Netflix: Will a Takeover Threat Boost the Stock?

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Carl Icahn's move to acquire a 10% stake in Netflix (NASDAQ: NFLX) is a sure sign that he is eying the company as a potential takeover target. The video streaming company's earnings are currently being weighed down by its global expansion. While this is not the distressed sale Icahn favors, Netflix's stock is hovering under $79, down from a high of $175.70 in 2010. Netflix has responded, restricting the percent of shares any one shareholder may hold. But Netflix's best takeover defense is to continue toward global expansion in order to position itself for future growth.

Icahn has opportunistically staked a position in Netflix while its global expansion is putting pressure on profits. With help from a 20% increase in U.S. video streaming subscribers, third quarter revenues for its streaming and DVD businesses rose 10% to $905.1 million. International streaming revenues more than tripled to $77.7 million, from $22.7 million in the same quarter of 2011. Yet, Netflix has not gained enough traction to cover the high costs of the global expansion. As a result of the revenue lag, earnings per share plunged 88% to $0.13 during the third quarter, down from $1.16 during the third quarter of 2011.

Going forward, Netflix's management will have to convince investors that global expansion is the best route to long-term profitability. Management expects to realize the full benefits of the global expansion in three years. To create international subscriber traction, Netflix is spending more than initially anticipated, including investments in the content library in the U.K. and Ireland. Netflix is also making significant investments in its Open Connect content delivery network, which allows internet service providers to directly provide Netflix streaming video services to customers through the Open Connect appliance.

Global expansion has contributed to a 20.1% increase in operating expenses, amounting to $226.3 million. Notably, marketing expenses were up 27.1%. Operating profit fell to $16.1 million from $96.8 million in the same quarter of 2011. Operating margins have fallen to 1.8% from 11.8%, while net margins stand at 0.8%, down from 7.6%. Management expects further pressure on earnings in the fourth quarter, with an earnings loss of $0.23, to $0.04, partly related to higher costs from its expansion into Nordic countries.

While these expenses are squeezing profit margins and eating into cash - free cash flow has fallen to negative $20 million in the quarter - they also position Netflix in high growth markets. Revenues are forecasted to increase seven to eight fold in the fourth quarter of 2012. Going forward, the company will benefit from two synergistic drivers of growth. Crucially, more of the world will be covered with high speed 4G networks to deliver high quality video streaming. At the same time, Netflix's global marketing efforts will gain traction and begin to attract new subscribers.

The growing demand for video services across computing, TV, and mobile devices explains why MicrosoftAmazon (NASDAQ: AMZN)Apple (NASDAQ: AAPL) and Verizon (NYSE: VZ) have all been cited as potential acquirers of Netflix. They are all seeking to meet the big push from mobile operators and service providers for more video services to sell to customers. Netflix is competing on price and its content library with Amazon and Hulu for this growing market. As a market leader in streaming video, Netflix is positioned to capture this growth, even if it has a few missteps in execution.

This places Netflix in an enviable position as more LTE-enabled smartphones are turned on in its global markets. Led by Verizon and AT&T (NYSE: T), most of the U.S. is covered. If the 25 million iPhone 5's sold in the first three months is any indication, a lot of video will be streaming over LTE networks in the coming year. With download speeds averaging 9 to 10 megabits per second (mbps), 4G delivers high quality video without the latency and lags.

As more households use internet video, Netflix's long-term target is to acquire 60 to 90 million subscribers, albeit at a slower pace than announced just a quarter ago. It has revised its 2012 subscriber growth forecast from 7 million to 5 million subscribers, but Netflix management retains a positive long-term outlook. "People are using Internet video in huge numbers and that is only starting and we continue to lead the market in a big way," says Netflix CEO Reed Hasting. Referring to the decline in subscriber growth in July and August in the third quarter conference call, Reed recalls that the drag on subscribers during the London Olympics was forecasted. Worldwide, 2 million new subscribers were added in the third quarter, bringing the total number to 29 million.

However, in making its most recent subscriber forecast, Netflix would not have accounted for more aggressive pricing just announced by its competitors. Amazon plans to go head-to-head with Netflix on pricing. The online retail giant is currently testing new Prime program pricing of $7.99 a month, in line with the pricing of Netflix and Hulu. The real threat is Amazon's move from a $79 per year plan to a monthly option. Amazon was missing a large market by ignoring the less committed consumer. Hulu's paid service, Hulu Plus, has two million paid subscribers and has locked up a contract with Apple to stream its video and TV programs to Apple TV.

Netflix needs to continue to up its investment in content to remain the leader. Amazon boasts 25,000 film and TV shows. Co-owned by NBC, Fox and Disney-ABC, Hulu is strong on TV programming but uses an advertising-supported TV model. Hulu is busy signing up deals, including a recent agreement to license old CBS shows. While Hulu has a strong presence in the US and Japan, Netflix has been more aggressive in establishing a global presence, and is thus better positioned to stream video to LTE smartphones and other enabled devices as they come online.

A third reason to bet on Netflix's management is Icahn himself, the very investor pushing for a takeover and new management. Takeover targets, whether or not acquired, improve long-term performance on average under increased shareholder scrutiny, In response to the poison pill, which was not put to a shareholder vote, Icahn has accused Netflix of poor corporate governance. In recent years Icahn has been actively advocating the abolition of the poison pill in The Icahn Report, a shareholder rights newsletter. In ensuring that no shareholder will control more than 15% of the shares in the event of a proxy fight, Icahn contends that poison pills stand between buyers and sellers and their desire to consummate a sale.

No one questions that Icahn's intention is to force a takeover of Netflix. This speculation has sent Netflix's stock soaring to around $78, over 100 times earnings. Any sale now comes at a much higher price tag for a suitor. Several of Icahn's recent attempts to spur takeover activity - namely Lions Gate and Mentor Graphics - have failed, reports Bloomberg News, although Icahn notes that these companies have created more shareholder value since he has taken a stake. Whether or not Icahn convinces shareholders that Netflix's poison pill "undermines shareholders rights," any takeover will ultimately come down to convincing investors that there is more value in selling the shares today to a larger suitor. Either way, shareholder activism is targeting the stock, which is bound to improve performance.

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The precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These kinds of issues are a must know for investors, which is why The Motley Fool released a brand new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to both buy and sell the stock. They’re also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.


StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Amazon.com, and Netflix. Motley Fool newsletter services recommend Apple, Amazon.com, Netflix, and AT&T.; Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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