6 Reasons Amazon Will Acquire Netflix

The bifurcation of Netflix’s (NASDAQ:NFLX) business into two separate websites, with no integration and separate billing, led us to consider whether there may have been some rational reason for the split.  Given the wild unpopularity of the move, it appeared to us to make no sense at all; upon reflection, we think that Netflix management may have implemented the split up in order to sell the streaming business to Amazon (NASDAQ:AMZN).

There are six primary reasons why the Netflix (NASDAQ:NFLX) streaming business makes sense for Amazon (NASDAQ:AMZN):

1) Tax implications: By acquiring the streaming business only, Amazon avoids purchasing Netflix’s fulfillment centers across the country, thereby avoiding physical nexus in a number of states. This would allow Amazon to continue to avoid collecting sales tax in most states. Should a transaction occurs, it is likely that Amazon will move Netflix headquarters out of California to avoid physical nexus there.

2) Amazon Prime: By acquiring Netflix streaming, which we estimate has ≈ 20,000 TV shows and movies, Amazon will triple the size of its own content library, which includes only ≈ 9,000 TV shows and movies. The perceived and actual quality of Amazon Prime content will increase dramatically as well, changing the service from an also-ran into an industry leader, helping to drive subscriptions for the $80/year subscription service.

3) Scarcity of content: Netflix has streaming deals in place with Starz, EPIX, and a number of independents such as Relativity, Nu Image/Millennium, and Miramax. Starz (NASDAQ:LSTZA) controls Disney (NYSE:DIS) and Sony (NYSE:SNE) movie content (≈ 30% of all box office) during the premium cable TV window that begins one year after theatrical release and can last 5 – 8 years. EPIX controls Paramount (NYSE:VIA), Lionsgate (NYSE:LGF), and MGM (a combined 20% of all box office), and the independents control roughly 10% of all box office. Therefore, Netflix has access to premium content from Starz, EPIX, and the independents (for a combined ≈ 60% of all box office). Given that competitor HBO, which controls Warner Bros. (NYSE:TWX), Universal, and Fox (NASDAQ:NWSA) content, is unlikely to sell its streaming rights to a competitor, Netflix has the best collection of premium content currently available. While it must re-negotiate the Starz deal at year-end, the acquisition of Netflix removes a key competitor for the content, and limits the likely bidders, positioning Amazon to strike a better deal.

4) Elimination of competition: If Amazon were to “build” a streaming business rather than buy one, it would have to compete with Netflix, likely generating several billion dollars of losses in the process. By acquiring the Netflix.com streaming-only business, Amazon can eliminate a key competitor, can immediately become the dominant streaming service provider, and can establish a first-mover advantage over potential competitors Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG).

5) Amazon’s superior financial resources: Netflix had $376 million of cash and short-term investments at the end of Q2, well below streaming content current and non-current accounts payable of $687 million, and $2.2 billion of streaming content commitments that did not meet recognition criteria. Netflix’s recognized and unrecognized streaming content liabilities amount is well below Amazon’s $6.4 billion cash and short-term investment amount. Amazon clearly has the cash available to renew Netflix’s crucial Starz agreement, which is due to expire in February 2012. Although Netflix may have balked at the increased terms reportedly sought by Starz (an annual payment increase from $30 million to up to $350 million), Amazon has the financial flexibility to easily absorb such an amount.

6) Customer attrition: We believe that once the sale is complete, existing Netflix streaming customers are likely to stay with Amazon, as Amazon can offer several synergies (discounts on Prime, discounts on merchandise, etc.) that Netflix could not, giving customers an incentive to continue as subscribers.

Investing Insights: Here’s Why The Netflix Moat Is Running Low.

The re-branding of the DVD service as Qwikster and the announcement of Andy Rendich as CEO of Qwikster adds more credence to our thinking.  The value of Netflix (NASDAQ:NFLX) lies in its customer list, its earnings power, and its brand equity.  The renaming of the DVD service as Qwikster clearly destroyed significant brand equity, and makes sense only in the context of a sale of the streaming-only business.  Any purchaser of the streaming-only business would value the Netflix brand name, which led us to conclude that it was this business that was for sale; were Amazon to buy the Netflix streaming-only business, it would not want customers to be confused about what Amazon was offering and what was left behind.  We also believe that if a sale was contemplated, the tax lawyers would be adamant that the two businesses must be operated separately, with no integration or commonality.  A potential sale to Amazon explains why the DVD service was re-branded, and why there was separate billing and elimination of integration between the sites.  The appointment of Andy Rendich as CEO suggests to us that Reed Hastings could be part of the package that may be sold to Amazon (NASDAQ:AMZN), with Mr. Hastings continuing in his role as CEO of the streaming business.

We may be wrong about this.  While it is possible that Netflix management has lost its way after 14 years of near-flawless execution, we don’t think it is likely.  The company’s CEO has always had a clear vision about the future of the company, and the bifurcation of the two businesses into separate entities with no integration and with separate billing makes no rational sense whatsoever, except in the event that Mr. Hastings is positioning the streaming business for sale to Amazon.  While there are other likely bidders for the streaming business — such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) or DISH (NASDAQ:DISH) — only Amazon would be concerned about nexus, requiring a split-up of the businesses into separate entities.

Micheal Pachter is an analyst at Wedbush Morgan.

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