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Exposing Netflix’ Extraordinary Net Neutrality Arbitrage

Netflix’ defensive reaction to the Appeals Court Verizon v. FCC decision in its recent shareholder letter speaks volumes about Netflix’s unique and extraordinary net neutrality regulatory arbitrage. It also begs much more scrutiny.

This analysis exposes: how deceptive Netflix has been to its investors about its regulatory risk; how critical Netflix’ misrepresentation of net neutrality to investors has been to its entire economic model; and how relatively wasteful and irresponsible Netflix is in its utilization of the Internet’s bandwidth.

Importantly, this analysis will expose how Netflix, more than any commercial entity, cleverly has lucratively gamed and misrepresented the net neutrality issue for its commercial gain, not for the purported benefit of its subscribers or Internet users overall. You will learn Netflix is a unique corporate net neutrality player and arbitrageur. It is actually very different from, and is a much less responsible corporate bandwidth user than Google-YouTube, the Internet’s second-highest bandwidth user in the U.S.  

The simple message of this economic analysis is what Netflix investors understand as exceptionally-lucrative, regulatory-arbitrage of implicit, zero-price regulation -- people in Washington can appreciate as rent-seeking from competitors and special-pleading for corporate welfare from the public.

In its shareholder letter, Netflix preemptively positioned itself as the potential victim of some future net neutrality violation and demonized ISPs as anti-consumer, if they are left to their own devices in a competitive market.

  • In principle, a domestic ISP now can legally impede the video streams that members request from Netflix, degrading the experience we jointly provide. The motivation could be to get Netflix to pay fees to stop this degradation. Were this draconian scenario to unfold with some ISP, we would vigorously protest and encourage our members to demand the open Internet they are paying their ISP to deliver.”  

Let’s first examine the regulatory facts about net neutrality and the court decision as it pertains to Netflix.

The Appeals Court said FCC has the “general authority to regulate,” broadband/net neutrality, and to “promulgate rules governing broadband providers’ treatment of Internet traffic,” in order to “preserve and facilitate the “virtuous circle” of innovation that has driven the explosive growth of the Internet.

Practically, this means the FCC has the section 706 authority to prevent blocking, degrading or impairing of consumers’ access to the legal content and applications of their choice.

However, Netflix is misrepresenting the court’s prohibition on applying common carrier price regulation of broadband prices. In the oral argument the Judges made it clear that it was common-carrier-like regulation that prevented a two-sided bandwidth market from forming. In its decision, it ruled that Congress “expressly prohibits” the FCC from regulating broadband information services as a common-carrier.

Investors in particular need to understand what this very big distinction means, because it is critical to Netflix’ regulatory arbitrage model, scheme, and market valuation.

Simply, Netflix’s model depends on the most-controversial conception of net neutrality, which is mandated zero-pricing of downstream traffic; in other words a new permanent economic entitlement of a huge price-subsidy of downstream-heavy players (like Netflix) by consumers. (To understand the thinking behind this most-controversial view of net neutrality, see Professor Tim Wu’s 2009 paper: “Subsidizing Creativity through Network Design: Zero-Pricing and Net Neutrality.”)

This knowledge of Netflix’ less-than-forthright public explanations should prompt Netflix investors to ask Netflix management some very specific questions central to the justification for its nosebleed valuation.

First, does Netflix want/need the FCC to retry and mandate an effective, permanent, zero-price regulation for downstream Internet traffic, which is what the FCC’s latest struck-down net neutrality rules implied, but did not make definitive?

Second, is Netflix calling for, or does its business depend on, the FCC reclassifying broadband as a Title II common carrier service, in order for its current regulatory arbitrage model of no-cost for downstream bandwidth to be permanent and administratively workable?

Third, is Netflix is calling for FCC reclassification even behind-the-scenes? And if so, what percentage likelihood does Netflix believe investors should factor in that the FCC will do what Netflix wants/needs?

Fourth, why has it not been a violation of Netflix’ vision of net neutrality for Amazon to pay for users’ bandwidth to download books and movies to its various Kindle devices over the last several years? And if not, why would it be a violation of net neutrality for Netflix to agree to share the cost of users bandwidth to watch Netflix programming, especially given the unique circumstances that Netflix’ consumes nearly a third of all downstream Internet traffic per Sandvine?

Second, let’s examine the economic facts to provide some more interesting and telling perspective here.

Netflix has positioned itself to the market as the lone consistent, fast-growth company in its stock category that should be worthy of the highest stock valuation. It has succeeded wildly at that clever scheme. Netflix enjoys a nosebleed valuation metric of a 325 price-to-earnings ratio.  That’s 16 times higher than the S&P 500 average and even 10 times higher than Google’s. 

So what is the “special sauce” that Netflix has sold investors to fuel such a speculative nosebleed valuation like Netflix currently enjoys?

With a wink and a nod to investors, Netflix claims with its net neutrality spin that Netflix will forever be exempt from paying anything for the very high cost of its video-streaming distribution of ultra HD videos to customers. That means Netflix effectively is promising investors that no matter how much of the Internet’s downstream bandwidth Netflix consumes or how much costs their wasteful their bandwidth usage is, that Netflix shareholders will never have to pay anything for the streaming delivery of their Ultra HD videos to consumers.

In other words, Netflix effectively is saying that it is deserving of, and will forever receive, a permanent FCC economic entitlement (implicit zero-price subsidy) of not paying for the costly delivery of their product to consumers, because it would be a net neutrality “violation” for broadband providers to experiment with a two-sided broadband business model to lessen the financial burden on consumers of shouldering to full cost of bandwidth.

Here we should connect the dots between Netflix’ claimed net neutrality economic entitlement and Netflix’s nosebleed valuation.

If Netflix paid part of the cost of its viewers’ bandwidth, like its competitor Amazon does on the Kindle Fire, it would expose that Netflix’ long-term cost projections are grossly underestimated.

That in turn would mean Netflix is actually much less profitable and has less money to fund fast subscriber growth overseas than Netflix lets on. And if Netflix does not grow as fast as it does now, its value could plummet as much as 75%, to Google’s generous price/earnings valuation of 31, not Netflix’ current 325.

That in turn could mean that Netflix in the real world without speculative stock levitation of bubble thinking, may not be worth its current $23b market valuation, but may be more in the earthbound range of ~$6B. That in turn again would mean Netflix’ management may not be billionaires.

This connect-a-dot exposes the huge financial motivation that Netflix has to misrepresent its definition of hoped for net neutrality policy, and also the legal/political reality that ongoing corporate welfare for billionaire arbitrageurs is not bankable long term.

Painting Netflix as the victim of discrimination and not the perpetrator of a stock levitation scheme may be clever PR, but it is not forthright forward-looking guidance to public investors.         

Lastly let’s now consider how Netflix is a uniquely irresponsible corporate user of the Internet’s bandwidth.      

Remember Sandvine tells us that Netflix consumes 31.6% of all downstream bandwidth while second place is Google-YouTube at 18.7% -- a relative downstream usage ratio or 1.7/1.

To put this in better perspective, we now need to look at the relative volumes of video streamed and hours viewed monthly between Netflix and Google-YouTube, in order to learn that while Google is a bandwidth hog, Netflix is a genuine bandwidth blue whale.

Let’s do some proxy math to expose just how voracious Netflix’ relative bandwidth consumption is.

Let’s start with Nielsen numbers because they are the only ones that recently (2012) relatively compare Netflix and YouTube by viewer hours per month – 10:25 for Netflix and 4:43 for YouTube – a relative usage ratio of 2.2/1. Now consider how many fewer streaming viewers that Netflix has ~33m vs. YouTube ~138m – a relative viewer ratio of 1/4.2. Multiplying the two ratios (4.2/2.2 = 1.9) to get a relative figure for how many relative total viewer hours a month, one then gets that Google-YouTube streams ~90% more hours of downstream viewing than Netflix.

Now let’s put these Neilsen relative numbers together with the Sandvine relative numbers. Google has 90% more streaming hours than Netflix in the U.S. (1.9), but Sandvine finds that Google uses 40% less downstream bandwidth than Netflix (.6). Combine these ratios 1.9/.6, and it indicates that Google is three times more efficient in its utilization of its downstream-bandwidth than Netflix is -- three times!

Now we can see why Netflix is such an irresponsible and wasteful user of the Internet’s bandwidth. Even though Google-YouTube streams 90% more hours of video than Netflix it utilizes 40% of the Internet’s bandwidth in the U.S.

While readers know I am highly critical of Google-YouTube’s many abuses, in this instance Google-YouTube is a vastly more responsible steward of the Internet bandwidth it utilizes than Netflix.

In part because of the 2008 research report I published showing how much bandwidth Google-YouTube used versus what it was paying for, Google has since invested billions of dollars in content delivery networks and local infrastructure to more efficiently use the collective Internet infrastructure. For this I commend them for being much more responsible in this area, and I spotlight how wasteful and irresponsible Netflix is in seeking to push all its distribution costs onto others because that’s the straight economic incentive of zero-pricing for downstream Internet traffic.

In sum, Netflix should be more forthright about its net neutrality scheme to investors and regulators.

First, Netflix is misrepresenting the extent of its regulatory risk to investors, given what it is really asking for and needs from the FCC is a business model bailout and a multi-billion-dollar, economic entitlement from the FCC, in the form of zero-price regulation for downstream bandwidth, based on common carrier regulatory authority that the Appeals Court just rejected.  

Second, Netflix has inflated its valuation to stratospheric levels in part by over-minimizing the real risk to Netflix’s grand, regulatory-arbitrage, business-model, assumption, that Netflix’ management has to know is much shakier than they are letting on to investors.

Third, Netflix’ own wasteful and irresponsible utilization of the Internet infrastructure is a direct result of the gross asymmetric pricing scheme Netflix promotes, i.e. 100% cost recovery in upstream price vs. 0%  cost recovery in the downstream price, despite the fact that provisioning to meet downstream demand costs vastly more than provisioning to meet upstream demand.

Netflix’ favored, upside-down, uneconomics are insanely distorting of the market and ripe for abuse, speculation and manipulation.

Lastly, if investors imagine that over-the-top video models should mean guaranteed, permanent, economic entitlement, of mandated zero-pricing for downstream Internet traffic paid completely by consumers, they are not being realistic… or investing – they are speculating on uneconomic, unsustainable, regulatory arbitrage based on a economically fantastical storyline from those who most financially benefit from the story. 

If anyone at the FCC imagines that it is good economic or regulatory policy that over-the-top video models should be granted a permanent economic entitlement of asymmetric, zero-price subsidies for downstream Internet traffic, they should go back and examine the centrally destructive role that uneconomic asymmetric FCC pricing mandates played in the late 1990s, which directly contributed to the burst of a trillion dollar fiber bubble and the bankruptcy of the entire CLEC industry when the tech bubble burst in 2002.

Simply, forewarned is forearmed. Trying to mandate asymmetric and/or uneconomic pricing on any party in the Internet ecosystem creates an arbitrage market not an economic competitive market. Promoting uneconomic pricing schemes predictably will end badly.   

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Netflix Research Series

Part 1:  Level 3 & Net Neutrality - Ignorance Unleashed! [11-30-10]

Part 2:  Level 3-Netflix Expose their Hidden Agenda [12-3-10]

Part 3:   Sinking Level 3 Seeking FCC Internet Regulation Bailout [12-8-10]

Part 4:  Netflix' Open Internet Entitlement Hubris [2-1-11]

Part 5:   Fact-Checking Netflix' Net Neutrality WSJ Op-ed [7-8-11]

Part 6:  Netflix' Glass House Temper Tantrum Over Broadband Usage Fees [7-26-11]

Part 7:  Netflix Crushes its Own Momentum [9-20-11]

Part 8:  Netflix the Unpredictable [10-10-11]

Part 9:   Is Netflix the AOL of Web Streaming? [3-9-12]

Part 10: Netflix' Net Neutrality Corporate Welfare Plan [5-9-12]

Part 11: 5 BIG Implications from Court Signals on Net Neutrality - A Special Report [9-13-13]

Part 12: Video: Why FCC Title II Reclassification of Broadband is a Legal Non-Starter [9-22-13]

Part 13:  Is Net Neutrality Trying to Mutate into an Economic Entitlement?

 

Q&A One Pager Debunking Net Neutrality Myths