Verizon Buying Netflix Wouldn’t Be So Crazy

The telecom giant could take the lead in the TV market of tomorrow

Takeover rumors are giving Netflix (NASDAQ:NFLX) shares a sudden lift this week. The stock was up 2.5% on Tuesday morning (then faded by midday) after leaping more than 8% on Tuesday. Who’s buying? Verizon (NYSE:VZ), if you believe the so-far sketchy reports that are floating around. And as far-fetched as it might sound, it would actually be a sensible deal.

Here’s what we “know” at this point. A Dec. 6 Reuters said Verizon was talking with TV and film content providers ahead of launching a streaming video service of its own to compete with Netflix. The service’s content range would be limited, but it would have a potentially large audience since it would be targeted at the 85 million U.S. households outside Verizon’s FiOS cable-TV coverage areas.

On Tuesday, though, a report at Deal Reporter (via Forbes) said Verizon might skip the laborious process of building its own service and acquire the $3.97 billion Netflix. Also on Tuesday, Bloomberg reported that Mediatech Capital investment banker Porter Bibb said he’s “hearing rumblings from inside Verizon that they are very serious about either Netflix or something similar.”

Of course, Verizon hasn’t said anything officially yet.

So, what would Verizon want with Netflix? Right now, TV represents a minuscule part of Verizon’s overall business, while telecom brings in around $106 billion in annual revenue. FiOS, which includes cable-based phone, Internet and cable TV service, brings in around $2 billion per quarter. The majority of that comes from Internet service (4.6 million subscribers) rather than TV (3.9 million subscribers.)

FiOS is still chasing the other major cable providers. It’s a bit more profitable than Cablevision (NYSE:CVC), which pulls in just $1.7 billion in revenue per quarter — but it trails the industry leaders in subscribers. Time Warner Cable (NYSE:TWC) has 11.9 million TV subscribers alone and generates $4.9 billion in revenue per quarter. Comcast (NASDAQ:CMCSA), however, dwarfs that with 22.4 million cable-TV subscribers and around $14 billion per quarter. Comcast’s TV and film business extends further if you include the $5 billion in quarterly revenue NBCUniversal generates.

Netflix wouldn’t transform Verizon’s TV business. At it peak of subscribers during 2011’s second quarter, Netflix generated just $789 million in revenue. That grew to $822 million in Q3, but with Netflix projecting further subscriber losses into the fourth quarter and beyond, it’s unclear what the company’s earning potential will be in 2012.

But buying Netflix isn’t about revenue for Verizon. It’s about radically changing the telecom’s TV business for a rapidly evolving market. By spending a few billion dollars on Netflix, Verizon will automatically secure around 23 million paying subscribers. Despite the mud on its reputation, the Netflix brand still carries significant cachet with consumers: The fall from No. 1 in 2010 is painful, but Netflix is still ranks No. 22 on Brand Keys Brand Loyalty Leaders 2011 list.

Verizon could go one of two ways with Netflix. It could buy the company to serve customers outside of FiOS’s  range, taking the biggest piece of the nascent streaming video market for itself. Or Verizon could completely redefine its TV service by killing off the FiOS brand entirely and bringing all of its TV, cable and streaming, under the Netflix brand. It could then slowly but surely over the next few years expand the streaming service to replace cable entirely. The trick for Verizon there would be to build its Internet subscriber rolls to provide access to the streaming TV service — which is what the market is evolving toward.

This would make content partners like Disney (NYSE:DIS), News Corp. (NYSE:NWS) and others uncomfortable. A shift from traditional broadcast to a fully streaming business is precisely what those companies are fighting so hard to prevent.

A Netflix deal might not add much to Verizon’s bottom line anytime soon, but it would give Verizon the opportunity to really transform the TV business. It can afford to take the risk involved for a much bigger potential long-term gain. And for Netflix shareholders? They could yet see a return on their fallen investment.

As of this writing, Anthony John Agnello did not own a position in any of the stocks named here. Follow him on Twitter at @ajohnagnello and become a fan of InvestorPlace on Facebook.

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