Microsoft-Netflix bid rumours feast on froth – and logic

Some of the big takeovers in the pay TV arena have taken analysts by surprise, but that will not be the case if, as looks increasingly likely, Microsoft tables a bid for Netflix.

We all know where the rumour began, with the announcement early in October that Netflix CEO Reed Hastings was standing down from his other big role as a Microsoft director. This would certainly have been a necessary preparatory step for a bid, avoiding or at least reducing accusations of conflict of interest on Hastings’s part in determining the value and nature of a bid while on the Microsoft board, or with his Netflix hat on whether to accept or reject it.

It is true that Hastings’ move may instead have reflected Microsoft’s continuing advance into paid OTT (over the top - definition) through content delivered via broadband on Xbox Live.

But that in turn would suggest Netflix itself could be on its radar screen, since Xbox Live alone will not turn Microsoft into a major all-round player in multimedia entertainment, competing with Google, Apple and Amazon.

And just as if to tell us to take this potential bid seriously, corporate raider Carl Icahn on Wednesday 31 October revealed that he picked up almost 10 per cent of Netflix stock, in an attempt to gain a leveraged position in any fully fledged takeover bid. The move drove up the share price 20 per cent on the day.

Buying Netflix would be entirely consistent with Microsoft’s emerging strategy for Xbox 360, morphing it from a pure video game console into an all round entertainment device. This in turn accords with other Microsoft moves, such as its launch into tablets, and the $8.5 billion takeover of Skype announced in May 2011, as well as the earlier abortive and ill-conceived attempt to buy Yahoo!.

Microsoft’s future is as a multimedia ecosystem giant of the IP age, which would lean it very much towards becoming a major OTT player with an efficient infrastructure dedicated to internet video delivery, rather than say an MSO (cable operator) with a load of unwanted infrastructure baggage that has to be dragged kicking and screaming into the IP age.

There are few candidates so right for Microsoft, the right size, the right price and in pole position in the right business

That doesn’t leave a lot of candidates of suitable calibre for Microsoft that are also affordable, other than Netflix. It really lies in the sweet spot of Microsoft’s target because it is an iconic brand whose stock among the world’s public is still increasing as the very same time as its actual stock value has sunk quite a lot, at $60 to $70 compared with its year high of $133.

This gives it a market capitalization around $3.7 billion, which is easily within Microsoft’s compass given it has $69 billion in cash, plus investments, even if only a proportion of that is readily to hand to acquire a US company, being scattered around the world in various overseas portfolios.

Also, the very investments that have made Netflix attractive to Microsoft, notably its international expansion and global CDN (content delivery network) infrastructure, have also helped depress its capitalization.

This was evident when the share price tumbled after the recent announcement of Q3 results, despite revenues being well up and marginally ahead of expectations at $905 million for the quarter compared with $822 million in the same period of 2011, while adding 1.16 million domestic streaming customers in the quarter, and 690,000 international streaming subs. This brought the domestic total to 25.1 million, which was within the predicted range of 24.9 million to 25.7 million, and the international total to 4.31 million, while DVD subs fell 630,000 to 8.61 million.

The adverse market reaction was caused by falling net income caused by the investments, down to $8 million for the quarter compared with $62 million a year earlier. The market was also spooked a little by Netflix’s warning that it could make a small loss in Q4, and that it may end with 27 million streaming customers, which is well short of the earlier forecasts of around 28.7 million subs.

Microsoft will have noted that international streaming sub gains exceeded all expectations, and that Netflix is the clear number one in streaming content. And from Netflix’s point of view a Microsoft takeover could be timely.

The company experienced great early success in negotiating lucrative movie rights when the big studios were not paying much attention to online streaming and were caught unawares by the rapid growth, but it is now finding it much harder going to obtain the lucrative early release windows. In some cases others, like HBO, are getting better deals, but Microsoft’s clout could help regain the best window positions. Microsoft has good relations with some of the very same rights holders that Netflix has been running into difficulties with.

But then on the last day of October the situation changed again as Netflix shares rose by 20 per cent after activist investor Carl Icahn reported a stake of nearly 10 per cent in the company. Icahn disclosed the stake in a regulatory filing with the US Securities and Exchange Commission. According to the filing, Icahn bought the shares because he finds them undervalued due to Netflix's "dominant market position and international growth prospects."

"Netflix may hold significant 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, mobile ...," Icahn reported in the filing.

What difference that will make to Microsoft’s deliberations remains to be seen. But it does suggest a bidding war may emerge, with other potential candidates being Amazon, Google, or possibly even Verizon.

Copyright © 2012, Faultline

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