There has been a lot of chatter over the past few years that Apple should make a more drastic move into the media/entertainment industry. While the company has been nibbling at the edges it made a major move this past week hiring two Sony Pictures Television executives where they have served as presidents since 2005. Jamie Erlicht and Zack Van Amburg have been instrumental in more than tripling Sony’s original primetime shows and utilizing Amazon, Hulu and Netflix for distribution.
One acquisition that investors and analysts have been calling for Apple to do is to buy Netflix. While there are strategic reasons that this acquisition could make sense (but would also have its challenges in various ways) I’ve built a financial model for the combined company with projections three years out. I’ve downloaded it into a Google Doc that is available via this link so that you can see my assumptions.
The first set of assumptions are for Apple’s and Netflix’s revenue, gross margin, operating expense ratio, other income and interest expense, tax rate and share count three years out from their last fiscal year.
The second set is the premium Apple will have to pay above Netflix’s current stock price (I’m using 30%) and how Apple pays for it using debt and/or stock. I’ve run three cases with 100% debt, 50% debt and stock and 100% stock. These provide EPS estimates and can be compared to a three year base case if Apple does not buy Netflix.
Obviously making three year projections is imperfect and more cases than the ones I have done would be run by an acquirer. However the results at least provide some insight what the financial ramifications would be with the merger.
Apple assumptions
Apple is a slower growth company than Netflix and has a longer history to make some rational projections. However given that the company’s iPhone hit driven revenue stream that makes longer term projections harder. That being said these are my Apple assumptions over three years.
- Average revenue growth of 5% per year
- Gross margins decrease from 39.1% to 37.0%
- Operating expenses as a percent of revenue fall slightly from 11.2% to 11.0%
- Operating margin falls from 27.8% to 26.0%
- Other income increases from $1.3 to $2.0 billion per year
- Tax rate stays essentially the same at 25.5%
- Share count decreases by 4% per year
When you run these assumptions Apple’s EPS increases from $8.47 in fiscal 2016 to $10.45 in fiscal 2019. So the $10.45 of EPS becomes the baseline to compare buying Netflix.
Netflix assumptions
Netflix assumptions have a higher degree of difficulty due to it being a younger and much faster growing company. Besides growing faster it is harder to determine how much earnings leverage the revenue growth will provide. I have tried to be generous in this aspect as the company’s operating margin increases from 4.3% in 2016 (and it was 4.5% in 2015) to 15.0% in 2019. These are the assumptions I am using.
- Average revenue growth of 25% per year (was 30% in 2016)
- Gross margin increases from 31.7% to 35.0%
- Operating expenses as a percent of revenue falls from 27.4% to 20.0%
- Operating margin increases from 4.3% to 15.0%
- Other income increases from $31 to $100 million
- Interest payments increase from $150 to $200 million
- Tax rate decreases slightly from 28.3% to 28.0%
As a point of reference if Netflix’s share count increases 1% per year (it increased 0.5% in fiscal 2016) then its EPS would increase from $0.43 in 2016 to $3.96 in 2019. At the current stock price its 2019 PE multiple would be 38.5x vs. the current 358x.
Combined companies EPS
When you smash together the two companies financials the first item to notice is that Netflix’s revenue is only 6.5% of the two companies in 2019. Next is that since their gross margins are fairly close to each other there isn’t a hit to it.
The impact winds up being on the bottom line. Netflix’s market cap is currently $67 billion so if Apple pays a 30% premium it will have to come up with $87 billion. Netflix has more debt than cash so there isn’t any help from its balance sheet.
If Apple could use all debt and assuming a 4% interest rate the annual interest payments would be a bit over $3.5 billion. Since Netflix on its own would only contribute $2.5 billion it would cost Apple just over $1 billion in pre-tax profit to buy Netflix using 100% debt. The resulting EPS would be $10.08, which is less than the $10.45 Apple is projected to earn on its own.
The case for using half debt and half equity is even worse for Apple’s bottom line. While the interest payments are cut in half Apple would have to issue 305 million extra shares. While the combined companies pre-tax profit is higher by $691 million the extra shares more than offset this and the resulting EPS is $9.82.
The worst case scenario is using all equity. While the additional interest payments aren’t incurred and pre-tax profit increases by $2.4 billion the share count increases by 611 million. This reduces EPS to $9.58 or almost a full dollar less than the $10.45 Apple could earn on its own. It isn’t surprising that the EPS result is worse if Apple uses all equity since Netflix sports such a high PE multiple.
While there are strategic reasons for Apple to buy Netflix, when you look at the financials, it would take a long time for the bet to pay off, if it ever does.
