Google (GOOG) to Acquire Netflix (NFLX) Corporate Proposal to Google’s Board of Directors
Executive Summary:
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 todeliver 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 enjoysproven 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 modelof 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.
*Note:
-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 determinea plan of action to more fully understandNetflix. 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.