Outlook: Netflix Announces Multi-Year Agreement With Comcast

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On Sunday, Netflix (NASDAQ:NFLX) announced a multi-year interconnection agreement with Comcast to provide the broadband provider’s domestic customers with a high-quality Netflix video experience. The agreement was described as “mutually beneficial” in the press release, but terms were not disclosed. We expect the agreement to prevent slowing down (or, throttling) of Netflix’s video streaming service by Comcast. Throttling has become a more high-profile issue for Netflix in the last couple of months due to the recent U.S. Court of Appeals ruling on Net Neutrality (see below) and reports of Verizon slowing down Netflix streaming for its FiOS subscribers. We believe that Comcast and Time Warner Cable, both currently in merger discussions, represent around 35 percent of U.S. broadband households. While we believe that the amount to be paid by Netflix to Comcast is likely relatively small, we believe that in the aggregate, payments to Internet Service Providers (ISPs) will be quite large in the next several years.

In its Q4:13 letter to shareholders, Netflix management described the concept of a domestic ISP impeding a Netflix video stream to get additional fees as a “draconian scenario.” In response, Netflix said that it would “vigorously protest and encourage our members to demand the open Internet they are paying their ISP to deliver.” We think that this comment was quite disingenuous, as Netflix was reportedly in talks with Comcast about paying for access to its broadband network at the time it issued its letter. We think that the agreement reinforces the leverage that broadband providers have over Netflix, leaving the latter no recourse other than to open its checkbook (albeit for an undisclosed amount), as service degradation is a real threat now that the Net Neutrality rules have been eliminated.

We expect agreements with other ISPs in coming months, also at undisclosed terms, although Verizon appears to be the most likely to seek very high fees from Netflix, given that it was the lead plaintiff in the Net Neutrality challenge discussed below. In our view, Comcast had an incentive to strike a deal prior to public hearings on its proposed Time Warner Cable acquisition, as the company seeks to expand its foot print in broadband service and likely preferred to have Netflix remain silent.

Last month, the U.S. Court of Appeals for the DC Circuit (one level below the Supreme Court) struck down the FCC rules requiring 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 that it 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.

We think Netflix may see its users throttled by ISPs unless users or Netflix itself pay for unrestricted delivery, as it appears to have done so with Comcast. Based on comments from Netflix CEO Reed Hastings on his Facebook page, it appears that the average Netflix household consumes 40 hours of streaming content per month; we believe that this level of streaming comprises 40-250 GB of data per month, given that a standard definition video stream to a 40-inch or larger television consumes approximately 1 GB per hour and ahigh definition video stream at 1080p resolution consumes approximately 6.5 GB per hour.

Based on these figures, we believe that the average Netflix household consumes more than 100 GB per month, and believe that the average Internet service bill is around $50 per month, meaning that consumers pay approximately $0.50/GB for access to Netflix content. The Comcast-Netflix agreement reinforces our belief that ISPs are reluctant to charge users more, but are unconcerned about charging Netflix a nominal amount. While we think Netflix received a preferential rate from Comcast for a limited period, we think that its aggregate costs will escalate considerably in the coming years.

We estimate that Comcast will charge Netflix between $25 – $50 million annually for a term of 3 – 5 years. We think that Comcast likely sought as much as $0.01/GB transmitted, but think that the companies settled for a fraction of that amount. As we stated above, we believe that Netflix’s 33 million U.S. streaming customers consume an average of 100 GB of data per month, suggesting that Netflix’s throughput across all U.S. broadband is 3.3 billion GB of data per month. At $0.01 per GB, we Netflix would be required to pay approximately $400 million per year, over two-thirds of 2014 consensus operating profit. We think that Comcast was motivated to get a deal in place prior to its merger, but do not expect Verizon , AT&T, Charter, Cablevision or any other U.S. broadband provider to be similarly motivated to strike a deal.

Michael Pachter is an analyst at Wedbush Securities. 

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