Just when it seemed as if Netflix (Nasdaq: NFLX ) was going to have another week of shrinking, the picture got bigger.
A rumor surfaced on Friday afternoon, indicating that Microsoft (Nasdaq: MSFT ) was interested in acquiring Netflix. The unfounded story was so appealing that Netflix's stock -- trading flat halfway through the trading day -- skyrocketed to close with a 13% gain on Friday.
Now, it's easy to see how this chatter can start making sense to investors. When Netflix CEO Reed Hastings announced earlier this month that he'll resign from Microsoft's board, the knee-jerk reaction by many Netflix watchers was that he was stepping down because Mr. Softy was inquiring about purchasing the leading video service.
That was my initial reaction, too.
A deal is unlikely. Hastings is still on the board. He doesn't step down until the annual shareholder meeting on Nov. 28 . If there's any truth to this matter, it can wait until Hastings has dismissed himself from the boardroom.
However, a Microsoft purchase of Netflix makes more sense than you probably think. Let's go over a few reasons this would be a good fit.
1. Microsoft needs to keep up with the monsters of tech
Microsoft's most formidable competitors are undeniably Google (Nasdaq: GOOG ) and Apple (Nasdaq: AAPL ) .
Think about it. Microsoft's "lost decade," if you will, is the result of Apple and Google. The recent decline in PC sales has come about because Google's Android and Apple's iOS power the vast majority of smartphones and tablets.
Everywhere Microsoft turns, it finds Google and/or Apple. Microsoft Office is being taken on by Google Docs -- and now Google Drive -- on the cloud. Microsoft's Xbox has been the console of choice for nearly two years, but the industry has been shrinking for three years as a result of apps that casual gamers are playing on iOS and Android devices.
Video is a new battlefield. There's a reason there's already a Google TV and an Apple TV. Along the way, Apple has been selling video through iTunes for years, and Google's YouTube just happens to be the world's most popular online video website.
Microsoft would catch up in a hurry if it had Netflix. We're talking about more than 30 million premium streaming video customers. Netflix serves up more than a billion hours of video a month, accounting for roughly a third of this country's peak downstream Internet traffic.
Netflix will obviously continue to play nice with all devices. However, just as it gave Xbox streaming exclusivity among consoles for a year -- which is probably how Xbox became the top dog, when you think about it -- just imagine what Netflix could do if Surface tablet owners or Windows Phone users got something extra out of Netflix.
2. Microsoft's already losing money online
Buying Netflix in its present state would be a losing proposition for many dot-com darlings. Held back by its intermittent profitability as it expands aggressively overseas, it may be a hard buyout for some investors to stomach.
That wouldn't happen with Microsoft at all. Remember, this is the same company that overpaid in shelling out $8.5 billion for Skype and $6 billion for aQuantive without being held accountable. Netflix, even with a modest buyout premium, could be had for less -- and it would make a material impact in improving Microsoft's operations.
Microsoft's online services division posted a loss of $364 million on revenue of $697 million this past quarter, and that's one of the smaller deficits it posted. During those same three months, Netflix squeezed out a small profit on $905 million in revenue. Yes, that's right. Netflix is bigger than Bing and all of the components of Microsoft's online services. More than doubling its revenue and improving margins doesn't sound so bad. Even if Netflix would get lumped into Microsoft's Xbox-centric entertainment division, it would still be a win for another pocket of crummy margins.
3. Microsoft would make Netflix better
This final point is going to raise some eyebrows, but I think Hastings' refusal to explore tiered pricing strategies or offer premium rentals of newer content is holding back Netflix's potential. The market just isn't getting excited about this $7.99-a-month ceiling, especially when there are signs that the domestic market at least is nearly saturated.
Microsoft wouldn't have to hold itself to those potential-capping beliefs.
Netflix wouldn't be losing so many members if it had access to everything, either piecemeal or via digital smorgasbord. Amazon.com (Nasdaq: AMZN ) offers this already, and it's Netflix's closest competitor. Isn't Amazon also a threat to Microsoft? It may not seem that way at first, but Amazon's moving into tablets and already has its own mobile browser. Smartphones are rumored to be next. If Microsoft can make Netflix smarter -- especially in competing against Amazon -- it would be doing itself a major favor.
The Microsoft name would also make it easier to break into new international markets.
Add it up
Friday's chatter seems fishy. It's too convenient, coming after a bad week for Netflix and during a weekend on which traders are bracing for the possibility of Hurricane Sandy.
Investors shouldn't place a lot of faith in that particular rumor. However, a Microsoft purchase of Netflix is a very plausible scenario. It would be a win-win deal for two companies that may not want to face the future alone.
This will probably be a hot prediction for 2013. Right now, it's just too soon.
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