The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.
Yesterday, funds controlled by Carl Icahn disclosed ownership of close to 10% of Netflix (NASDAQ:NFLX). Mr. Icahn’s filing states that his primary reason for buying the stake is that the stock is “undervalued due to [its] dominant market position and international growth prospects”. The following sentence of Mr. Icahn’s filing says that he believes “Netflix may hold strategic value for a variety of significantly larger companies that are engaging in more direct competition with one another due to the evolution of the internet [sic], mobile, and traditional industry”. It concludes that his various entities are “considering ways for [Netflix] to maximize shareholder value, but have reached no conclusion”.
Read together, we believe the first and second sentences say that Icahn hopes to find a buyer for Netflix, and his history suggests that he will be activist, if necessary, to get a deal done.
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We think he’s completely wrong. His belief that there are a “variety of larger companies” that see strategic value in buying Netflix is way off the mark. In fact, we can think of only one, Amazon that makes strategic sense, and only three, Amazon, Hulu and Verizon, who are even engaged in a business sufficiently similar to Netflix’s that they could potentially justify an acquisition.
Netflix consists of three main assets: Its brand, its technology and its customer list. A strategic buyer must consider whether any of these assets helps them to achieve their business strategy more rapidly, and whether the cost of acquiring Netflix is lower than the cost of building the business themselves. That essentially means that potential buyers will only pay up (at yesterday’s price, Netflix is worth $4.8 billion, and presumably Icahn would seek a premium) if they think it is less costly than building themselves. In our view, that means that the only buyers would be companies already in the business—Amazon (NASDAQ:AMZN), Hulu or Verizon (NYSE:VZ)—and that other companies would likely be far less interested. For example, Microsoft (NASDAQ:MSFT) would have little to gain from an acquisition of Netflix, as it is highly unlikely that Microsoft has any interest in being in the movie streaming distribution business, and there are few synergies for Microsoft from such an acquisition. We think it is highly unlikely that Microsoft management would believe the company was any more likely to sell additional copies of Windows 8 or additional Surface tablets to Netflix customers if it owned Netflix outright. The same could be said of Apple; the company would gain synergies only if it did something drastic like making Netflix content available only on Apple (NASDAQ:AAPL) devices, and such a limitation would draw the ire of the Justice Department.
Netflix is a distributor of other people’s content, and has no real competitive advantage on that front, aside from its size, technology and brand. While many of our peers (and perhaps Mr. Icahn) think that ownership of Netflix makes sense for a media company that owns IP already, we think such an acquisition would merely be a forward integration into distribution. The media companies’ attempt to exploit distributors in order to squeeze every last penny of economic rent from distribution—this is why the movie exhibitors and MSOs trade at relatively low multiples—and other than DISH’s ill-advised purchase of Blockbuster out of bankruptcy (for less than $200 million), we cannot think of a single acquisition that led to forward integration by a media company. The only combination we’ve seen that is similar in the last decade is Comcast’s purchase of NBC Universal, and that acquisition led to backward integration by a distributor who decided that ownership of content would help protect their distribution business. Netflix apparently believes the same thing, and is taking steps to create its own content in order to differentiate its distribution business from competitors. Given that Netflix has no significant ownership of high value content, we see an acquisition by a media company as exceedingly unlikely.
Michael Pachter is an analyst at Wedbush Securities.