Netflix Flexes Its Muscles

Having played a pivotal role in persuading the Federal Communications Commission and the Department of Justice to reject Comcast’s attempted merger with Time Warner Cable, Netflix has seemingly done an about face and given its blessing to Charter Communications’ bid to acquire TWC. In a letter to the FCC dated July 15, VP of global public policy Christopher D. Libertelli said, “Netflix  supports the proposed Charter – Time Warner Cable transaction if it incorporates the merger condition proposed by Charter.”

reed_hastingsKey to the apparent change of heart was precisely that “merger condition proposed by Charter,” specifically a commitment by Charter to offer settlement-free peering with edge providers like Netflix across its entire expanded footprint.

“Charter’s new peering policy is a welcome and significant departure from the efforts of some ISPs to collect access tolls on the Internet,” Libertelli wrote. “Charter’s policy will promote efficient interconnection with on line content providers and with the transit and content delivery services that smaller online content providers rely on to reach their consumers. Charter’s endorsement of the policy as an enforceable merger condition will ensure that consumers will receive the fast connection speeds they expect.”

Charter outlined the new policy in a separate filing with the FCC, also dated July 15.

Comcast’s successful effort to impose interconnection fees on Netflix was the main reason Netflix aggressively opposed Comcast’s bid for TWC. Peering agreements were also the main focus of Netflix’s lobbying in support of net neutrality, urging the FCC to require open interconnection policies as part of its Open Internet order (in the end the FCC did not include specific rules for interconnection arrangements in its order, but set up a process for reviewing complaints against ISPs brought by consumers or edge providers).

Seeing Netflix’s success in both the Comcast-TWC review and the net neutrality proceeding, Charter apparently decided the better part of valor was to forgo interconnection fees — effectively granting Netflix de facto veto power over ISP mergers.

BTIG Research analyst Rich Greenfield also calls attention in a recent blog post to a speech to the American Bar Association given by Deputy U.S. Assistant Attorney General for Economic Analysis Nancy Rose in which she discussed the department’s deliberations over the Comcast-TWC deal at length, and in particular the department’s concern that increasing the size of a cable ISP increased both its incentive and ability to harm competing technologies like over-the-top video. Presumably, Charter is aware of those concerns, which may also have been a factor in its do-no-harm pledge (Greenfield, by the way, is skeptical that it will help).

Charter’s commitment to settlement free peering is not indefinite, however. In its filing it pledges to maintain the policy only through December 31, 2018, a mere 3.5 years from now. Still, Netflix is probably right to assume time is ultimately on its side.

By coincidence (or not), Netflix’s letter supporting the Charter-TWC merger came on the same day it reported adding a record 3.3 million new subscribers in the second quarter of 2015, bringing its total to more than 65 million, including more than 42 million in the U.S. If it continues to add an average of a million a quarter in the U.S. it will have more than 56 million U.S. subscribers by December 31, 2018.

At that point, the dynamics of peering arrangements could begin to shift. Netflix would be sending even more traffic onto ISPs’ local networks than it is now with that many subscribers, but it would be virtually impossible by then — if it isn’t already — to sell broadband access service that did not, for whatever reason, include access to Netflix. The history of most media markets, in fact, is that distribution ends up paying for content, not the other way around, as Netflix surely knows. If any money changes hands where Netflix and an ISP’s network meet three and a half years from now it’s as likely to be the ISP paying Netflix, not the reverse.

By the end of 2018, moreover, Netflix will likely face a meaningful incentive to seek revenue from distribution. Domestic growth will have slowed, content costs will have grown, and margins will be under pressure. Netflix CEO Reed Hastings has ruled out advertising as a revenue source, and, though Hastings acknowledged in Netflix’s Q2 earnings interview that some consumer price increases are coming over the next decade there is a limit how far Netflix can push that strategy and still maintain its perceived value advantage over cable, especially as bundles get skinnier.

That leaves distribution as a source of new revenue.

Cable ISPs, of course, understand that logic all too well, and it fills them with dread. Having watched their video margins get eaten up by ever-increasing content costs they are very keen to make sure their high-margin broadband business doesn’t go the same way. As I’ve argued before, the decision by some ISPs to start charging Netflix for interconnection was at least partly motivated by a desire to create facts on the ground that would discourage over-the-top content providers from trying to charge for carriage.

As Greenfield notes in his blog post, that decision has now blown up in the ISPs’ faces at the Justice Department, and Netflix is still riding high. But the inevitable tug-of-war between over-the-top content and distribution is just getting started.