Why Walt Disney Co (DIS) Should Buy Netflix, Inc. (NFLX) (And Why It Shouldn’t)

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The rumors of a merger between Walt Disney Co (NYSE:DIS) and Netflix, Inc. (NASDAQ:NFLX) continue to swirl. Last month, both Sanford C. Bernstein analyst Todd Juenger and the New York Times’ Jennifer Saba both argued for DIS to buy out NFLX.

Why Walt Disney Co (DIS) Should Buy Netflix, Inc. (NFLX) (And Why It Shouldn't)

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The speculation has continued into 2017, likely one reason Netflix stock is at an all-time high.

There’s a lot to like in such a deal, and it seems like it could be a win-win for both Disney stock and Netflix stock. But there also appears to be at least two key sticking points that make a DIS takeover of NFLX unlikely — and perhaps even foolish.

Why DIS Should Buy NFLX

The most obvious and compelling reason for Disney to buy Netflix is the marriage of Disney’s powerhouse content with Netflix’s best-in-breed distribution platform. Through its purchases of Marvel, Pixar and LucasFilm, along with its own legacy catalog, Disney has a large number of major franchises.

Those include Star Wars, Cars, The Lion KingCaptain America and many others. All could form the cornerstone of a Disney-owned Netflix offering. It would be the next generation of Comcast Corporation’s (NASDAQ:CMCSA) merger of content (NBC Universal, USA Network, etc.) with distribution — and without the constant “cord-cutting” fears.

There would be more subtle benefits for Disney stock to boot, as Netflix would broaden Disney’s international reach. Consider that 45% of NFLX subscribers come from outside the United States, according to the company’s most recent 10-Q. In contrast, excluding theme park sales, less than 27% of Disney revenue is generated overseas. Netflix would instantly expand Disney’s presence in key growth markets in Asia and Latin America.

Disney’s ESPN also could benefit. The impact of ESPN to Disney stock often is underestimated — but it shouldn’t be. Media analysis firm SNL Kagan has estimated that ESPN now charges over $7 per month per subscriber, with ESPN2 bringing the total to over $8. Given that Disney disclosed 90 million ESPN subscribers in its 10-K (89 million for ESPN2), that means subscriber fees alone bring in more than $9 billion a year for Disney.

That’s roughly one-sixth of Disney’s total revenue, and 40% or so of its Media Networks sales. Add advertising revenue and ESPN accounts for roughly one-quarter of total DIS revenue. The earnings contribution almost certainly is higher, given that the Media Networks segment is far and away Disney’s most profitable.

Subscriber losses at ESPN have hurt Disney stock over the past few quarters, but a NFLX acquisition could ease those declines — or reverse them. A Disney-owned Netflix could add ESPN to the base product, again burying high per-subscriber fees, and allowing for monetization of users not interested enough to buy ESPN on its own. At the very least, Netflix’s impressive distribution capabilities could provide a technical backbone for a standalone, streaming-based ESPN.

And the duplication of that infrastructure, along with managerial and administrative expense, provides ample room for cost-cutting that could fund an acquisition of Netflix stock.

Why DIS Shouldn’t Buy NFLX

There are two problems with a Disney takeover of Netflix, however. The first is the price — cost savings or no. It’s too simple to say that DIS trades at 19 times this year’s earnings and NFLX 136 times next year’s earnings. Netflix is growing much faster than Disney, and unlike Disney stock, NFLX is focusing on that growth, not trying to increase cash flow. And there are potential cost synergies. Netflix is on pace to spend $550 million in general and administrative expense alone in 2016, a figure that Disney could no doubt slash.

But any premium paid for Netflix stock would mean a price for Disney of at least $65 billion. That’s over one-third of the current market capitalization of Disney stock. The magnitude alone makes such an acquisition tremendously risky. Disney isn’t a risk-taker by nature. In fact, it spent between $4 billion and $7 billion each for Pixar, Marvel and LucasFilm.

Even if Netflix boosts ESPN profits, and Disney can find $1 billion in cost savings (out of roughly $8 billion total spend by Netflix in 2016), the acquisition still only adds $1 billion to $2 billion in cash flow for Disney stock. That makes any purchase essentially a bet on Netflix stock, which even NFLX bulls likely admit is a high-risk investment.

The larger problem is strategic. Yes, a Disney-owned Netflix would have Disney-created and Disney-owned content. But would other content providers be willing to supply their competitor?

Disney does own 30% of Hulu, but the remainder is owned by Time Warner Inc (NYSE:TWX), Twenty-First Century Fox Inc (NASDAQ:FOXA), and Comcast, which limits Disney’s influence. And one of Netflix’s key selling points to content creators is precisely that it’s unbiased. Under Disney’s ownership, that would change. Certainly, NFLX rivals like Amazon.com, Inc. (NASDAQ:AMZN) would try to outcompete Netflix by being the neutral distributor the company used to be.

All told, it’s fun to speculate about a DIS-NFLX tie-up, and there is some logic behind the consistent speculation.

But considering the size of the potential takeover, the acquisition of Netflix needs to be a slam-dunk, clear winner for Disney stock holders, both financially and strategically. And on both counts, it’s not quite logical enough.

As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.

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After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.


Article printed from InvestorPlace Media, https://investorplace.com/2017/01/disney-dis-stock-buy-netflix-nflx-stock-should-shouldnt/.

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