LPO 3351 – Spring 2012 PBL 1: Google to Acquire Netflix Professor Doyle
Heather Curler, Zac Ford, Jordan Jones, Elizabeth Likins, Dan Oliver & Jonathan Sawyer
Google, the world's most powerful brand, endeavors to purchase Netflix, the largest U.S. based online movie rental service provider.
This acquisition is consistent with the Google focus on improving how people connect with information. The acquisition will address a strategic opportunity to deliver more diverse online content to the world, where the graphical and video display-ad market is estimated to grow to $200 billion (Efrati, 2012). It will also further build on the expansive Google acquisition model strategy and use of capital (Rosoff, 2012).
Google enjoys proven success and market dominance in online advertising. With its graphical and video advertising successes through its YouTube platform and thousands of other sites, the company has established a significant competitive advantage in the market of display-advertising. With Netflix, Google would leverage its ad expertise to pair advertisements with video search requests and video themes/genres. This acquisition will continue the Google growth model of winning loyalty across every facet of the internet experience which translates into "overall time spent on Google services,[...]more time (for consumers to be) exposed to ads, [and] increased brand loyalty (Young, 2011).
The acquisition would provide a diversified monetization model of membership/fee based service which provides strong direct customer and revenue competition to Hulu (streaming video currently offered only to users in Japan and the USA and its overseas territories), Amazon Prime Streaming and Apple's iTunes in the global market (Wikipedia, 2012). If leveraged by Google in the manner explained in the following report, Netflix’s current base of 21.5M subscribers paying $8 per month per contract will add significant profitability. This strategic revenues diversification -- in combination with a Hulu-like streaming advertisement model – could provide a conservative base revenue addition of $989M to the existing Netflix annual revenue (see Appendix 1.4). Given the forecasted exponential growth and demand for streaming video, Google’s entry into the market would be very savvy. In the fourth quarter of 2011, Netflix streamed 2 billion hours of online video (Trefis, 2012). By 2013, the expected monthly bulk IP traffic is expected to increase eight times over the 2009 monthly rate (OneSource, 2012).
Research shows that organizations with similar cultures are more likely to be part of a successful acquisition (Pfeffer & Sutton, 2006; Harding & Rouse, 2007). While Netflix and Google have certain cultural differences, they also have particular similarities, “including their ability to succeed internationally and their positions as industry disruptors” (Taylor, 2011). As with all prospective acquisitions, Google will engage in extensive research, on-site observation, and other human due diligence measures to evaluate the corporate culture of Netflix and craft a strategic plan for integration. If, however, it becomes apparent through such efforts that cultural divides are too great, the proposed acquisition will be abandoned.
Post-acquisition synergy plans call for Google/Netflix to offer a Freemium model in addition to its subscriber model. The combined forces would also deliver a la carte rentals to non-subscribers from Netflix’s vast content library. Movie/TV offerings will increase with international content as Google substantially expands Netflix’s international reach. Google's worldwide footprint tips 1 billion unique visitors per month (Efrati, 2011). This translates into $18.44 dollars per year per unique visitor. With a conservative conversion rate of .5% of Google customers to a Netflix single movie rental/month at $3.49, $209M will be additionally realized with unlimited upside potential.
Netflix users would also be required to establish Google accounts. Social website commerce could potentially deliver $20.7M through the 90M users of Google+. Reduction in direct expense associated with moving away from the current purchased Amazon cloud services to a Google-provided platform may realize $64.5M, and head count rationalization would approach $8M over two years. A summary of the increased revenue streams, savings and synergies approaches $1.144B annually (average of annual synergies across 5 years – Appendix 1.4). The Netflix stand-alone value is $10.4B (as valued by Google with the assistance of Peabody Financial Services).
The acquisition of Netflix would add to earnings after the first full year. The EPS accretive test summary shows the stock price would rise from $578.54 to $631.94 per share.
The offer price of $17.9B needs immediate Board approval consideration.
I. Google (Goog) to Acquire Netflix (NFLX) – Strategic Acquisition: As Google endeavors to acquire Netflix, four important questions are to be considered:
(1) Is this acquisition a move that is consistent with stated strategy and prior actions?
(2) Does this acquisition address a competitive advantage?
(3) Does it strengthen a key advantage?
(4) Does it accelerate progress on a key strategic initiative? (Alexander, 253).
The following information is intended to make clear to the Board of Directors that Google’s move to acquire Netflix is a sound, strategic move and that the answer to all four key questions is a resounding YES. The acquisition should meet with the Board approval.
(1) Google’s Brand Power & Worldwide Reach prefigure its ability to leverage its greatest asset -- Advertising Expertise -- for Netflix:
In 2010, the search engine and online advertising giant was named the world’s most powerful brand (OneSource, 2012). In the United States alone, Google controls 78% of the search market share and 80% of the online pay per click advertising market (Travlos, 2010). Worldwide, the corporation leads the search engine market share by 65% (OneSource, 2012). With the introduction of its browser software Google Chrome, Google tripled its global market share (Travlos, 2010).
The internet titan, known for its overwhelming success in online search and web-search text advertising, is also enjoying growth and profit in an additional advertising market: selling online display-ads on its YouTube site and thousands of other sites not affiliated with Google (Efrati, 2012). Currently a market worth approximately $12.1 billion in the United States and $25 billion worldwide, the graphical and video display-ad market is projected to increase in value to nearly $200 billion (Efrati, 2012). Between 2008-2011, Google’s share in the display-ads market grew from 2.4% to 9.3% (Efrati, 2012). The fast-growing ad-display market, which looks to produce more than $5 billion in revenues per year, is Google’s second-largest generator of revenue behind web-search text ads (Efrati, 2012).
Google’s strategy of success in growing its display-ad business includes the use of its YouTube platform for dissemination of ads. In the last year, display-advertisements by Google Creative Labs were viewed 67.3 million times (Learmonth, 2011). Such exposure makes Google the third most watched brand on YouTube (Learmonth, 2011). Google is able to market its YouTube site as a “reach fire hose” to advertising agencies, since the search and advertising behemoth is able to “deliver an audience that is three to four times that of the Super Bowl” (Steve Minchini, as quoted in Shields, 2010).
In addition to having its own platform for display-ads, Google’s lucrative display-ad market share is driven by bulk sales of cheaper advertisements, also known as remnant inventory, to advertisers (Efrati, 2012). These cheaper, bulk inventories reach broad audiences online through the internet and mobile devices. Advertising executives acknowledge that Google has a “competitive advantage” in this arena, since it has invested more than its rivals in the remnant inventory market (Daniel Khabie, as quoted in Efrati, 2012).
Implications for Google and Netflix:
As Google eyes the platform acquisition of the pioneer in internet subscription services that streams movies and television shows, it can certainly stand confident in its success and competitive advantage with display-advertising through YouTube and other internet sites. Such proven success affords Google a degree of assurance that Netflix would serve as yet another valuable avenue for display-advertising. Google could deliver ad-like features around movies and television shows based on qualities and themes (Travlos, 2010).
(2) Acquisition of Netflix - Consistent with Google’s Strategy of Everything/Ubiquity:
Google’s business model “involves winning loyalty across every facet of the internet experience,” and its strategy is characterized as a “Strategy of Everything” (Young, 2011). Google product range is enormous, and it continues to seek new avenues for growth and expansion of its brand. Because of its size, market share, and cash flow, Google is able to leverage its assets and strengths for new products and catapult them to great success and profitability (Young, 2011). For Google, each successful product or acquisition translates into “overall time spent on Google services, […] more time [for consumers to be] exposed to ads, [and] increased brand loyalty” (Young, 2011). With over 108 acquisitions to date since its incorporation in 1998 and more than 70 companies acquired for over $1.3 billion in fiscal year 2011, Google’s appetite for acquisitions is still quite great (Rosoff, 2012). It plans to continue its pattern and pace of acquisitions as an important component of its strategy and use of capital (Rosoff, 2012).
Implications for Google and Netflix:
Entering the market of streaming TV and movie media is also of benefit to Google, for such a strategic move would hinder Amazon from dominating the realm of streaming movies. Such a competitive advantage would also allow Netflix – as part of Google – to meet its cloud storage needs at home. This would keep approximately $129 million costs from being paid to direct competitor Amazon for cloud capabilities. The acquisition of Netflix would diversity/increase Google’s monetization strategies/revenue streams, as the current streaming content provider is built on a membership/fee-based business model, which Google plans to incorporate into its current model.
Through its acquisition of Netflix, Google would be pursuing a strategic opportunity – the growing demand for online video. In the fourth quarter of 2011 alone, Netflix streamed more than 2 billion hours of TV shows and movies to its customers (Trefis, 2012). The demand for streaming/online video is expected to explode in the very near future. By 2013, total IP traffic per month is expected to be eight times greater in bulk than the monthly traffic amount in 2009 – reaching 56 exabytes per month (OneSource, 2012).
II. Financial Value of Netflix as a Stand-alone Company:
To assess the financial value of Netflix as a stand-alone company, the analysts at Google, with the assistance of Peabody Financial Services (PFS), decided to use the discounted cash flow (DCF) method. This is an industry accepted and thorough method based on projections of future company cash flows (Alexander, 2007). In projecting future cash flows, the financial analysts at Google and PFS used Netflix’s Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). This was used to give the board a quick, yet accurate estimate of Netflix’s Free Cash Flow (FCF).
In determining Netflix’s stand-alone value, the first step was to find and project Netflix’s future revenue growth estimates. Using historical financial reports, the analysts from PFS and Google reviewed Netflix’s financial reports and found that revenue grew by 48% from 2010 to 2011 (Appendix 1.2). However, Netflix’s EPS (projected to drop 30% by some analysts) fell 16% in Q4 2011 from the year-ago quarter (Hastings, 2012). Taking this data into account, along with the four year revenue average increase of 33% from 2008-2011, the team decided to be conservative and project Netflix’s 2012 revenue to increase 20%.
The next step in determining the Netflix’s stand-alone value was to figure out future growth for their Cost of Goods Sold (COGS) and operating expenses. Using historical data, it was found that the four year average for COGS for Netflix was 36% (Appendix 1.2). Furthermore, operating expenses had a 3 year average of an increase of 32% of revenue, with the increase from 2010 to 2011 (year-to-year) being 50%. (Appendix 1.2). Based on this information, we decided to use a conservative projection for COGS at 36% annually. Finally, using the same rationale, it was also decided to have future growth of operating expenses to be 24% of revenues, which is consistent with the four year average (2008-2011). (Appendix 1.2) Using all of the above information, the analysts could then calculate EBITDA’s projections through 2016.
The final step in determining the stand-alone value for Netflix was then to calculate the Terminal Value. Assuming no future growth past 2016, the analysts added up the EBITDA (cash flow) and then divided that number by the Discount Rate which was determined to be the industries' current Weighted Average Cost of Capital (WACC) or 9%.
In the end, it was determined that Netflix’s stand-alone value is $10.4Billion.
- The numbers/methods annotated above would not generate a DCF Value of 10.4B; however, this value was determined by PFS on 23. January, 2012 for project purposes. Therefore, the DCF 10.4B does not reflect Netflix’s 2011 Q4 earning report.
-The numbers presented in the appendix, and in the above explanation, do reflect the values from the most recent earnings report.
III. Strategic and Cultural Fit -- Human Due Diligence:
Despite the frequency of mergers and acquisitions, the majority of them fail. Research shows that about 70 percent of mergers are unsuccessful (Pfeffer & Sutton, 2006). Unfortunately, there is a lack of empirical information available regarding the most common factors involved in the downfall of mergers and acquisitions. Cisco, an organization which has undertaken many flourishing mergers and acquisitions, has noted that a close locational proximity and a dissimilar size between two organizations may be an indicator of success (Pfeffer & Sutton, 2006). Based solely on these two factors, the likelihood of Google finding success in an acquisition of Netflix looks promising. Headquartered in Mountain View, CA, Google is a mere 14 miles from Netflix’s headquarters in Los Gatos, CA. The physical closeness of these two headquarters is a sign that they are more likely to thrive after an acquisition. Additionally, the noticeable size difference between the companies further enhances this theory. Google currently has 31,358 employees (thestreet.com, 2012) with an enterprise value of $146.22B (Yahoo Finance, 2012), compared to Netflix, which has 2,180 employees (thestreet.com, 2012) and an enterprise value of $4.86B (Yahoo Finance, 2012).
Despite the previous presumptions, truly understanding whether or not Google would be able to successfully merge the two cultures effectively depends on intensive research as a part of due diligence. A considerable factor in the success of mergers and acquisitions lies in the similarity or dissimilarity between the original company cultures. Research shows that organizations with more similar cultures are more likely to be part of a successful merger (Pfeffer & Sutton, 2006; Harding & Rouse, 2007). The first step in the research process is gaining a general understanding of both company cultures, and deeply observing the similarities and differences.
Unfortunately, though Netflix and Google have some similarities, the primary foundations of the two cultures are drastically different. Google’s culture is based on employees “who share a commitment to creating search perfection while having a great time doing it” (google.com, 2012). Both headquarters and other offices are noticeably involved in a major green initiative, and employees experience this daily. Each location has “local expressions,” which enhance the cultural feel and “showcase each office’s personality” (google.com, 2012). From rock walls, to bicycling to and from meetings, to lava lamps and inflatable balls, Google strives to be an exciting place to work. They also strive to maintain a small-company feel. Employees work hard to achieve the company mission, and are compensated with a friendly work environment, snack stations, and additional amenities.
On the other hand, Netflix’s culture is transparently based on “Freedom and Responsibility” (Netflix.com, 2012). While the corporation has a very logical approach to doing business, some describe the atmosphere as a “culture of fear” (businessinsider.com, 2010). The company is very direct about attrition in its cultural slide show, and it indicates that those who aren’t stars, those who mess up, and even those who are “brilliant jerks,” will be let go (Netflix.com). This leads to employees fearing for their jobs and to a very high turnover rate. Those who are responsible stars are given as much freedom as they want. There is no vacation day limit, as long as employees are getting the job done correctly and efficiently. The physical environment of the corporate office is very professional and clean looking, whereas the distribution facilities have a drastically different atmosphere. Employees sit at rows of tables in large warehouses, and they stuff DVDs into envelopes or enter information from returning DVDs into computers.
While Google and Netflix have some very obvious cultural differences, they also have some similarities “including their ability to succeed internationally and their positions as industry disruptors” (Taylor, 2011). These company traits have led to a cultural attitude which overlaps Google and Netflix. To account for certain cultural differences, it is important to note that Google would strive to capitalize on shared cultural traits when merging the two organizational cultures.
After culturally comparing Google to Netflix, the second major initiative in the acquisition process would be to research and study the cultural impact other organizations have faced during mergers and acquisitions. Cisco claims they feel their own success in mergers and acquisitions is derived from this tactic (Pfeffer & Sutton, 2006). Considering both successful and unsuccessful organizational fusions would give multiple perspectives and bring about new, possibly unforeseen, insight. This insight would later be applied to the results of more focused research of Netflix and its employees.
The third step in Google’s research process would be to hone in on understanding Netflix’s culture and needs. Specifically, this means that Google would determine a plan of action to more fully understand Netflix. This process would allow Google to compare several cultural aspects of both companies, to evaluate results, and to apply findings in a manner which would benefit both organizations. Through hands-on observation and research, Google would be better able to recognize the scope of cultural compatibility and identify any potential problem areas. Problem areas may include capability gaps, points of friction, or differences in decision-making. Each of these factors has the potential to negatively impact the acquisition in a significant way (Harding & Rouse, 2007). The following processes would be put into action prior to the financial evaluation of the acquisition and the introduction of its possibility to Netflix.
Steps to Cultural Compatibility Evaluation (adapted from Harding & Rouse, 2007):
Analyze organizational chart and compare to Google’s organizational chart
Where do the similarities and differences lie?
Which of the differences will have significant impact on the merger?
Head count and job descriptions
How many people work in each department?
What are the departments?
What is the overlap with Google?
What is the role of these people within the organization?
What are their duties and responsibilities?
Meet with Netflix executives to discuss the current findings
Google will learn their views on decision-making, strategies, etc.
Compare what is learned against the data that has already been collected. This will show where paper and reality differ. These differences will be important in designing implementation plans to ensure a smooth merger.
Evaluate assets and capabilities
What are they?
Where are they located?
Which people possess expertise? This will assist in the decision of who stays and who is let go.
Create and distribute an employee survey to both Google and Netflix employees
This will be distributed to a random sample of employees within both organizations throughout all levels.
The purpose of this survey is to solicit information on how the employees see the potential merger.
Analyze survey for potential merger problems.
Google will dissect the findings and share them amongst executive leaders in order to better create strategies for potential problems.
Google will apply input from Netflix’s management to the analysis of the surveys.
Spend time at Netflix observing the organization and meeting with employees one on one
This will allow Google to get a feel for Netflix’s true culture as well as get to know the employees and their thoughts.
Compile information on employees using an outside source and past performance reviews.
This step is to assist in the decision of which employees to keep.
Inform employees of decisions regarding who will stay and who will be let go
After the acquisition, it is unrealistic to keep everyone. There will be some redundancy, therefore some employees will have to be released.
This will create an atmosphere of openness and communication between the merging organizations, which is will lead to a smoother and more successful cultural fusion.
**A timeline of the above steps along with samples can be found in Appendix 1.10**
With regard to a merger or an acquisition, it is imperative that an organization recognizes what it is becoming culturally involved with (Harding & Rouse, 2007). Potentially vital changes may be unrealistic or intangible, and this knowledge will assist in the decision of whether or not to proceed with the acquisition at all.
Google recognizes that Netflix currently has experts of its own trade. Google needs to maintain these experts in order to thrive. As it stands, Google is significantly larger; therefore, Netflix would likely be the organization which faces more drastic cultural movement and adjustment. Employees would not be let go by Google at any point before the merger is complete. This is not to say that Netflix cannot release its own employees during the acquisition process. Any employees who are not kept on will be compensated fairly with a severance package.
If - in its research and analysis of culture - Google finds that there are cultural differences too difficult to overcome or that would be detrimental to either of the organizations, Google would walk away from this deal. The cultural compatibility cannot be underestimated and could severely impact the success of this acquisition. Google would use the aforementioned steps to ensure that everything possible is done to increase the potential for a successful acquisition. IV. Post-Acquisition Synergies – Google and Netflix (4 principal synergies):
Summary: Under the Google umbrella, Netflix will maintain its subscriber model but will also open up a freemium version of the streaming service. Using a small portion of the Netflix content library, Google will deliver ads through the streaming movie platform in order to monetize free customers. This move will leverage Google’s advertising platform and increase the organizational reach, span, and depth of it advertising capability.
Details: Google and Netflix have a lot to learn from fellow streaming entertainment provider, Hulu. Currently Hulu+, Hulu’s premium service, has 1.5M subscribers who pay $8 per month for access to a significantly smaller content library of television shows and movies (Kilar, 2012). This subscription model provides a total of $144M in annual subscription related revenue for Hulu. As a whole, however, Hulu generates approximately $420M in total annual revenue (Kilar, 2012). The remaining revenue gap of $276M in annual revenue is advertisement generated (Ji, 2011).
The Hulu business model confirms gigantic upside potential in delivering advertisement for Google/Netflix as both Netflix and Hulu+ are very similar services. If leveraged correctly, it is likely to generate significant advertising revenues.
Netflix’s current streaming subscriber base of 21.5M generates roughly $1.92B in annual subscription related revenue at an $8 per customer per month price point (Carmody, 2012). Applying the above referenced formula for Hulu’s advertising generated revenue, Google/Netflix could stand to generate an additional $3.95B in non-subscription revenue. We recognize that Hulu pales in comparison to Netflix’s scale, thus making the direct comparison of advertising potential moot. Given Google’s advertising expertise, we have reason to believe that Netflix could capitalize at a rate equal to 25% of the same effectiveness as Hulu in an expected/base scenario. There’s also reason to believe that substantial upside exists in maintaining these lowered productivity expectations for Google/Netflix.
Best Case Revenue = $1,978,000,000.00 (50% effectiveness) Base Case Revenue = $989,000,000.00 (25% effectiveness) Worst Case Revenue = $395,600,000.00 (10% effectiveness)
(2) A La Carte Streaming Rentals (Appendix 1.7): Summary: Two of Google’s key competitors, Amazon and Apple, already have a competitive edge in the streaming movie rental business. In order to compete with Amazon Prime Streaming and Apple’s iTunes movie streaming capacities, Google will leverage the Netflix platform and content library by allowing non-subscribers to rent movies a la carte at competitive prices.
Details: Google is currently the first and only website or network of sites to tip the 1 billion unique visitors per month threshold (Efrati, 2011). Being an advertising platform clothed in search engine form, Google maintains key metrics related to its advertising effectiveness. The average conversion rate, or the transition from a unique visitor to a retail purchaser, is roughly 1.9%. Social networks like Facebook and Twitter realize conversion rates significantly below this average and range from .5-.02% respectively (Nelson, 2011). AOL (2.9%), Bing (2.6%), and Yahoo (2.4%) lead the pack in conversions rate, yet Google can afford a lower conversion rate because it completely dominates shopping-specific search engine traffic with 80.6% market share (Nelson, 2011).
Armed with this data, we believe that a conservative .5% of Google’s monthly unique visitors will convert to paying customers for one (1) streaming new release per month at a price of $3.49. This change will result in an additional $209.4M per year in revenue (see spreadsheet calculations).
Best Case Revenue = $230,340,000.00 (+10% in conversion performance) Base Case Revenue = $209,400,000.00 Worst Case Revenue = $167,520,000.00 (-20% in conversion performance)
(3) Adding Link to Google Account/Connection with Google + (Appendix 1.8):
3a. Google Account -- Summary:
Google receives a mean of $18.44 per unique visitor each year (Yarow, 2010). Realistically, we believe that 10% of Netflix users who aren’t currently involved in Google will become unique visitors as the creation of a Google account will become mandatory for a Netflix account. In order to incentivize Netflix users to merge their existing accounts with current Google accounts, we will provide users strategic opportunities.
Our financial rationale for merging of accounts is as follows: Netflix currently has 21.5M subscribers who we believe will convert to Google users at the rate of approximately 10%. This conversion will provide additional revenue estimated at 39.64M annually.
Best Case Revenue = $79,292,000 (20% more unique visitors)
Base Case Revenue = $39,646,000 (10% more)
Worst Case Revenue= $19,823,000 (5% more)
3b. Google + /Social Network Conversions -- Summary:
Although shoppers who come to retail sites from Facebook and Twitter are less likely to make purchases in general (conversion rates of 1.2 percent and 0.5 percent respectively), they spend – on average -- more per order than shoppers who come through Google. The average of Facebook and Twitter conversion rates is .85%. Shoppers from Twitter had the highest average order value of $121.33 of all shoppers, compared to the average order value of Google shoppers: $100.16.
Social commerce will reach $30B globally by 2015 with approximately $14B in spending in the U.S. market.
Details: (cited from articles/research)
“How ready are consumers to buy products through social media? A 2010 survey by Booz & Company of consumers who spend at least one hour a month on social networking sites and who have bought at least one product online in the last year provides some insight. Twenty seven percent of respondents said they would be willing to purchase physical goods through social networking sites. Moreover, 10% said their buying through social networking sites will be incremental to other buying they do—that is, they will end up buying more physical goods overall. The 73% who said they would not purchase goods through social networking sites largely cited concerns related to security and privacy, two areas that many big social networking sites are already working to improve" (Anderson, 2011).
"Hyves, the most popular social networking site in the Netherlands, has developed a payment system that allows users to transfer as much as €150 (US$201) to other users to pay for goods available within the Hyves payment system. The Hyves site, which has more than 10 million accounts, has also created a consumer-to-consumer marketplace called Supply & Demand that is analogous to Craigslist, allowing members to post items for sale" (Nelson, 2011).
"Lead generation—the ubiquitous “likes” of Facebook—will not be the most important activity for long, however. The next phase will go beyond mere communication and influencing. Consumers will transact commerce inside social networks—selecting products, adding their selections to shopping carts, and completing purchases through payment with credit cards and points. As they do so, the era of social commerce will commence in earnest" (Anderson, 2011).
Our financial rationale is as follows: If 27% of the 90M G+ users are willing to make purchases, that would provide 24.3M potential purchasers. These potential purchasers may then convert to purchasers at the rate of .85% -- leading to 206,550 conversions. With an average purchase of $100.16 per convert, the synergy could produce $20, 688,048.
Best Case Revenue = $25,818,750 ($125.00 Average Order Value)
Base Case Revenue = $20,688,048 ( $100.16 Average Order Value)
Worst Case Revenue= $15,491,250 ($75.00 Average Order Value)
(4) Tech Savings (Appendix 1.8):
Currently, Netflix does not build or rent out data centers to house its data that is leveraged for the company’s streaming service. Netflix decided to put its infrastructure on Amazon’s cloud services. Netflix's Vice President of Personalization Technology, John Ciancutti, describes it this way: “We could have chosen to build out new data centers, build our own redundancy and fail-over, data synchronization systems, etc. Or, we could opt to write a check to someone else to do that instead” (2010).
That someone is Amazon, the leader in enterprise cloud services -- with Netflix being its highest paying customer for this service. Netflix does not own content, nor does it own much infrastructure. Netflix’s greatest asset is its brand and subscription base. However, with an acquisition by Google, we purport that a synergy of transitioning this data from Amazon’s cloud service to Google’s self-operated data centers would be a net gain of $64.5 million (which is the operating expense to Amazon and is a transferrable price for Google). We believe that these continuous cost savings will have a tremendous impact on value by affecting operating margins for Netflix (and income) over the long term. The value will increase by the present value of the resulting higher income (and cash flows) over time.
Further explanation of our synergy value is that Netflix had 23.8 million total U.S. subscribers as of Sept. 30. 2011, with approximately 21.5M customers having streaming subscriptions. If we use $0.05 cents per streaming movie in Cloud expenses (not content costs) with an average of 10 rentals per month per account, the numbers show that $.50 x 21.5 million subscribers equals $10.75M. Multiplied by 12 months, this approaches $129M in annual cloud expenses (Rayburn, 2009). Based upon 50% profit margin for Amazon’s cloud service, Google could use its own data centers for $64.5 million.
Best Case Revenue = $60,630,000 (6% less cost than Amazon)
Base Case Revenue = $64,500,000 (same price as Amazon)
Worst Case Revenue= $68,370,000 (6% more cost than Amazon)
(5) Minimal Workforce Rationalization/Human Capital Synergy (secondary synergy)
Whom do you keep on?Google kept all 65 employees when it bought YouTube, but there were 4% cuts to Motorola pre-regulatory approval, with many more expected after the finalization of the deal. Based on this and our further research, we are purporting that Google will cut 10% of part-time employees and 5% of full-time employees at Netflix. This will project a cost savings of $8.05M over 2 years.
Netflix currently has 2,180 employees – of whom 400 are full time and compensated with a salary including benefits averaging $137,000 per year per employee. This adds up to $54.8M in direct expense annually (Glass Door, 2011). Additionally, Netflix employs 1780 part time employees with an average salary of $26,153 each, which adds another $46.5M (Glass Door, 2011). Full time and part time compensation totals $101.3M.
We used Motorola’s severance model (after Google acquisition) – it provided an average of $34,000 per employee.
Savings $9,300,000 (Part time employee reduction over 2 year)
Savings $5,480,000 (Full time employee reduction over 2 years)
$ 8.05 million projected cost savings over a 24 month period.
V. Value of Netflix as Part of Google – Offer Price:
Our conservative case, base-level analysis demonstrates that synergies with Netflix total slightly more than $5.27B over a five (5) year period. This synergy value -- combined with a $10.4B stand-alone value -- brings the acquisition total to $15.67B. However, we firmly believe that Google needs to acquire Netflix quickly and quietly at a premium acquisition price of $17.89B.
Economically, we have been in the trenches of a recession for the last 3 years and have reasonable expectations for stronger economic expansion in the next 2-4 years (Lanman, 2012). Despite this recessionary time, Netflix and Google’s business models have expanded. An increase in likelihood for better economic conditions will only provide additional positive impact on this acquisition. Additionally, the Netflix brand is still culturally relevant and growing, as demonstrated by subscription numbers that outperformed expectations in Q4 2011 to the surprise of analysts (Farrell, 2012).
Additionally, we see compatible human capital and culture synergies that are difficult to quantify, yet add qualitatively to the deal. Historically, in pursuing our “Strategy of Everything,” Google has sought to hold onto employees in its platform acquisitions, like YouTube, which has proven to be very effective and profitable.
Finally, the competitive advantage of keeping Netflix out of our primary competitors’ portfolios is perhaps the most significant purpose for this acquisition. Analysts suggested that we overpaid for Motorola Mobility at $12.5B, but this has proven also to be very synergistic and productive, as the Android and iOS mobile phone platforms are competing neck-and-neck domestically (Brodie, 2012, Marsal, 2012).
Amazon: Amazon Prime Streaming is the largest and most direct competitor to Netflix. Google cannot afford to have Amazon dominate the streaming market place. Though cash is not a prerequisite for a deal, it does make it easier. Amazon has approximately $6.33B in cash-on-hand per its Q3 SEC filings (YCharts, 2012).
Apple: Apple has generally followed a technology centric acquisition strategy, thus a Netflix acquisition would be out of character especially considering that Apple has an existing rental platform in iTunes. Cash is king, however, and Apple has $97.6B in cash-on-hand (Emerson & Smith, 2012).
Microsoft: Microsoft is not in the streaming movie space (to the degree it would like to be). It does, however, have an agreement with Netflix to provide streaming services through the Xbox360 gaming system. In 2009, Microsoft reformatted existing search engine capabilities into Bing. It has $51.74B in cash-on-hand per its Q3 SEC filings (YCharts, 2012).
**Works consulted for SWOT include OneSource Reports and “Liqddynamite”**
VII. Key Considerations – Why Netflix should Accept Google’s Offer:
In considering its options for acquisition, Netflix has a multitude of benefits to gain from accepting Google’s bid to become part of the world’s top brand.
(1) Google’s Worldwide Reach and Brand Power:
In 2010, Google was named the world’s most powerful brand (OneSource, 2012). In the United States alone, Google controls 78% of the search market share and 80% of the online pay per click advertising market (Travlos, 2010). Worldwide, the corporation leads the search engine market share by 65% (OneSource, 2012). With the introduction of its browser software Google Chrome, Google tripled its global market share (Travlos, 2010).
As part of the Google Brand, Netflix would gain enormous exposure to worldwide market access. Ultimately, Netflix could tap into any market in the world where Google exists. With 1 billion unique visitors to its site each month, Google’s got the hookup (Efrati, 2011).
(2) Google’s Cash Flow and Technology Savings:
With cash equivalents and short-term marketable securities of $44.6B at its disposal, Google can open its wallet and invest in nearly any strategic, quality initiative of interest (Google, 2012). For Netflix, this would mean a cash deal and access to deep coffers through which the combined companies could greatly enhance, broaden, and diversify the streaming content library. With cash on hand, Google/Netflix could negotiate competitive, lucrative content deals with providers/ licensing firms.
Additionally, Google’s network storage facilities/capabilities would allow Netflix to move its content “in house.” Such a move would not only save Netflix $64.5 million annually, but it would also strengthen Netflix’s competitive advantage over its strongest competitor and current data storage provider – Amazon.
(3) Cultural Synergies:
In planning its approach to acquire Netflix, Google has strategically designed measures to assess cultural compatibility and to evaluate in earnest the areas within each company that would require the most human due diligence efforts prior to, during, and after the acquisition.
Beyond the carefully devised integration plan, several other factors are at play that bode well for the success of the acquisition. Google and Netflix are basically neighbors in California – Mountain View (Google) and Los Gatos (Netflix) are only 14 miles apart. Data and studies show that acquisitions between companies within close locational proximity of one another are more likely to succeed (Pfeffer & Sutton, 2006). Employees and their families would be able to stay rooted in their local neighborhoods and communities, as the acquisition would not require any relocation of talent.
(4) A World of Synergies and Opportunities:
Beyond the benefit of cultural synergy, Google and Netflix have before them a host of grand opportunities for growth of their brands together. From connecting users from both companies through joint Google/Netflix accounts to exposing the Netflix brand to the world through Google’s many platforms, Google can open doors and present Netflix with opportunities for innovation, expansion, and increased profitability and market share.
(5) Actions Speak Loudest – Show Netflix the Money:
As part of Google, Netflix is estimated to be valued at $15.67B (synergy + stand-alone values). Google, however, is offering a premium bid of $17.9B, because it believes fully in the synergies and rewards which both companies would enjoy as a result of Google’s acquisition of Netflix.
VIII. Appendices and Explanations:
Appendix 1: EPS Accretive Dilutive Illustration
Earnings Per Share (EPS) Accretive Test
EPS Accretive Test Summary:
The Earnings Per Share (EPS) Accretive Test is a quick test to show Google’s board of directors that the acquisition of Netflix by Google Inc. would add to its earnings after the first full year after the acquisition (Alexander, 2007). This is based on the notion that the expected 2012E earnings added by both Netflix and the valuation synergies will exceed that of the costs of financing the acquisition. *Since Google Inc. has decided to pay cash for the acquisition the financing costs for Google would be zero. Per the test, Google’s EPS will increase from $28.93 to $31.60 which will take the stock price from $578.54 to $631.94.
Google’s P/E Ratio - The referenced P/E ratio came from Yahoofinance.com.
Shares Outstanding - This number came from Google’s 2011 Annual Financial data where the Diluted Weighted Average Shares was 327.21 (Google, 2012).
Tax Rate - The United States uses corporate tax rate of 35% (Paletta, 2012)
Acquisition Finance Interest Rate - *Per Google’s 2011 Q4 report, the company’s cash equivalents and short-term marketable securities were $44.6 Billion (Google, 2012). Since Google has so much cash, along with the belief that Google’s stock price is currently under-valued, the prudent way forward for acquiring Netflix is through a full cash transaction. This would be no different than how Google made its last major acquisition (Motorola Mobility), for which cash was used to make the transaction for $12.5 Billion (Wauters, 2012).
Appendix 1.1: Google Financials
Assumptions/Justifications made for Google FY12 Financials (used for EPS Accretive Test):(All money referenced below in Millions)
2012E Revenue Growth Rate - Google’s Q4 2011 earnings fell short of expectations (shares fell 8.2%). This was due to a decline in the average cost that advertisers pay Google -- declined from 2011 compared to 2010 levels (Vlastelica, 2012). However, future revenue growth still looks bright with the success of Google Chrome, Google+ and other ventures. With Google’s revenues having increased 29% from 2010 to 2011 and a three year growth rate of 20.7%, it was decided to use the historical information to anticipate revenue growth rate of 20% for 2012 (Google, 2012). This came out to FY2012 revenues being $45,486.00.*
*Note: This 20% growth rate is the same rate used for the growth of synergies (Appendix 1.3, 1.4 & 1.5)
Operating Expenses – Google’s total operating expenses during FY2011 were 69% of revenues. This was quite consistent with 2009 and 2010 (65%) numbers (Google, 2012). Staying consistent with this % of revenues, it is assumed 2012 operating expenses to be at 66% of revenues. This came out to $30,020.76.
Operating Income (EBIT) – Google’s projected FY2012 EBIT was again based on historical trends. Using that average % of revenue from the past four years, it was assumed EBIT to be at 32% of revenues for 2012 (which matched 2011). This came out to $14,555.52
Appendix 1.2: Netflix Financials
Assumptions/Justifications made for Netflix’s FY12 Financials (used for EPS Accretive Test):
FY2012E Revenue Growth Rate - To determine the 2012 revenue growth rate, several different factors were used. First, it was determined that the average year-to-year revenue growth from 2008-2011 was approximately 33% (Hastings, 2012). However, it should also be noted that revenues for 2011 were at a 48% increase from 2010. Additionally, it was predicted by analysts just a few quarters back in 2011 that revenues would be at 68% from 2010 to 2010 (Maurer, 2012).
In addition to reviewing historical data, the present actions and future forecasts needed to be a part of estimating Netflix’s 2012 revenues. Currently, the industry is saturated with competition. However, Netflix saw its first increase in subscriptions in Q4 2011 in a year. Additionally, as it continues to shift its focus from the legacy DVD mail in service to its streaming capability, Netflix customers in Q4 2011 watched more than 2 Billion hours of TV shows and movies through its streaming service (Hastings, 2012). However, analysts are still forecasting Netflix’s 2012 revenue growth to be just 13.6% (Maurer, 2012). With all this said, it was determined that Netflix’s revenue growth rate for 2012 be 20%.
Assumptions/Justifications made for Synergy Valuations - (used for sensitivity analysis appendix 1.9 too)
Synergy Growth Rate – As discussed previously, since Google’s revenues increased 29% from 2010 to 2011 and had a three year growth rate of 20.7%, it was decided to use the historical information to anticipate revenue growth rate of 20% for 2012 (Google, 2012).
Synergy Operating Cost % of Revenue – Figuring the projected operating costs of the added synergies was based on both historical data for the two companies involved with this acquisition and the calculated ratio of assumed synergy implementation costs to added synergy revenue for 2012. When reviewing the last four years of Netflix’s operating expenses, the average for those years was 24% of revenue. Additionally, when looking at the Google’s operating expenses over the last four years, the average came out to approximately 68%. Finally, when determining the implementation costs % of synergies ($445.9/$1,015.52) it came out to 44%.
Therefore, using the operating costs % of revenues (as noted above), it was decided to use Netflix’s operating cost average % of revenues (24%) as the “best case” operating cost % (Appendix 1.3), 44% (Implementation costs of synergies) for the synergies “base” (Appendix 1.4), and 68% as our “worst case” operating cost average % of revenues (Appendix 1.5).
Appendix 1.6: Synergy Waterfall Chart and Valuation Appendix 1.7, 1.8: Synergies 1,2,3,4 Calculations Appendix 1.9: Synergy Sensitivity Analysis Appendix 1.10: Human Due Diligence/Culture Supplements
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Anderson, Matt, Joe Sims, Jerell Price, and Jennifer Brusa. Turning Like to Buy. Booz