- Wall Street is awash with rumors of Disney's planned acquisition of Netflix.
- With 80 million premium subscribers, Netflix could give a huge boost to Disney's streaming dreams.
- However, Netflix is a big fish to swallow, which could get stuck in Disney's throat.
Wall Street is awash with M&A chatter. After Twitter, it was Netflix’s turn to be part of the rumor. Netflix stock breached the $100 mark, gaining around 5% on the rumors that Walt Disney Co (NYSE:DIS) is planning to acquire the media streaming company. Interestingly, Disney is also part of the buyout chatter surrounding Twitter. Yesterday Wall Street Journal came out with a report saying that Twitter is fielding bids from Alphabet Inc (NASDAQ:GOOG), salesforce (NYSE:CRM) and Disney.
So why is Disney involved with rumors surrounding Netflix? And does it make sense for Disney? Let's answer the first question. Disney stock has been facing tremendous downside pressure in the last one year or so. The stock has declined more than 11% this year. And this is after producing 4 of the 5 top grossing films of the year, having a strong line up of movies to be released and after opening its largest theme park in Shanghai which is likely to bring millions of dollars in revenue. And to top it all Disney has delivered an earnings beat in three of the last 4 quarters. So why has the stock been declining?
Also Read: Will Walt Disney Co Stock Fall Below $90?
The ESPN Worry
Many investors are worried that declining subscription numbers of the ESPN franchise will pull down Disney's media business, its largest segment, which contributed around 40% of Disney's total revenues in the latest quarter. Rampant cord cutting has resulted in ESPN losing more than 10 million subscribers in the last three years. To augment its media business and to protect itself from the downside of rampant cord cutting Disney has been scouting for streaming businesses. In the last quarter, Disney announced that it has acquired a stake for $1 billion in sports live streaming company BAMtech. Live streaming is also the reason why Disney has been linked with Twitter, which is making tremendous progress in this field. But Netflix is a different ball game together.
Why Disney May Be Interested
There are significant synergies between the two media businesses. Netflix is the largest streaming company, with more than 80 million subscribers worldwide. Netflix's huge subscriber base is what Disney wants right now. It will act as a counter weight to the declining ESPN subscriber numbers. Also, both the companies create excellent content which might help their subscriber growth. To be sure, Netflix and Disney are already having a strong partnership. Netflix is the exclusive pay tv host for Disney's new movies and also TV shows and movies from its major franchises: Pixar, Lucasfilm, and Marvel.
But Netflix also comes with a hefty price tag and a stretched valuation. As of yesterday, Netflix had a market capitalization of $44 billion compared to Disney's market cap of $148 billion. While Disney is more than 2 and half times the size of Netflix (by Market cap), does it have the resources to acquire Netflix? Twitter is already up more than 25% after the buyout rumors and may go up even more. Even at a conservative 20% premium from yesterday's close, Netflix would cost Disney, more than $52 billion.
Strong Financials, But Strong Enough?
Disney is a company with a strong balance sheet. In 2015 it generated more than $10 billion in operating cash flows and $6 billion in free cash flows. While free cash flows are likely to improve this year, it is still far less than what Disney will require in order to acquire Netflix. In the latest quarter, Disney had around $8 billion in cash and investments. So, it would either need to raise debt or issue new equity shares or a combination of both to finance an acquisition.
Disney already has more than $20 billion in long-term debt, with a debt to equity ratio of around 0.42. An addition of another $52 billion in debt will immensely increase the leverage. The combined entity will have a debt to equity ratio of 1.5, more than three times today's leverage. This will make the balance sheet weak, and given that Netflix is already a risky business, the risk addition for shareholders will be huge. It will be difficult to convince Disney's generally conservative investors. On the other hand, if Disney goes for an equity route then it will be highly dilutive. An all equity deal will dilute Disney's earnings by a third and will also affect its dividends. It is more likely that Disney will go for a mixed funding, but that will still be risky and have a huge dilutive effect on its earnings.
The Valuation Premium
And then there is the problem of valuation. Netflix currently trades at a PE multiple (ttm) of 320 while Disney trades at a multiple of 16. Netflix's valuation premium is high because of its fast subscriber growth. But even that is not likely to sustain. Like Disney, Netflix stock has also lost more than 10% this year after it failed to meet analysts' subscriber growth estimate. And with increasing competition, growth concerns are likely to persist. Also, as fellow Amigobulls contributor Piyush Arora pointed out, Netflix doesn't have enough local content to entice users in most of the international markets. And according to a report on Benzinga, Q3 could be another disappointing quarter for Netflix in terms of growth. The report also indicates that Netflix's penetration in U.S may be declining, so valuation may drop. As a post on Seeking Alpha pointed out, this may be the best time for Netflix to sell itself, and so it may not be a good time for Disney to buy it.
Disney has been linked with two M&A rumors, both involving online streaming business which Disney is desperately trying to get into. Disney stock is under pressure despite good results because of cord cutting in ESPN, and it feels online streaming is a good way to limit the decline and participate in future growth. While Netflix has a huge premium subscriber base worldwide, it may be too big to acquire for Disney. A Netflix acquisition is likely to be value destructive for Disney's shareholders.