SAN FRANCISCO (CNN/Money) -
Last week, Netflix investors gave two thumbs-up to the news that the company had been awarded a patent that appears to offer protection for many key parts of its DVD subscription service. The stock had shot up nearly 20 percent during the week, trading Friday near its 52-week high of $26.35.
But what does the patent cover? Is it enough to help Netflix compete with the newly launched, less expensive Wal-mart (WMT: Research, Estimates) DVD service? More important, does the patent make Netflix an attractive takeover target for Wal-Mart or Blockbuster (BBI: Research, Estimates) (which is toying with the idea of launching its own DVD subscription service)?
First, a little background. Netflix (NFLX: Research, Estimates) applied for the patent, which covers most aspects of its business model, in 2000, two years after the company was formed and one year after it launched its online DVD subscription service.
Even without patent protection, Netflix has done well in its short life, signing up more than 1 million customers, stocking over 15,000 titles, and effectively rewriting the way Hollywood views its inventory (see "How Netflix Is Fixing Hollywood").
The company was no slouch in its most recent quarter either. Netflix reported $55.7 million in revenue and announced that it would begin expensing stock options. Including its recent patent-fueled run-up, the stock has more than doubled since the beginning of the year.
"We're going to win in the marketplace, with or without the patent," a Netflix spokesperson says. "But the patent is a nice acknowledgment."
Indeed it is. "It's an incredibly extensive patent," says R.J. Jones, an analyst with Delafield Hambrecht. The patent covers the processes that enable customers to rent a maximum number of DVD titles at one time and to search for those DVDs by title, actor, or genre. This appears to spell trouble for both Wal-Mart and Blockbuster, neither of which would comment on the patent.
What to do with the new patent?
The most obvious question is, What will Netflix do with its new patent? It could immediately send a cease-and-desist notice to Wal-Mart and Blockbuster, both of which possess deep pockets and could try to bleed Netflix through the courts.
Or Netflix could try to establish licensing agreements with its competition to open up a healthy revenue stream like the one pouring into Amazon.com (AMZN: Research, Estimates) thanks to Apple Computer (AAPL: Research, Estimates), which licensed Amazon's "one-click" patent for its iTunes store. Apple gives Amazon a small percentage of each song sold through the one-click technology (both companies were tight-lipped on the specifics).
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But some observers believe that the Netflix patent makes the company a very attractive takeover target. "It's the frosting on the Netflix cake," Jones says.
Interest in a Netflix acquisition makes sense: The company has been around for five years, has built a solid distribution system, expects to post a profit this quarter for the first time, and has more than 1 million customers. The fact that a buyer could score all that and a patent to boot is pretty sweet.
Of course, with a market cap north of $500 million and climbing, Netflix is out of reach for most prospective acquirers.
But Dennis McAlpine, a managing partner at McAlpine Associates, points out that only a few companies are likely interested. "If I were a company that had a distribution system like Wal-Mart, and I wanted to get into the business, I would say, Let's buy Netflix and eliminate the build."
Netflix won't comment on that idea. But one thing is certain: Netflix and its new competitors are heading for a season of action and adventure.
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