Netflix Needs Theatrical Distribution/Acquisition To Compete With Disney

Summary

• The Disney-Fox merger changes the nature of the media industry.
• Netflix will need to react aggressively, radically.
• Netflix will now have to consider getting into the theatrical-release business.
• The streaming service will also have to think about merger/acquisition possibilities, maybe even with tech giants like Alphabet.

There is no choice now. Netflix (NASDAQ:NFLX) will need to move beyond its debt-funded original-content initiatives that are for subscribers only. The reason: the merger between Disney (DIS) and Fox (FOX) (FOXA), the latter excluding the broadcast network and the news asset.

I'm not suggesting that Netflix is off its growth path immediately. Netflix would always need to invest in other areas of the media spectrum some day, but the future has suddenly become closer. Given the time it takes to change strategic thinking in the corporate boardroom and then act upon it, it would behoove CEO Reed Hastings to begin the conversation if he hasn't already (I would find it difficult to believe that he has not).

Here's where Netflix is now: it has a lot of debt and no cash flow. From the Q3 shareholder letter (.pdf file), we see no free cash whatsoever for the latest quarters; the third quarter itself generated a deficit of $465 million in the metric. Long-term debt as of the end of September was just under $5 billion and current content liabilities are over $4 billion (these numbers will grow over time as further content investments are made; Stranger Things and the like don't come cheap). The company does, however, have over 100 million consumers as a subscriber base and eventual pricing power based on its coveted brand equity. No need to declare the stock a bad long-term investment; I still own it, even in the wake of the Disney news (I also own Disney).

Now, though, shareholders must consider what they want to see from Hastings and the board. Two plans should be made at this point:

• A comprehensive releasing strategy for theatrical movies that will have day-and-date, near day-and-date or exclusive windowing depending on the specifics of the particular project, one that will include films with several categories of budget.
• Identification of acquisition targets, both small and large, that can effectively complement the current Netflix business model while simultaneously being of utilitarian value against Disney-Fox - i.e., allowing essentially an investment in content for platforms other than the core streaming service. Acquisition targets will ideally be ones that are value-based as opposed to premium-based, but all price points should be considered if a given target is strategically attractive/optimal.

Movies and acquisitions arguably will allow Netflix to grow into its speculative valuation. The timeline has now shifted because of the Disney-Fox event, forcing the company's hand into exploring these concepts. I've proffered the notion that Netflix needs to release movies and get further into the Hollywood industrial landscape, but obviously that was always up for debate - in other words, there were always reasonable arguments against moving too fast in this area (with which I respectfully disagreed). Today, assuming Disney does meet regulators' standards, Netflix can't really argue any longer over this topic.

There's an immediate step that can be taken. It has been reported that Netflix has eighty films in production for 2018. I'm not sure of the details in terms of how those films are to be released, but presumably, the vast majority will remain exclusive to the streaming product. The company could instead take some of those projects to the theatrical marketplace and experiment with releasing models.

Complicating things will be the level of quality for such an ambitious slate. On the one hand, subscribers probably find value in the service by having something like an Adam Sandler or Will Smith film on their television screens as opposed to the silver screen - even if they wouldn't normally patronize products from either two actors, they'd be more likely to watch since it is on the service. However, Smith's Bright, which recently debuted on Netflix and was heralded as a great creative initiative that would test the resolve of theaters to survive in the digital-direct-to-consumer age, appears to have been an expensive failure according to some metrics: it cost $90 million and it was not a critical hit as this SA news item summarizes. This movie might have been better as a near day-and-date release - in theaters for a few weekends, then on Netflix. Add to that, it also could have been ported to digital sales/rental platforms like iTunes and cable pay-per-view for purposes of recouping costs.

Again, though, that would be a big change for Netflix, and it wouldn't have to do it for every release. Hastings is obliged to at least consider mixing it up in terms of distribution. That would be a tough sell, as Netflix is Netflix: it is a disruptive business whose executives are probably loath to mutate its best practices.

It may be time, though, to disrupt the disrupter. Besides different releasing strategies, the company should look at other media content businesses before they are bought by other entities. I suspect Comcast (CMCSA), which lost Fox to Disney, is not going to sit still; that company will want to out-Iger Bob Iger.

It won't be easy. Netflix already has made an acquisition in the content arena, but it was a relative small one: Millarworld. The price on that comic-book entity is not known, thus backing up the claim of economic size. The company could certainly do more smaller acquisitions. How much would Robert Kirkman of The Walking Dead franchise and his company, Skybound Entertainment, be worth to Hastings? Could Netflix somehow acquire Jason Blum and Blumhouse Productions away from its relationship with Comcast/Universal?

Now for the bigger media concerns/investment ideas. Presumably, CBS (CBS), Viacom (VIA) (VIAB), Lions Gate Entertainment (LGF.A) (LGF.B), and Sony (SNE) are all up for grabs. The problem for Netflix is clear: it's already in debt to its mission statement of exclusive original content, and if it uses what some consider overvalued stock to acquire other media giants, it might not work out well for shareholders. The other side of the argument is that with a merger/acquisition, Netflix will be more valuable. Pick your side.

Netflix has a market cap of around $80 billion as of this writing. CBS has a market cap of around $24 billion; Viacom: $13 billion. Sony's market cap is much higher at $57 billion. Netflix may end up being courted by others acting as the acquirer. Comcast would definitely make sense; it would be an easy way for the cable giant to enter the streaming wars as a strong competitor. Any of the FAANG stocks might want to merge with Netflix (or each other) at this point. Facebook (FB), Apple (AAPL), Amazon (AMZN), Alphabet (GOOG) (GOOGL) - all are going to have do something as far as their content ambitions are concerned. Alphabet especially could be a very logical buyer of Netflix: the company's market cap is well over $700 billion, it has big operating cash flow ($26 billion for the most recent nine-month period according to the press release) and its YouTube asset could use the assistance.

The investment theme of the FAANG stocks and beyond has taken on new meaning: besides the fundamental cash flow arguments, consolidation has become another element. These companies would of course naturally be the acquirers, but long term, there may be mergers between them. Their equities represent good investments, as well as the media-stock targets mentioned. Once consolidation heats up, it will be interesting to see what is left unaffiliated, and what fills up the increasing vacuum - presumably new production companies, financed by private equity and foreign funds, will start to emerge. We may see new companies like Legendary Entertainment pop up, as well as concerns like STX Entertainment (e.g., Bad Moms franchise) and eOne (e.g., Peppa Pig IP); all of them would be targets of Netflix/etc. And all will attempt new direct-to-consumer streaming experiments that are destined to fail yet will garner attention and increased valuations. Of all the ideas here, I think Lions Gate, with a market cap of $7 billion, makes the most sense as an acquisition prospect, but again, everything is on the table. Disney-Fox will be remembered as the catalyst.

Disclosure: I am/we are long AAPL, AMZN, CMCSA, DIS, FB, GOOG, LGF.A, LGF.B, 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.