biggest problem at the moment is ESPN's declining viewership, if Disney concludes that integrating with Netflix won't effectively boost their ESPN segment compared to the capital it would need to spend, then they might pass on the deal.

Furthermore, by merging with Netflix, not only does Disney lose capital, they also give up ongoing licensing fees to other streaming platforms who demand exclusivity--something that won't happen if Disney is putting its content on Netflix, most likely free of charge to Netflix as they would have a vested interest in seeing Netflix succeed. My opinion is that even with the price increases, this is not the most profitable deal for Disney, and comes with a lot of uncertainties in terms of how the customers will respond to all the sudden changes.

Lastly, let's not forget that Disney has already passed up Twitter and the idea of people being able to stream live sports events while commenting on it live through their Twitter feeds on an equally easy-to-use interface. There is a possibility that Disney might pass up the idea of streaming sports on Netflix, too. It's certainly a possibility that shouldn't be overlooked, especially considering that Disney would have to figure out how to distribute its movie content and get a fair price for it. It's uncertain whether merging with Netflix would bolster ESPN viewership at a magnitude worth the price tag of buying out Netflix, and it's uncertain how Disney would handle the distribution of its movie portfolio and whether it should give it to Netflix for free or continue shopping it to the highest bidder (which in that case, it would be a big gamble to spend north of $50 billion.)

How ISP's and Cable Companies could combat a hypothetical Disney-Netflix merger.

AT&T and other cable companies such as Verizon and Comcast could retaliate against a Disney-Netflix merger by simply incentivizing bundled deals as aggressively as possible. For example, AT&T could structure their prices so that if a customer only buys Internet/phone service, then AT&T would charge that customer say, $300 per month. But if the customer buys a bundled package that includes cable TV services (which would include on-demand access to Time Warner content), then that bundled package would only cost the customer $200. These are just arbitrary numbers by the way, but the point is not the price but the spread between the prices in order to incentivize bundling and discourage stand-alone Internet services.

So basically, to combat the trend of people ditching cable for alternative entertainment sources, AT&T could incentivize bundled TV services, while also intentionally discouraging stand-alone Internet/phone services by increasing prices for those services. The purpose is to make customers say, "Hey, I bought it, so I might as well watch it." And in the process, maybe they'll find a bunch of shows and on-demand movies they like, and feel less compelled to own a Netflix subscription. In the end, what's cheaper--$200 for everything you could possibly need, or $309 for just Internet and Netflix? The current market environment allows price-conscious consumers to simply buy a cheap DSL subscription and buy Netflix for entertainment. But AT&T and other similar companies are gatekeepers, and change the price-value curve to affect consumer choices.

If executed properly, common sense would dictate that the customer would undoubtedly choose to bundle their services. From here, AT&T's hope is that once customers realize how much quality on-demand content there is from their TV services, they will feel less compelled to keep a Netflix subscription and eventually cancel it.

The risk is that if other wireless providers such as Verizon don't adopt a similar strategy, they can undercut AT&T and cause AT&T to lose market share, and that plan would backfire.

It would require a coordinated effort between cable/wireless providers to starve out Netflix, and I phrase it that way specifically because Netflix cannot sustain its current cash burn. Not surprisingly, Netflix announced today that it is planning to raise an additional $800 million through senior notes, increasing their long term debt by another 33.7% to a total of $3.17 billion.

For the foreseeable future, Netflix will continue to deteriorate its balance sheet in a Hail Mary gamble to survive the siege of cable/wireless providers as well as competitors, but everyone seems to have deep pockets, and everyone can raise debt, and they can sustain losses longer than Netflix can to bolster market share.

By itself, Netflix will have trouble surviving in the long run--it is best if the company were acquired by an entity that could better withstand the cash burn of Netflix's operations. But Netflix is grotesquely overvalued compared to what it can offer its acquirer. My last calculation about a week ago showed that investors are paying $248 for every $1 of earnings for Netflix, and that ratio has increased since I've made the calculation.

At the moment, Netflix is the equivalent of a $1000 cheeseburger. It doesn't matter how good the cheeseburger is, it's just not worth $1000, and if someone needs to sit you down and explain why a cheeseburger is not worth $1000, then you'll simply never understand it no matter how much someone explains it to you. Nonetheless, in my next article, I will present a more in-depth analysis of my estimates for Netflix's future business prospects and a proper valuation as a stand-alone entity based on its forward 5-year prospects.

Truly, investors have ignored valuation and have opted to ride the wave of momentum, but with the $800 million senior notes offering announced this morning, I believe it's a potential catalyst for investors to finally begin paying attention to the long-overlooked fundamentals once again. Even without in depth-analysis, it is very easy to see that even if Netflix continues growing rapidly for another 5 years, the current stock price still wouldn't have caught up to intrinsic value, which makes the chance of making money in the long run on Netflix stock very unlikely if you choose to buy at these sky-high levels.

Personally, I don't think Netflix is finished raising cash, as $800 million probably wouldn't last more than six months (Netflix burned through $472 million in the last quarter alone) so perhaps there may be a secondary offering to go along with the senior notes.

Wall Street and its Quick Buck

Once Wall Street has made their "quick buck" by helping Netflix raise more capital in the short term, more firms may be compelled to finally call Netflix out on its overvalued shares, rather than acting like a bunch of employees afraid to publicly disagree with their manager because "pay raises are being evaluated next week." With capital raising out of the way, more firms would be willing to publicly short Netflix on the basis of its extremely high price-value ratio, and perhaps that subsequent price decline can open up the doors for a serious acquisition.

Disclosure: I am/we are short NFLX.

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.

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