Would Microsoft and Netflix Make a Pair?

I'm starting to feel like a used car salesman trying to unload Netflix (Nasdaq: NFLX  ) on a willing driver. I pleaded the case for Netflix to cash itself out to Amazon.com (Nasdaq: AMZN  ) earlier this week.

It wasn't long before I was deluged by critics, arguing that Amazon will never buy Netflix because of the sales tax implications. Under Amazon's arm, Amazon shoppers living in states with Netflix distribution centers would be automatically hit with corresponding sales tax rates on all of their Amazon purchases. Right now that is limited to Amazon's distribution center presence in Kentucky, Kansas, North Dakota, and Washington.

I could offer potential workarounds, point to the inevitable repeal of the Internet Tax Freedom Act, or explain why it would still make perfect sense for Amazon to buy Netflix. However, fellow Fool Seth Jayson wrote me to offer up an even more attractive buyer for Netflix: Microsoft (Nasdaq: MSFT  ) .

Microsoft offers the perfect set-top solution for digital distribution through its Xbox Live connectivity. Netflix CEO Reed Hastings was added to Microsoft's board of directors earlier this year, so you know that the two companies are already chummy. Microsoft would also be able to enhance Netflix's offerings and its monetization strategies.

In short, Microsoft and Netflix were practically made for one another.

The Xbox connection
Amazon scored a major coup with its fledgling Unbox digital delivery service when it hooked up with TiVo (Nasdaq: TIVO  ) . The ability to have Web-delivered film rentals and purchases go right into your DVR is brilliant, as long as you are one of the 4.3 million TiVo box owners. A fraction of those don't even have their systems tethered to broadband access, making the Unbox perk useless.

The Xbox Live base is much larger. There are now 7 million active accounts, all connected to Microsoft's entertainment network. The company expects to have 10 million users by next summer. That compares favorably to TiVo, a company that is watching over a slightly smaller installed base than it had a year ago, as former partner DirecTV's users are leaving at a quicker pace than the company is signing up its own accounts.

You may wonder what Netflix -- a company that staunchly refuses to rent video games -- could possibly have to offer diehard Xbox gamers. Did I mention that the hot Xbox 360 add-on is an HD-DVD drive for flick consumption? The company's nascent online marketplace is cutting deals with major studios to deliver movies right into Xbox Live user hard drives.

Netflix has its Watch Now online streaming service for computers, but Microsoft has perfected the delivery of media into Xbox-connected television sets. It's the best way to assure that Netflix will have a prominent role in the digital delivery world of tomorrow, as Microsoft makes the most of the cash cow business that Netflix has perfected today.

Putting on its game face
Mr. Softy wouldn't exactly be getting a fixer-upper here. Netflix is profitable, even as it finds itself neck deep in a pricing war with Blockbuster (NYSE: BBI  ) . However, there are ways that Microsoft would make Netflix even better.

For starters, Microsoft would be motivated to add video game rentals to the arsenal of Netflix. Naturally it would limit itself to Xbox and Xbox 360 titles. It also wouldn't hurt if it initially limited itself to titles like the Halo series that it actually owns.

Netflix has avoided diving into the video game space for several reasons. Video games are much more expensive than DVDs. The discs are more likely to be damaged as they are manhandled. There is also a limited lifespan here. Nobody will want to rent Madden 07 games when Madden 08 hits retailer shelves next week.

Those cons are offset by several benefits. Game rentals are held longer, saving Netflix when it comes to shipping costs. It would help open up the market, beyond just film buffs, while also setting itself apart. The last thing that Netflix would want after watching Blockbuster sign nearly twice as many users as it has over the past nine months, is to have Blockbuster plunge the dagger even deeper by hopping on the video game bandwagon first.

Microsoft would have the developer connections and promotional might to make sure that video games can be added constructively.

More than just games
It's not just about delivering movies, games, and music through cyberspace. Microsoft would help Netflix in many other ways. Imagine Netflix sign-ups -- bundled with Watch Now demos -- loaded in new Windows Vista computers and laptops.

Netflix has also been slow to cash in on the lucrative potential of its mailers beyond the occasional ad. Microsoft could bundle DVDs with things like PC software samples and Xbox demo discs.

Along the way, Microsoft would also be the beneficiary of five years of Netflix subscriber preferences. Netflix knows the movies that a member is likely to enjoy based on the data-crunching platform that analyzes user ratings against millions of peers. Wouldn't that be wicked sweet for Microsoft as it can fine tune its offers for the right Live marketplace products to its users?

Netflix also runs one of the most popular, stickiest sites in the Internet. As long as it's not way over the top, Microsoft would love to get its contextual marketing ads on the site before Google (Nasdaq: GOOG  ) does.

So I have to hand it to Seth. He really did come up with the perfect suitor for Netflix. I have to wonder -- if even in jest -- it hasn't come up during a Microsoft board meeting this year. Hastings is there already. Now it's just a matter of making him an offer that he can't refuse.

The Fool's Read Now:

Netflix and Amazon.com are recommendations for Motley Fool Stock Advisor newsletter subscribers. Microsoft is an Inside Value recommendation. Finding out why is just a 30-day free trial subscription away.

Longtime Fool contributor Rick Munarriz has been a Netflix subscriber -- and shareholder -- since 2002. He owns shares in TiVo, too. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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