Apple, Not Amazon, Should Buy Netflix

Rumors of a merger between Amazon (AMZN) and Netflix (NFLX) have been rampant for months now, with the latest sending Netflix shares up over $25 each last week. However, with Blockbuster (BBI) lowering prices on their online movie rental service, Netflix is slumping back down to $20 per share. Amazon seems to be trying to get their hand in everything these days, which is probably why rumors of a Netflix purchase won’t go away. However, given the price tag that it would take to land Netflix (about $1 billion after accounting for the company’s $400 million in cash), I think it would make more sense for Apple (AAPL) to make the deal.

Obviously, the mail order rental business won’t be around long term given the move to digital media distribution, so the value in Netflix is their subscriber base. It isn’t clear which method of digital home movie watching will win out five or ten years from now. The retail storefront is already dying, thanks in part to the mail order business, but video-on-demand (VOD) from cable companies like Comcast (CMCSA) seemed like the most reasonable candidate to take over the movie rental industry.

However, Apple TV might throw a wrench into that idea. Being able to purchase movies online, download them to a set-top box, and watch them on your television as well as your computer, iPod, or iPhone could be a game changer. We also learned this week that Apple is in discussions with the movie producers about electronic movie rentals through iTunes, rumored to be $3.99 for a 30-day rental. If Apple can perfect both renting and purchasing movies online, video-on-demand might have a tough time competing since the cable companies would house the content on their own servers, allowing for a lot less mobility and flexibility.

If Apple is serious about rivaling VOD, a purchase of Netflix could make a lot of sense. The mail order business will likely do well until new digital technologies become mainstream, at which point converting users over to a digital model wouldn’t seem to be very difficult. After deducting the cash on Netflix’s balance sheet, an acquirer is paying less than 1 times revenue for their millions of subscribers. I think a Netflix-Apple combination would really match up well against Blockbuster and the cable companies. Netflix is already trying out some new digital download technology to distance itself from Blockbuster, so Apple would be a great partner on that end. An Amazon deal just seems to make less sense, which is perhaps why that rumor seems to never come true.

Full Disclosure: Long shares of Apple at the time of writing

Usually a Contrarian Investor, Kerkorian Takes Aim at Bellagio, City Center Instead

In recent years billionaire investor Kirk Kerkorian and his investment company Tracinda Corp. have been focused on potential value in beaten down automobile companies like General Motors (GM) and Chrysler. However, despite a huge upward revaluation in Las Vegas properties during that time, evidently he still sees value in that area.

Monday we learned that Kerkorian is interested in acquiring the Bellagio hotel and casino as well as a new development project, City Center, which is set to open in 2009. Kerkorian is the majority owner of MGM Mirage (MGM) with a 56% stake in the gaming giant, worth about $10 billion before his intentions were made public. MGM shares rallied 10 points in after-hours trading Monday to $73 per share on the idea that Tracinda might wind up taking MGM private at some point down the line.

The announcement is interesting given Kerkorian’s recent foray into domestic car companies at very depressed prices. MGM Mirage is not a cheap stock (about 12 times 2006 cash flow) but has many growth opportunities ahead, both in Vegas and abroad in Macau. Such a move indicates that he is not worried about a severe economic slowdown, which would almost certainly adversely impact the boom in Las Vegas and Macau that has been very strong during the current worldwide economic expansion. With Kerkorian still willing to buy at these levels, he must think those predicting doom and gloom on the economic front aren’t likely to be vindicated anytime soon.

Full Disclosure: No position in MGM Mirage (unfortunately) or any other company mentioned at the time of writing

Gordon Gekko Coming Back?

The movie Wall Street starring Michael Douglas as a greedy corporate raider in the 1980’s is a classic and although two decades old, it appears the film will be making a comeback. According to a New York Times source, Gordon Gekko is back. Edward Pressman, the producer of the original film, has signed on to make a sequel entitled Money Never Sleeps. Other movies have tried to duplicate Wall Street’s success, Boiler Room comes to mind, but none have really been able to do so. Sequels are rarely as good as the original, but this project is definitely something that has the potential to be a pretty solid film.

Could the Bancroft Family Reject a 67% Premium for Dow Jones?

One of the things I look for when picking stocks is high insider ownership. The logic goes that you want people running the company you own to have their interests aligned with yours. Who is more likely to act in the interests of shareholders, someone with a guaranteed salary and bonus or someone with a large stake in the company and performance-based compensation?

However, few companies do fact have high insider ownership, so finding examples that fit the bill can be difficult. If a CEO gets options that are priced below market and vest immediately, he or she will likely sell them right away and not see any meaningful ownership maintained for the long term.

In the case of media company Dow Jones (DJ), you have very high insider ownership (the Bancroft family controls 64% of the voting rights), so you might think they have shareholders’ interests at heart. However, we get news that News Corp (NWS) has offered $60 per share for DJ, a premium of 67 percent, and yet reports have surfaced that the Bancrofts may be prepared to vote against the deal.

How on earth can the Bancrofts reject a $60 cash offer when their stock is trading at $36 per share? Isn’t that a huge disservice to DJ shareholders? Don’t they have a fiduciary responsibility to take the deal? Legally, probably not. They can vote their shares any way they want. Other shareholders should have been well aware that the family has been against a buyout for years, and should have taken that information into account when they made the choice to invest in the company.

Although the Bancrofts have every right to reject the offer, they should do the right thing for their other shareholders. They should take the company private. If you want to keep the company in your family, as it has been for more than 100 years, that’s fine and very understandable. However, when you are part of a public market, you do have a responsibility to your fellow shareholders. It might be legal, but it is absolutely unfair to DJ investors if you reject a $60 offer for shares that the market says are only worth $36 each.

The “low-ball offer” defense won’t work here. If you want to make financially irrational decisions, then take the firm private and run it any way you want. If you want to open the company up to outside investors, then make sure you treat your shareholders with respect. You own the stock, so it’s your choice which road to go down, but it’s unfair to try and have your cake and eat it too. People invest in public companies to make money. If you make it impossible for them to do so, then you shouldn’t be in the public marketplace in the first place.

Full Disclosure: No position in any of the companies mentioned

Blockbuster Lays Out Growth Targets

Blockbuster (BBI) CEO John Antioco, speaking at an investor conference yesterday, said his company could double its online DVD subscriber base to over 4 million during 2007 as its Total Access promotion continues to pay off. Antioco said that in the 60 days since Total Access was unveiled, Blockbuster has signed up 700,000 new subscribers.

These growth numbers are very interesting. Netflix (NFLX) only added approximately 650,000 subscribers in the fourth quarter, which implies that Blockbuster is ahead of its main competitor in grabbing new business right now. Blockbuster stock is reacting positively, as one would expect, jumping 5% to over $6 per share. It will be interesting to see how Netflix’s 2007 growth projections are impacted, if at all, from Blockbuster’s big push aimed directly at them.

Full Disclosure: No positions

Playing the Online DVD Rental Market

After years of trailing Netflix (NFLX), movie rental giant Blockbuster (BBI) has finally realized that it might have a competitive advantage over its main rival; about 8,500 storefronts worldwide. By integrating in-store and online DVD rentals into its new Total Access movie rental program, Blockbuster is finally making some gains at Netflix’s expense.

However, looking at the share prices of both companies, one has to wonder if Wall Street is too optimistic about Netflix’s future and too pessimistic about that of Blockbuster. Despite having annual revenue that trounces NFLX by a factor of four, Blockbuster’s market cap ($1.09 billion) trails that of Netflix ($1.75 billion) by nearly 40 percent. Netflix’s EBITDA for the first nine months of 2006 came in at $46 million, only 25% of Blockbuster’s $188 million.

So, Blockbuster at first blush appears to be a much cheaper stock with 60% of the market cap of Netflix, but with 4 times as much revenue and EBITDA. Even using a P/E ratio, which hurts Blockbuster given they have a fairly high debt load, BBI shares trade at more than a 10% discount to Netflix based on 2007 projections.

Given these numbers, there has to be some explanation for the wide valuation disparity. Growth investors would surely point out that Netflix is focused solely on the high growth online DVD rental market, whereas the bulk of Blockbuster’s business comes from the storefront, which is a deteriorating market.

That said, Blockbuster’s 8,500 stores are worth something, even if it is far less than five or ten years ago, and Netflix has no stores. Going forward, does NFLX have an advantage over Blockbuster when it comes to securing incremental online DVD rental customers? Making the case that they do is difficult, especially since BBI is now allowing customers to return their online DVD rentals at local stores.

Another way to look at it is to analyze the online DVD rental market itself. I have made the point before on this blog that five or ten years from now it is very possible that nobody will be renting DVD’s on a web site and returning them through the mail. The cable companies seem to have a powerful distribution network via the on-demand model, and there is no reason to think that every movie that Blockbuster and Netflix have could be part of a mass digital library, accessible to every customer who has a cable box.

If the online mail order model does indeed go away, it would be hard to argue that Netflix is better positioned than Blockbuster. Both companies could very well die under such a scenario, but Wall Street seems to be unfairly down on Blockbuster’s prospects versus those of Netflix. The current valuation disparity seems pretty drastic to me, and I’m not sure it makes any sense.

As always, your comments and opinions are welcome.

Full disclosure: No positions in BBI or NFLX.

Harrah’s Apparently Underwhelmed by Offer

While some of the less-knowledgeable anchors on CNBC today were saying that Harrah’s was being bought out by private equity, I couldn’t help but sit back and consider the odds that the casino giant accepts the $81 per share cash offer from Apollo and Texas Pacific. After all, the company’s shares opened at $75.42, jumped to as high as $80.01, and closed back down at $75.62 each.

Since I play arbitrage deals every once in a while, a quote of $75 and change would be intriguing indeed, if the odds of a deal were fairly high. It would likely take 6 to 9 months for a deal to close upon an official agreement, which makes for a nice annualized return for merger arbs. However, after thinking it through, I decided not to pounce yet. And the reasons below might partly explain why the stock is more than $5 below the offer price.

If Harrah’s was truly happy with the offer, wouldn’t they have accepted $81 per share? Instead they merely issued a press release announcing that they had received the offer and formed a special committee to consider it. The way I see it, there are only two reasons why Harrah’s would not have agreed to the proposal. Either they aren’t totally sold on the idea of going private, or they are open to it, but want a better price.

Now it’s true that by making the offer public knowledge, other interested parties could emerge and a bidding war could push the price up. However, we are talking about a $15 billion offer for the HET equity, plus another $10 billion or so in debt, for a total deal value of $25 billion. How many other buyers can afford a deal like this? Not many, so a bidding war seems unlikely.

A more plausible scenario would be for other private equity firms to join in on the bid, allowing for a second offer to be extended if Harrah’s balks at $81 per share. With more investors, the acquiring group can increase their bid, and at the same time, reduce the amount that each must put into the deal.

Who knows exactly what Gary Loveman and the other folks at Harrah’s are thinking here. The offer does represent a 22% premium, but is also slightly below the stock’s 52-week high. Loveman, the CEO of Harrah’s, likely won’t have to worry about losing his job, since it is unlikely that private equity firms have a seasoned gaming executive who would be a better fit for the company. Going private does take away the flexibility of paying for future acquisitions with stock, rather than cash, so that could be a consideration as well.

So how should investors play this? Current holders of HET should hold on, since anything is possible and the stock is not most likely not overvalued at $75 per share. If you are considering getting in as an arbitrage opportunity, make sure you do a stand-alone valuation for the company and feel confident that there is not much downside longer term at $75 should no deal materialize. And finally, for you corporate bond investors out there; Standard and Poor’s downgraded Harrah’s debt to junk status after word of the offer hit the wires. This seems silly to me.

It should be interesting to see how this all plays out and as events unfold, I’ll be sure to post my thoughts.

Disney’s Pixar Buy Looks Even Better

Investors might have been worried when Disney (DIS) announced it would shell out $7 billion for Pixar. However, not only does the animation studio have $1 billion cash on its balance sheet, but Disney announced Monday that it is selling radio station assets to Citadel for $2.7 billion. All of the sudden, DIS only has to cough up about $3 billion of its own money to fund the Pixar acquisition.

Swapping terrestrial radio for a piece of Pixar seems to make sense. By ridding itself of huge licensing payments, Disney should reap much fatter margins on future animated hits. Combined with strong earnings just reported, do recent events make Disney stock a buy?

While Bob Iger’s moves seem to be the right ones, DIS shares don’t look like much of a bargain. Paying 17 times forward earnings for DIS looks steep to me. Plus, the company’s dividend yield is a paltry 1.1 percent, far below the S&P 500’s yield. Investors hoping for great things might be disappointed, but at least the company is making moves.

Changing My Tune on Blockbuster

Many of you may recall my negative piece on Blockbuster (BBI) back in August. At the time the stock was $7 and looked pricey given an extremely competitive business environment and a horrendous balance sheet.

While I still believe video-on-demand is the future, and online DVD rental services are not the answer to BBI’s profit woes, the stock’s swoon to $3.85 as of today’s close signals to me that much, if not all, of the bad news has now been fully priced in.

While a turnaround will not be easy, the company’s stores clearly have some value. Blockbuster’s creditors have been very lenient with respect to possible violations of debt covenants, so bankruptcy in the short-term does not appear to be an issue.

Would I go long now that the stock has dropped 45 percent and could rebound to a decent level? It’s not at the top of my list by any means, as there are many better, safer values to be had.

That said, most of the bad news seems to have played out, so short sellers may be wise to take their hefty profit and move on to something else.

Stern Gets 34M Sirius Shares

The jury is still out on whether or not Sirius Satellite Radio (SIRI) got itself a good deal when it signed Howard Stern to a 5-year, $500 million deal in 2004. Shareholders though, have to question if it was smart to offer Stern and his agent shares of stock, in addition to $100 million a year for his show.

Massive dilution is nothing new to Sirius, as they give stock out without a second thought. CEO Mel Karmazin got $14 million of stock in 2004 alone. This trend explains, in part, why the company is valued at $8.5 billion despite only a $6+ stock price. There are more than 1.3 billion shares outstanding today, and that isn’t even a fully diluted number.

For those keeping track at home, the 34,375,000 share allotment to Howard and his agent, to be delivered on Monday, will be worth $220 million, or 2.6% of the company’s current market value.