Netflix (NASDAQ:NFLX) has been in the news lately along with Roku (NASDAQ:ROKU), with rumors of Netflix acquiring Roku. Both the companies have witnessed significant declines (-70%) in their stock from their 52-week high, as intense competition and a slowdown in revenue weighs on the stocks.
Factors to consider before acquiring Roku
Revenue and synergies from the acquisition
Both Netflix and Roku’s stock have been hit hard in recent times as competition continues to weigh on the stock price. Netflix needs ways to improve both revenue and margins as it relies mainly on creating original content to drive revenue. Such a business model is expensive, and with management executing poorly on content over the last couple of years, Netflix has lost ground to its competitors. The company needs to find a way to overcome its stagnating growth, and Netflix’s management continues to consider acquiring Roku as way to achieve its goal.
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Roku’s business model is based on what’s called ‘controlling the rails’, where it provides a range of on-ramp services, and makes money through advertising, distribution, and audience-building tools.
If the two were to merge, there would be plenty of opportunities to integrate their operations. There would undoubtedly be accretive effects through the streamlining of content, distribution, and advertising. The reduction from the in costs from the integration of the two companies would allow Netflix to improve margins and/or lower the price of its products for its competitors. Thereby, moving the company in a positive direction.
Roku currently has 66 million users, and Netflix has around 200 million users. These users could benefit from lower costs, and since many users have switched from Netflix to competitors citing quality and price concerns, lower prices could in turn slow down some of those losses.
Netflix could further benefit as the acquisition reduces operating costs. Netflix currently has over 11,300 employees whose cost make up around 5% of revenue. Meanwhile, Roku’s labor cost is closer to 15% of its revenue. It is likely these costs would be streamlined along with other SG&A costs, resulting in higher operating margins.
Accretive effects of the acquisition on margins
Netflix has a gross profit margin of 40%, and Roku's gross profit margin is closer to 50%. As the cost of revenue streamlines, Netflix should be able to push its gross margins towards 43-44%. Meanwhile, operating margins could increase from 20% to around 21-22% due to a reduction in selling and administrative costs. At the moment, Roku runs at a slight loss of about 3% of revenue; as the company’s cost of revenue and operating costs are both absorbed and streamlined by Netflix, Roku would likely turn a profit.
Revenue, profit, and valuation
Roku currently makes around $2.5 billion a year, and Netflix’s revenue stands at around $20 billion. The acquisition could result in a slightly lower total revenue run rate, as the purchase will likely result in re-pricing of products. . Additionally, if Netflix decides to reduce advertising on Roku’s platform, it may result in lower revenue. On the other hand, the investment could also see increased revenue from advertising, with the integration bringing in new advertising streams other than the traditional sources such as other networks
Analysts estimate that Netflix might witness revenue anywhere from $30-32 billion in 2022, and Roku is expected to bring in anywhere from $3.5-3.7 billion. If the acquisition were to go through revenue for the year could come in at anywhere from $35-36 billion. If net profits come in line with estimates, net profit for the year would be anywhere from $7-7.5 billion.
Netflix is likely to fund the takeover of Roku through a mix of cash and debt, when combined with Roku’s debt the acquisition could increase the company’s debt to equity ratio to 1.1-1.2. Currently, Netflix has around $6 billion in cash and $17 billion in short and long-term debt, with a debt-to-equity ratio of 0.825. Debt, should the acquisition go through, would manageable, and the combination of cash flow from the acquisition should help Netflix bring down that debt over the next few years to a more reasonable level.
Negative aspects of the acquisition
Roku does not make much money from Netflix, and if Netflix’s competitors feel Roku’s platform is prioritizing Netflix over, they could move to other OTT platforms. Regardless, competitors aren’t likely to be thrilled about sending revenue to a competitor, even if Netflix remains neutral. Although, it should be noted that buying products and services from competitors isn’t unheard of.
Beyond issues related to the acquisition, Netflix still has issues with its core business, which is content. Content is the primary source of Netflix’s revenue and issues surrounding poor content are yet to be resolved. Unless Netflix improves content, it is likely to continue to lose users to its competitors.
Should the acquisition go through execution will determine whether or not Netflix can successfully turn around its stock price; should the company execute well, the stock may well get back on track.
Netflix is a part of the Entrepreneur Index, which tracks some of the largest publicly traded companies founded and run by entrepreneurs.
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