Outlook: IPS May Squeeze Netflix for Data Fees

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The U.S. Court of Appeals for the DC Circuit (one level below the Supreme Court) today struck down the FCC rules requiring Internet Service Providers (or, ISPs) to be neutral in their restrictions on bandwidth. Stated differently, with the Net Neutrality rules eliminated, ISPs are permitted to discriminate between various websites, based upon the demands placed on their bandwidth. This means that ISPs can charge content providers for preferential treatment, and means that they can charge based upon the data transmitted. As a practical matter, this ruling will impact those websites that transmit the most data, so sites that stream video content (particularly in high definition) will potentially feel the most significant impact.

Before today’s decision, ISPs were free to charge their end users fees based upon data consumption, but were limited in their ability to charge the websites accessed for transmission over their Internet networks. In the U.S., ISPs have long been reluctant to impose bandwidth caps on end users. Although this practice has become fashionable for cellular data plans, it has seldom been adopted for household data plans, and it is our view that ISPs fought so hard to eliminate the Net Neutrality rules because they have always hoped to charge websites, which would in turn pass the costs on to their advertisers or customers.

This can be read both ways for Netflix. It is arguable that Netflix (NASDAQ:NFLX) might be able to obtain preferential treatment by paying to ensure that its streams queue faster or stream faster and in higher fidelity than its competitors. However, we expect ISPs to behave as if they were profit motivated, and think that they will seek to extract as much value from all websites as the court’s ruling will permit. We think it is far more likely that Netflix will see its users throttled by ISPs unless they pay for unrestricted delivery. In our view, it is most likely that ISPs would seek to extract a set fee per gigabyte “GB” of data transmitted; if we are right, the result would be more costly for Netflix than the status quo, with little or no incremental benefit. It is impossible to predict how this will play out in dollar terms, but directionally, it should mean higher payments by Netflix and/or higher payments by Netflix subscribers.

We think that in the final analysis, Netflix is likely to see its substantial fees imposed by ISPs. Netflix has approximately 30 million users in the U.S. watching an estimated 40 hours of content per month. Standard definition video content contains around 1 GB of data for each hour, while 1080p HD content contains around 6.5 GB of data for each hour, when streamed to a 40 – 50” television (data per hour is much lower for streams to phones or tablets). Based on these assumptions, Netflix customers in the U.S. consume between 14.4 billion GB and 93.6 billion GB of data per year. In our view, ISPs will seek to monetize the repeal of the Net Neutrality rules by imposing a fee on data providers like Netflix on a usage basis.

It is impossible to speculate what the ISPs will do, but we believe it will be helpful to investors to provide an example. As stated above, the ISPs have always been able to charge end users more via data caps, they have so far not done so in the U.S., and appear reluctant to do so. The elimination of Net Neutrality suggests to us that the ISPs find it far more palatable to squeeze the data provider, not its customers. We cannot speculate whether they will charge Netflix, when they will choose to do so, or the amount they may propose to charge. However, based upon the usage calculated in the preceding paragraph, each penny charged per GB of data would result in a range of $144 – $936 million in annual fees charged for Netflix’s current level of data transmission.

We believe it is realistic to assume that ISP charges could be a penny per GB or more. Most people in the U.S. pay $20 or more per month for Internet access, and $40 or more per month for broadband, and most people use around 20 – 100 GB of data. That means that the average user pays $0.20 – $0.40 per GB for consumption (or higher, if they use little data), although the plans do not currently restrict data usage. The current ISP “pie” is approximately 85 million households paying an average of $500 per year for Internet access, totaling $40 billion annually. In order for ISPs to gain 2 – 5 percent of revenue from the repeal of the Net Neutrality rules, they would have to charge data providers $0.01/GB.

Michael Pachter is an analyst at Wedbush Securities. 

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