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Netflix Buying Spotify - An Unrealistic Idea Or Actually A Good Match?

|About: Netflix, Inc. (NFLX), Includes: AAPL, GOOG, GOOGL

Summary

My previous research excludes Google as a likely contender to buy music streaming service Spotify.

Netflix might be a suitable contender because both companies run a successful streaming service.

In this article, I analyzed the organizational fit and the potential financial structure of the deal.

Based on the potential benefits and threats, I make my case that Netflix should consider buying Spotify.

In this previous article, I discussed why Google (GOOG, GOOGL) is not likely to acquire Spotify anytime soon. Besides Spotify's lofty valuation, I found that Google and Spotify are not a good match from an organizational point of view. On the one hand, Spotify runs a subscription-based service. In 2014, subscription fees represented 91% of the company's total revenue. On the other hand, Google's YouTube platform is an ad-supported streaming service. Further, an acquisition of Spotify would likely be the end of Google's own Google Play Music All Access.

Based on these three arguments, I concluded that Google and Spotify are not a good match and that an acquisition of Spotify by Google is probably never going to happen. After writing the article, I started thinking about a suitable candidate to take over Spotify. Likely contenders are Apple (NASDAQ:AAPL) and Facebook (NASDAQ:FB). However, Apple recently introduced its own streaming service called Apple Music and Facebook is working on the introduction of its own music streaming service in the future as well.

How about Netflix (NASDAQ:NFLX)? The idea of Netflix buying Spotify came up while reading Netflix's Q2 earnings report. Netflix reported strong net subscription and revenue growth in the second quarter of this year. The market was quite enthusiastic about Netflix's results considering the 18% pop of its share price the day following the announcement. It is fair to say that both Spotify and Netflix are growth companies. Therefore, I decided to research the idea of Netflix buying Spotify. Is such an acquisition unrealistic or actually a good match?

Organizational fit

One of the reasons why I found Google an unlikely contender to buy Spotify was the bad organization fit between the two companies. In case of a bad organizational fit, an acquisition is probably not going to be realistic or successful. Therefore, I start my research idea with an analyses of the two companies' businesses.

Netflix is one of the world's leading subscription-based video streaming services. The company has operations in the United States and internationally. Netflix has over 60 million paying subscribers in over 50 countries. The company's subscribers can watch over 2 billion hours of television shows and movies. For content, Netflix acquires a content license from the owner of the video content. Normally, Netflix agrees to a fixed fee and period for the use of the content. Further, Netflix is engaged in the production of its own original series and movies. The company also plans to release some of their original movies in cinemas. For Netflix, it is all about scale. With fixed fee content licenses and fixed production costs for original content, increasing the number of subscribers is key for the development of the company's profitability.

Spotify is the world's leading subscription-based audio streaming music service. Spotify offers a free ad-supported streaming music service as well. The Sweden-based company runs operations in 58 countries all over the world. Spotify has over 75 million total active users and over 20 million users of Spotify Premium, the company's subscription-based service. The Spotify library accounts for over 30 million songs. Spotify pays royalties to the owners of the music rights based on the total number of streams. According to this article, Spotify charges music right owners 30% of total net revenue (after sales tax) for its services. Therefore, the company's gross profit grows along with the growth of net revenue. Recently, Spotify introduced video streaming in the United States, United Kingdom, Sweden and Germany. This new service will include original non-music video content.

Considering the nature of Netflix's and Spotify's business, I find that the combination of the two actually makes sense. Netflix is a dominant player in the video streaming business and Spotify is dominant in music streaming business. The combination of the two companies will be able to compete with companies like Apple, Google, Amazon (NASDAQ:AMZN) and other large technology companies. These companies offer both video and music services. These companies all offer video streaming and music streaming compared to Netflix's focus on video streaming. So, from a competitors point of view, Netflix should consider buying Spotify.

The combination of Netflix and Spotify could realize synergy benefits as well. Like in most cases, the combination is likely to be more efficient in terms of corporate, marketing and salary expenses. However, the benefits from complementary strengths probably more important. One of Spotify's biggest advantages is to pursued users of its free ad-supported service to subscribe to its $9.99 per month Premium subscription-service. Currently, only 20 million out of a total of 75 million Spotify users (or 26%) are Premium users. However, Premium revenue accounted for 91% of Spotify's total revenue in 2014. Only 26% of Spotify's users earn 91% of the company's revenue. Therefore, it is important for Spotify to not only increase the number of total active users, but grow the percentage of Premium subscription users as well. Adding paying users to a subscription-based service is one of Netflix's strengths. For example, Netflix added 3.2 million new subscribers in the second quarter of this year alone. Netflix's experience to lure users into a subscription service could be a big advantage for Spotify.

Another strong argument for Netflix to buy Spotify is Spotify's latest attempt to enter the video streaming business. At this time, Spotify's video streaming business is still quite small. However, with over 75 million active Spotify users compared to Netflix's 65 million active users, Spotify may become a new competitor for Netflix. To eliminate the potential threat of a new competitor, Netflix could consider buying Spotify before its video streaming business takes off. However, taking away a competitor is not the only argument for Netflix to acquire Spotify. Netflix could use Spotify's platform, original content, license deals and user base on behalf of its own streaming platform. Here are two interesting cross-selling ideas between Netflix and Spotify. First, Netflix could add music videos to its content library and become a serious competitor of Google's YouTube music channels. Or the company could start offering exclusive Netflix previews on Spotify's video streaming platform in order to convince Spotify users to take a Netflix subscription as well.

Overall, I am positive regarding the organizational fit between Netflix and Spotify. Both companies could easily be complementary to each other's businesses. However, there are possible threats to the combination of Netflix and Spotify to consider as well. Netflix is an American-based company, while Spotify is an Sweden-based company. It is no secret that American companies are managed in a different way than European companies. The difference in culture might be challenging for both companies to overcome. Further, Netflix generally agrees to a fixed license fee while Spotify pays a variable royalty fee to the owners of the content. Therefore, Netflix's scale benefits are larger than Spotify's scale benefits, because the license fee is a fixed amount instead of a variable fee. Netflix's gross margin will grow exponentially compared to a more straight growth for Spotify.

Financial aspects

Another important part of the potential acquisition of Spotify by Netflix is the structure of the deal. Spotify is worth $8.53 billion based on the company's latest financing round. In order to acquire Spotify, Netflix has to come up with a sum of at least $14.1 billion. At least, this is the rumored price Spotify asked from Google in March of this year. Given the latest valuation, Spotify could easily ask for a higher sum than the initial price tag of $14.1 billion for Google.

Unlike technology giants like Google and Apple, Netflix has limited cash available. Based on Netflix's latest earnings report, the company has only $2.8 billion in cash and short-term investments available. A significant sum of this money will be used for investments in future growth and original content. Netflix's lack of cash makes an acquisition of Spotify more complicated. In order to come up with the required funds, Netflix could decide to a large bond offering, issue new shares or a combination of the two.

I prefer Netflix to issue new shares, because of the company's relatively high valuation. Netflix's current market capitalization is around $49 billion and trades at $115 per share. Let's assume that Spotify is worth $15 billion. In that case, Netflix needs to issue 130 million new shares in order to finance the acquisition of Spotify. Not all new shares have to be placed on the open market. I believe it is likely that Spotify's founders will be interested in holding a share in the new combination. Next to Spotify's founders, all three major record labels hold a stake in Spotify as well. It is uncertain whether Sony (NYSE:SNE), Vivendi (OTCPK:VIVEF) and Warner Music will be interested in a Netflix stake. These companies tried to cash in their stake in Spotify last year.

Overall, there are some financial obstacles that could block a deal between Netflix and Spotify. Given the potential price tag, I cannot imagine a deal without Netflix issuing new shares. Therefore, the deal needs to be approved by Netflix's shareholders as well. Further, Spotify will have a negative effect on Netflix's bottom line in the first year(s) following the acquisition. In 2014, Spotify recorded a loss of $182 million. However, Spotify's bottom line should recover along with the company's subscription-based user growth. Like Netflix, Spotify has great a scale potential and key is growing the number of users. Further, Netflix itself is not very profitable yet as well. The company trades at 200 times last year's earnings per share. Therefore, I do not consider Spotify's poor bottom line as a deal breaker for Netflix at this point.

Conclusion

It started with the spontaneous idea that Netflix could be a serious contender to acquire Spotify. In this article, I researched the idea in order to determine whether Netflix buying Spotify is an unrealistic idea or actually a good match. The arguments in favor of a deal and against a deal are summarized below.

Arguments in favor of the Netflix/Spotify combination:

  • Both companies have a subscription-based focus.
  • Netflix's strong video streaming presence and Spotify's strong audio streaming presence are two complementary businesses.
  • The combination will be better positioned to compete with companies like Apple, Google and Amazon.
  • The combination will realize financial synergy benefits.
  • Both platforms could strengthen each other in order to grow the number of subscriptions.
  • By acquiring Spotify, Netflix eliminates the potential threat of a new competitor in the video streaming business.

Arguments against the Netflix/Spotify combination:

  • Two different cultures and management styles.
  • Different approach of buying content licenses.
  • Price tag of over $14.1 billion.
  • Lack of free cash will lead to a more complex structure to finance the deal.
  • Netflix's shareholders need to agree to a deal in case new shares need to be issued.
  • Spotify is not making any profit just yet.

Based on my research, I find that Netflix and Spotify are a good match from an organizational point of view. However, financing the deal is more difficult for Netflix compared to other technology companies like Apple and Google. Considering the arguments in favor of an acquisition and against an acquisition, I find that the arguments in favor have the upper hand. The match might not be perfect, but an acquisition of Spotify would be very interesting for Netflix and will likely send the company's share price even higher. Therefore, Netflix should consider buying Spotify.

Disclosure: I am/we are long AAPL.

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.