In recent years, Netflix(NASDAQ: NFLX) has presented a clear growth story for investors: It’s the largest subscription streaming service, operating on a global scale, leveraging its operational efficiency and pricing power as it expands.
But confusion entered the story earlier this month when Netflix announced a definitive agreement to acquire Warner Bros. Discovery‘s(NASDAQ: WBD) Warner Bros. studios and HBO’s streaming business in a cash-and-stock transaction valued at $27.75 per WBD share, representing approximately $82.7 billion in enterprise value. The deal not only introduces risks to the business, but it may also inadvertently expose weaknesses.
Ultimately, Netflix now arguably looks less like a focused platform with an attractive business model and more like one with a capital-intensive need to own more franchises and studios in order to continue growing rapidly.
However, shares have pulled back sharply since the deal was announced. So, are these risks already factored into the price?
Image source: Netflix.
To be clear, Netflix is a great business. Its third-quarter revenue rose 17.2% year over year — an acceleration from 15.9% in Q2. And third-quarter free cash flow was $2.66 billion. Even more, the company expects its operating margin to expand meaningfully in 2025 compared to 2024, even when including a massive one-time charge related to a Brazilian tax dispute. Clearly, the streaming service specialist is not trying to make this massive acquisition to fix some major issue, because there really aren’t any.
But is the acquisition exposing a potential future weakness? Part of the bull case in recent years has been that Netflix can win with product quality and global reach, even as competitors spend heavily. The company has become well-known for its ability to create its own original programming and blockbuster hits, without relying heavily on licensing content from other studios.
The Warner Bros. deal, however, suggests that Netflix’s own content is on a more level playing field with other studios than investors might have assumed. Previously, the story investors bought into was that Netflix was more efficient at creating and distributing content than its competitors. This meant investors were under the impression that Netflix could build out its content slate in a measured and efficient way. But, apparently, the assets Netflix wants to buy from Warner Bros. Discovery are worth $82.7 billion to Netflix — and that’s $82.7 billion that could have been spent on more incremental content creation and product development in the coming years.
The acquisition will “improve our offering and accelerate our business for decades to come,” said Netflix co-CEO Greg Peters in a press release about the deal.
A mega-deal shifts Netflix from a model where content spending is adjustable to a massive investment that investors now have to speculate will work out well.
Complicating matters, Netflix says it plans to maintain Warner Bros.’ current operations. While this would help protect Warner Bros. creative studios, it also limits some of the potential synergies that could occur from a more streamlined approach to combining the companies.
While Netflix stock has taken a substantial hit since the company announced the acquisition, shares still trade at a high premium. The stock’s current price-to-earnings ratio is about 40. But this multiple could compress quickly if Netflix’s acquisition goes through and investors start feeling like the new content, studios, and distribution may not pay off in the return Netflix management was hoping for. Of course, the opposite could also occur; perhaps the deal works out even better than management expects. But the point is, there is a wide range of possible outcomes for such a big acquisition, and this risk factor could weigh on the stock’s valuation as investors demand a wider margin of safety until they have clearer insight into how the acquisition will unfold.
With all of this said, until there’s more visibility about how an acquisition valued at $82.7 billion can provide an attractive return on investment, I’m dubious about the stock’s potential. In other words, I believe that the risk of the growth stock’s valuation multiple coming down over the next few years could offset some of the company’s expected earnings growth, ultimately leading to underperformance.
Of course, I wouldn’t short the stock. Even more, I wouldn’t predict that shares would be trading lower a few years from now. But I wouldn’t call the stock a buy either — at least not until I have more visibility.
So, is Netflix stock a buy, sell, or hold?
For now, I’ll go with “hold.”
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Daniel Sparks and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Netflix and Warner Bros. Discovery. The Motley Fool has a disclosure policy.
