Netflix: Starring in Merger Story?

Posted on November 09, 2005

) provided the latest confirmation of why, saying it lost $491 million in the third quarter, thanks mostly to $459 million in noncash charges. More important, Blockbuster said growth in its online business was flat. Like Los Gatos (Calif.)-based Netflix, Blockbuster's Web service lets consumers rent unlimited numbers of DVDs for a flat monthly rate.

The announcement by Blockbuster, which has lost about $300 million in its bid to enter the online market, is the second big step backward by a Netflix competitor this year. In May, Wal-Mart Stores (WMT

) said it would shut down its own online DVD-rental business.

TOO HIGH A PRICE? But Netflix's stock surge may also relate to the plans of a much-feared potential competitor: Amazon.com (AMZN

). Banking sources credit much of the move to rumors that Amazon had made a private, $42-a-share bid for Netflix in the past two weeks. Both companies declined to comment. Several Netflix directors privately cast doubt on the talk, however, saying it's only the latest of many rumors that have surrounded their company.

Last year, Netflix had said it expected Amazon to enter the U.S. video-rental market after testing the concept in Britain and Germany. Yet, with Amazon's British service trailing in market share in that country, Netflix now thinks Amazon will stay out of its business.

So, is Netflix really takeover bait? At some point, and some price, the answer is probably yes. Analysts are split on whether $42 a share, which represents nearly a 50% premium over today's stock price, is too much to pay. Through the first nine months of this year, Netflix posted $492 million in revenue, but made just $3.8 million in net income, as it fought off Blockbuster's marketing barrage. For next year, Netflix is promising only "at least $60 million" in pretax income.

DIFFICULT TO DUPLICATE. At $42 a share, the purchase would be at least $2.2 billion -- and could rise, depending on how many stock options are outstanding, if and when Netflix is sold. It actually may be more valuable to an acquirer a year or two from now, once the video-on-demand wars heat up. When it does happen, the buyer probably is more likely to be a media-distribution or online-content player than an e-commerce outfit such as Amazon.

With the rumored price tag of $42 a share, Netflix would be commanding about 30 times next year's estimated earnings before interest, taxes, depreciation, and amortization, Piper Jaffray analyst Safa Rashtchy says. That's pretty rich even for Internet companies: Amazon trades significantly more cheaply. But it's not all that crazy, counters Jason Avilio of First Albany Securities. Blockbuster and Wal-Mart have failed to significantly slow Netflix' growth.

Over the past year, Netflix' subscriber base grew 61%, to 3.6 million, and management expects at least 5.65 million customers by the end of 2006. That shows it's harder and more expensive than previously thought to enter the movie-rental business, Avilio says. One bearish take on Netflix has always been that some rival could duplicate the service overnight, but Blockbuster's experience suggests it will cost at least $300 million to build a profitable business.

DIGITAL DELIVERY. That means the hit to earnings from buying Netflix, while substantial, might be smaller than the reduction that would result if Amazon tried to build a Netflix-like service from the ground up, according to Avilio. "It might be twice as much dilution to build it," he says.

In any event, a Netflix-like rental plan could conflict with Amazon's goal to sell as many DVDs as possible, a strategy that generates more revenue per disk in the short run. Billy McNair, co-founder of Peerflix, an eBay-like (EBAY

) service that lets consumers trade their own used DVDs, says a business like his might be a better fit for Amazon, because its model assumes that people initially buy the DVDs that Amazon wants to sell.

That's why a Netflix takeover may still be down the road a piece -- and the buyer is likely to be a cable operator, a telecom pushing into movie delivery, or even a Web media player such as Yahoo! (YHOO

). Today, Netflix delivers its DVDs by mail, shipping them from a network of distribution centers in the U.S. The long-term threat to Netflix is that a company like Comcast (CMCSA

) or SBC Communications (SBC

) could gradually take over the movie-rental market by delivering content digitally to TVs, either via a computer link or a set-top box.

Netflix Chief Executive Reed Hastings thinks video-on-demand won't develop into a major market for several years. On Netflix' third-quarter conference call, he said the company is holding off on plans to develop a movie-downloading service of its own, primarily because the number of films that studios have licensed for digital delivery is a fraction of the 50,000 available on DVD. "We will continue to enhance our technology and infrastructure, and will be ready to quickly launch when the content climate begins to thaw, and it becomes possible to deliver a compelling consumer experience," Hastings said.

HAPPY ENDING? By then, Netflix simply could be too big to ignore -- and too juicy a prize not to get snapped up in the land grab for consumers' video-on-demand business. Any company that owns a means for moving films over the Internet could team up with Netflix to get millions of customers, as soon as the owner of the pipe can serve them all.

Hastings says by 2010 to 2012, Netflix could have 20 million customers, each already paying a monthly flat rate for unlimited movies, whether they're available on DVD only, pay-per-view, or both. Someday, Hastings will likely face the sweetest possible outcome when Hollywood and Wall Street collide: an offer he can't refuse.

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