Netflix Acquiring Starz? Why?

Akram's Razor submits:It's amazing what passes for financial news these days. CNBC, citing The Los Angeles Times as a source, just reported that Netflix (NFLX) might acquire Starz in a deal valued at around $3 billion. Of course, had CNBC done its homework it would have realized that the same article also predicted that American Idol will struggle without Simon Cowell, Katie Couric will stay with CBS News, Howard Stringer will retire early and Leslie Moonves will try to acquire Sony Pictures. And that wasn't the only Netflix news we got today. The word out of CES is that your remote control will soon have a Netflix button. The only thing surprising about this news is that Netflix shares didn't respond by rising 10%. What's happened? A few months ago, any press release out of the company would be followed by a sharp rally in the share price. But seriously, there is nothing surprising about this news. Netflix is a brander; that is its number one competitive advantage. It started early on with gaming systems, moved on to DVD players/streaming boxes/DVRs, then web-enabled TVs, and finally tablets. CEO Reed Hastings wants Netflix to be as synonomous with movie streaming as it was with mail-in DVDs, and so far he is succeeding. Netflix has a beautiful business model. It licenses content, outsources its hosting, and banks on telcos and cable companies to provide the web infrastructure needed to be a mass distributor. All it needs to focus on is building its brand recognition. So I am not surprised that it now wants its own remote control button. Though I have to admit I don't think this is going to do much for it. Accessibility is no longer an issue for Netflix; digital device integration is taking care of that. How long before every TV comes with a standard Internet connection? Netflix no longer needs to worry about getting on every single consumer electronic device ever created. Success from now on will hinge on content quality/availability and cost. Matters that are, if you ask me, now out of its hands. Which brings me to the Starz rumor. Why would Netflix want to buy it? Starz is a distributor that has done a pretty good job of branding itself. It exclusively licenses content in big “output” deals, and then collects a per-subscriber fee from the cable/satellite companies that have the infrastructure in place needed to reach a mass audience. What would Netflix be buying? The ability to only be able to watch a channel on cable/satellite subscription enabled TVs? Starz users can’t watch Starz over their Playstation, Blu-ray player, iPad, computer, and/or web-enabled TV; they need a cable package. Netflix users can access the service from all of the aforementioned devices. Isn’t this precisely why Starz turned to Netflix for its online distribution via Starzplay instead of pursuing a go-it-alone strategy? When these two parties signed their now infamous sub-licensing deal, the online digital streaming distribution channel didn’t exist. The Starz deal allowed Netflix to get off the ground and establish some critical mass. Yes, Starz shortchanged the industry by giving Netflix content for what amounts to less than 20 cents per subscriber versus the $2+ some cable providers are paying for the same content. That is one way of looking at it. The other is to recognize the fact that this one deal is the reason content owners can now license content online in mega-output deals. So I ask again: Why buy Starz? As things stand, Starz's most valuable asset is its two big output deals. The Sony (SNE) deal was extended in late 2009 well into the next decade, and earlier this year the Disney (DIS) deal (after much trash talking over the Netflix situation) was extended until 2015. In the current environment, Starz will be able to demand at least $250 million a year for the online rights to this content. If Netflix won’t pay it, I am sure Amazon (AMZN) or Google (GOOG) will.So buying Starz to save money doesn’t really make much sense. The only logic I see here is that you make such a move to buy yourself a few more years to dominate your industry and cement your position ... but that can be accomplished without an acquisition. Does Netflix really want to be negotiating per-subscriber fees with the same cable companies it is competing against for subscribers, and also depending on for unfettered Internet pipe access? I doubt it. And what happens once the Comcast (CMCSA)/NBC Universal deal goes through? Comcast is going to control 30% of Hulu with the other 30% still sitting in Starz output partner Disney’s hands. Then you have "TV anywhere" services like Xfinity that you are competing with. Time Warner (TWX) CEO Jeff Bewkes has been pretty frank when it comes to what he thinks of Netflix’s strategy, so I doubt that HBO is becoming a content partner anytime soon. Crazy, isn’t it? And I have not even gotten into rental/purchasing services wanting more protection for their release window from subscription-service content aggregators like Netflix. Will anyone be buying any movies for their home library five years from now? This is a tangled and complicated web, and things are only going to get messier over the next few years. Nobody is going to dominate the industry. The only thing I am certain of is that this market will remain fragmented for years to come. The cross-ownership structure, shared infrastructure, and multi-year deals guarantee that. Now, what would I do if I was Reed Hastings? I’d buy a pure-content house. It’s basically a "No-Limit Hold 'em" strategy. The market seems to think that all the aforementioned issues in the digital media space don’t exist. For all intents and purposes, everyone else at the table thinks Hastings is holding pocket aces. The problem is that Hastings, despite his recent post, knows that is not the case (diversification isn’t the only reason he has been steadily selling his shares). His hand is a lot weaker. So he should take advantage of the respect he is being given and cash in quickly before everyone else at the table wises up. Netflix can pull an AOL/Time Warner style move at this point. It needs to own some exclusive content. The problem with Starz is that it doesn't offer that yet. (The Spartacus series is about as far as it has made it so far.) Buying Starz for its future content potential would be a serious gamble. Why not go after Lions Gate (LGF) or Showtime instead? Whatever Netflix does, it won’t be good news for shareholders. It will either issue equity to pay for very pricey output deals, or it will over-pay for a content player to protect the longer term viability of its business. But don’t try explaining that to the stock market. Since I last wrote about Netflix, shares of the stock have risen 26%, and that’s after a recent pullback. It seems that all investors not named Whitney Tilson don’t see things my way. But then again, the market has been a lot more stupid than usual lately. Last Friday, we had Disney/Imax (IMAX) rumor move Imax shares over 20%. Even though Disney's model has been almost solely about buying and controlling high quality content like ESPN, Marvel, and Pixar, some people are willing to bet it will buy a 3-D technology distributor. Amusing stuff.Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in NFLX over the next 72 hours.Complete Story »