All the ways Netflix actually won even though it lost Warner

The streaming giant’s formal exit from the bidding war for Warner Bros. Discovery has cheered its own shareholders, sending the stock up nearly 14% on Friday. The stock has languished since Netflix announced its deal to acquire Warner in early December, and it was trending down even before that simply on rumors that it might make a play for the storied Hollywood studio. Before Friday, Netflix had shed about a third of its market value since The Wall Street Journal reported in mid-September that Paramount was preparing a bid for Warner.

Why such a harsh reaction? Buying Warner Bros. made sense for Paramount Skydance, whose subscale streaming service has long struggled to compete against the much larger offerings from Netflix, Disney and Warner.

But for Netflix, such a deal would have complicated the business model for a company that had already vaulted to a leading position in Hollywood on its strength as a streaming pure-play. Even its recently diminished market cap had Netflix nearly twice as valuable as Disney and far above any other media outlet. And at $72 billion, the price for Warner was steep for a company with just under $10 billion in annual free cash flow—and no history of doing megasize deals.

Warner could have ended up costing Netflix even more, in terms of both Hollywood drama and political trouble. The entertainment industry remained highly skeptical of Netflix’s stated plans to keep Warner Bros. active in the theatrical movie business. And lawmakers had worries about a deal that could make Netflix even more dominant in the business of scripted entertainment. The need for government approval also made Netflix extra vulnerable to the whims of President Trump, who demanded last week that the company kick a former Biden administration official off its board of directors.

Instead, Netflix will walk away about $2.8 billion richer thanks to the termination fee outlined in their agreement with Warner. And it has run up the price on what will be a larger competitor, once Paramount Skydance and Warner Discovery get their merger over the necessary regulatory hurdles. One risk to losing the deal had been that a combined Paramount-Warner entity could pull popular content off Netflix to use for their own streaming offerings. But the merged company will now need all the cash flow it can muster to service a substantial debt load, so it is unlikely to fully turn away from the biggest payer in town.

That debt load—which Bernstein analyst Laurent Yoon estimates will total close to $100 billion—raises fresh questions about how combining two major studios will affect Hollywood, which has already been battered by shrinking TV and movie production. Substantial layoffs seem certain, but cost cutting alone won’t make the operation into the sort of entertainment powerhouse that can better compete with the likes of Netflix and Disney. Compelling shows and movies will still be needed, and the costs of producing quality content are only going up.

In a report Friday, Robert Fishman of MoffettNathanson said content spending by Paramount-Warner will need to rank “atop its media peers.” But the company will also need to pay down a lot of debt to get back to an investment-grade credit rating, which Paramount Chief Strategy Officer Andy Gordon said the company was “absolutely committed to” in an earnings call on Wednesday.

Peter Supino of Wolfe Research said in his own report that Paramount Warner faces “the difficult task of growing share while simultaneously deleveraging, a balance that could come at the expense of content investment.” In a statement Friday afternoon, Paramount said it sees “a clear path” to investment-grade credit metrics within three years of the deal closing.

Netflix, meanwhile, now needs to convince investors that its pursuit of Warner wasn’t coming from a place of weakness. Even with Friday’s jump, the stock remains about 7% below the price it fetched before the company announced the deal in December. “We believe it is important that Netflix management articulate how it can achieve its long-term growth goals, despite failing to obtain an asset for which it undertook significant risk in trying to acquire,” Guggenheim analyst Michael Morris wrote on Friday.

To that end, Netflix at least showed some strength by pulling the plug early. The company had four business days to top Paramount’s latest offer after Warner said Thursday that it found that bid superior. But Netflix called the whole thing off less than two hours after Warner’s announcement.

That move showed discipline and helped buttress the case by Netflix management that Warner was nice to have, but not a need to have. Keeping a viewing audience engaged in a world awash in YouTube and TikTok videos will provide Netflix plenty of drama on its own.

Write to Dan Gallagher at dan.gallagher@wsj.com