Netflix Should Stay Independent

First, a round of applause for two of my Foolish colleagues: Rick Munarriz and Seth Jayson. They're both right in that Netflix (Nasdaq: NFLX  ) would be an attractive buyout candidate.

Rick first mulled the implications of a deal with Amazon (Nasdaq: AMZN  ) a week ago. Seth then responded that Microsoft (Nasdaq: MSFT  ) would be a better suitor. They're both right. Netflix would be very valuable in the hands of another -- especially Mr. Softy, the would-be Google (Nasdaq: GOOG  ) slayer.

Why sell now?
But they're both wrong in one really important respect: There's no reason for CEO Reed Hastings to sell his company right now, at the dawn of the age of video-on-demand.

To suggest otherwise is to suggest that Netflix doesn't have the financial or management wherewithal to withstand the pressure that comes with operating in a highly competitive market. I beg to differ:

Free Cash Flow

Total*

Trailing 12 months

$240.0

2006

$220.6

2005

$129.8

2004

$129.6

2003

$80.9

2002

$37.3

Source: Capital IQ, a division of Standard & Poor's
*Numbers in millions

Those are Netflix's free cash flow (FCF) totals over the past five years. FCF has grown by more than 50% annually since 2002. But, impressive as that is, it gets better when you see this:

Net Income

Total*

Trailing 12 months

$63.1

2006

$49.1

2005

$42.0

2004

$21.6

2003

$6.5

2002

($20.9)

Source: Capital IQ
*Numbers in millions

Take a minute to read those charts again. Notice something? I do. Netflix rakes in the cash even when there isn't a penny of GAAP profit to be found. That's why I'm not in the least convinced that Blockbuster (NYSE: BBI  ) and its capital-intensive business model will be able to discount Netflix into oblivion.

In pursuit of Jack Bauer
What's more, few give Netflix credit for what it's doing with its "Watch Now" service, which delivers movies-on-demand to any Windows PC connected to the Web. Rick was especially harsh here. I think that's crazy. (Fellow Fool Rich Duprey chimed in with his thoughts, too.)

Thanks to TiVo (Nasdaq: TIVO  ) and its time-shifting technology, we viewers have become accustomed to watching what we want, when we want. I know I have. Check my bedside table and you'll find a handy episode chart for past seasons of Fox's 24. I'm tracking which episodes we can tape in the middle of the night for later viewing. (We're in the middle of season 3.)

But there's more than TiVo at work here. Video-on-demand site Joost, which was created by the same folks who built Skype, already has more than one million users. Amazon's Unbox service offers rock-bottom rental pricing on flicks that can be stored on your TiVo for up to 30 days. Apple's (Nasdaq: AAPL  ) iTunes boasts more than 500 movies in its for-purchase library. And let's not forget Blockbuster, which thinks enough of VOD to spend $20 million to acquire Movielink.

Some very smart people see dollar signs at the end of the RJ-45 connector -- analysts especially. Researcher iSuppli predicts that the market for Internet-based TV delivery -- or iPTV, as it has become known -- will rise like a fresh bag of Jiffy-Pop, from $779.2 million to $26.3 billion by 2011.

You're watching the Netflix Channel
Those are exactly the sorts of eye-popping numbers that must have Hastings salivating. At least they explain why Netflix has finally started pitching Watch Now -- it's the future of the company.

But we know that. Hastings has been talking about digital delivery for years. If anything, he's been criticized for not moving fast enough when it comes to Watch Now. I'm not sure that's fair. I think it is better to have Netflix carefully collecting customer data so as to price its digital service appropriately, because it won't be free forever.

Nor is it likely to always be a service of netflix.com. Video-on-demand works best when it's integrated into your TV viewing experience, as both the cable and satellite operators have learned. What they lack is a meaningful menu of choices. Netflix and its peers can (and should) change that.

Don't expect movie-playing cable channels to get in the way, either. You didn't subscribe to Showtime to watch Bruce Willis vanquish bad guys with a spoon and a fire hydrant in the latest installment of the Die Hard series. You have Showtime because you like Weeds, and you have HBO because you like Entourage.

Neither of these channels or their peers is anxious to pay royalties for yesterday's let's-see-what-trouble-Mr. Bean-can-get-into-now goof-fest when there's more money to be had in original programming. Enter the Netflix Channel, stage left.

Don't throw out the popcorn during the previews
Now isn't the best of times for Netflix. Subscribers aren't coming in as fast as they used to. Price cuts aren't likely to help profits. And Blockbuster, suddenly, has become a very serious competitor.

But these aren't the worst of times, either. Today's Netflix will barely resemble tomorrow's. It's as Web 1.0 is to Web 2.0 -- different times, different businesses. At least we know that Netflix is investing now to protect and cultivate what should be a very profitable future.

So, stay and fight, Netflix. The war over video-on-demand has barely begun, and you're as well armed as anyone.

Foolishness-on-Demand:

Netflix and Amazon are Stock Advisor recommendations. Get a 30-day free pass to the service to find out how David and Tom Gardner have engineered a 37-point drubbing of the S&P 500 over the past five years. There's no obligation to subscribe.

Microsoft is an Inside Value selection.

Fool contributor Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. Find Tim's portfolio here and his latest blog commentary here. The Motley Fool's disclosure policy wishes Netflix would add the original Die Hard to its Watch Now collection.


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