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Do the markets see an entry problem for new content providers?

On 18 February 2016, the Federal Communications Commission issued a notice of inquiry asking for comments on how regulation can best address reducing barriers to entry to the video content provider market. The Commission believes that cable companies and other multi-channel video programming distributors are in a position to impede the entry of smaller video content providers into the video market. But do video content providers really need the Commission’s help to enter the content provider market? I don’t think so. Rather than going through the twists and turns of a legal argument on whether the Commission has the authority to address the question, why not let the markets determine what content gets offered and accepted by its participants?

Take for example Netflix. Netflix started out as a supplier of rented DVDs distributed via the U.S. mail. While the company still rents out movies in DVD format, it’s its online format that Netflix is best known for today. Consumers now download video content that Netflix has a license to present or can download content produced originally by the online content provider. While its stock has taken a beating over the last twelve months, traders still look at the online video provider as competing ably with the likes of a Comcast or Time Warner’s video product.

From the programming perspective, Netflix produces original content i.e. “House of Cards”, “Orange is the New Black”, and “Marco Polo”, as a hedge, according to Morningstar analyst Neil Macker, against other content programmers that may be holding back their own content from distribution. Netflix, as a result of data captured from its user base, is able to develop or purchase content that suits its viewers’ needs. In other words, Netflix has properly reinvested its capital and other resources to provide a superior content experience as well as built rapidly on an older business model after recognizing and taking advantage of new technology.

Other content providers are going down Netflix’s path. Amazon not only distributes content via the internet but also produces its own content. Hulu is reportedly purchasing original content for distribution as well.

The Commission is running the risk of promising a more open environment for all content imaginable; sending a message that all content is created equally. The Commission is ignoring the fact that there are limited number of distribution channels, whether via cable or over-the-top, and that this natural limit in distributors will create a bottleneck through which only the content deemed attracting the greatest demand will be able to wiggle through. Content that attracts the greatest demand will draw the most see capital investment creating the vicious cycle that smaller entrants will face and the Commission naively assumes it will regulate away.

 

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Is FCC net neutrality policy forcing investors to play broadband providers off of video streaming services?

Do we regulate vans when used to deliver newspapers to grocery stores or pharmacies?  Do we ask grocery stores or pharmacies to disclose the contracts they enter into for displaying The Wall Street Journal or People Magazine on their shelves?  Renting a van to deliver magazines or striking placement deals with grocery stores and pharmacies is the cost of doing business that magazines and newspapers incur when distributing their product and I don’t see why online content providers like Netflix should avoid the same costs of business under a disingenous practice of open internet or net neutrality.

The Federal Communications Commission so far has successfully skirted this argument, having phrased net neutrality as a consumer’s rights issue versus what it truly is: a cost-of-doing business issue for content providers who would rather not pay Comcast, Verizon, or Time Warner a fee to interconnect opting instead for a “bill and keep” scenario.  But like any other media company, Netflix, Hulu, or Amazon should be responsible for putting together their own content production and distribution network.

On the content side these companies will hire their own staff to create content in-house or hire a production company to provide them a set amount of programming.  They will, in the case of movies or television, pay licensing fees that enable them to re-broadcast a television or theatrical production.

The distribution side is trickier.  Netflix depends on mid-mile providers like Cogent and last mile providers like Comcast to connect their content to final end-users or consumers.  To keep these distribution costs low, Netflix would prefer to interconnect at no costs with last-mile providers. In its latest 10-K report filed with the U.S. Securities and Exchange Commission, Netflix describes risks related to its relationship with last-mile providers:

“We rely upon the ability of consumers to access our service through the Internet. To the extent that network operators implement usage based pricing, including meaningful bandwidth caps, or otherwise try to monetize access to their networks by data providers, we could incur greater operating expenses and our member acquisition and retention could be negatively impacted. Furthermore, to the extent network operators create tiers of Internet access service and either charge us for or prohibit us from being available through these tiers, our business could be negatively impacted.
Most network operators that provide consumers with access to the Internet also provide these consumers with multichannel video programming. As such, many network operators have an incentive to use their network infrastructure in a manner adverse to our continued growth and success. For example, Comcast exempted certain of its own Internet video traffic (e.g., Streampix videos to the Xbox 360) from a bandwidth cap that applies to all unaffiliated Internet video traffic (e.g., Netflix videos to the Xbox 360).
While we believe that consumer demand, regulatory oversight and competition will help check these incentives, to the extent that network operators are able to provide preferential treatment to their data as opposed to ours or otherwise implement discriminatory network management practices, our business could be negatively impacted. In some international markets, these same incentives apply however, the consumer demand, regulatory oversight and competition may not be as strong as in our domestic market.”

The irony of Netflix’s statement on the threats broadband operators impose on their streaming business is that a few paragraphs prior to this statement, Netflix describes these providers as partners, specifically when it comes to streaming over devices provided by cable and telecommunications companies:

“We currently offer members the ability to receive streaming content through a host of Internet-connected devices, including TVs, digital video players, television set-top boxes and mobile devices. We have agreements with various cable, satellite and telecommunications operators to make our service available through the television set-top boxes of these service providers. We intend to continue to broaden our capability to instantly stream TV shows and movies to other platforms and partners over time.

If we are not successful in maintaining existing and creating new relationships, or if we encounter technological, content licensing or other impediments to delivering our streaming content to our members via these devices, our ability to grow our business could be adversely impacted. Our agreements with our device partners are typically between one and three years in duration and our business could be adversely affected if, upon expiration, a number of our partners do not continue to provide access to our service or are unwilling to do so on terms acceptable to us, which terms may include the degree of accessibility and prominence of our service.

Furthermore, devices are manufactured and sold by entities other than Netflix and while these entities should be responsible for the devices’ performance, the connection between these devices and Netflix may nonetheless result in consumer dissatisfaction toward Netflix and such dissatisfaction could result in claims against us or otherwise adversely impact our business. In addition, technology changes to our streaming functionality may require that partners update their devices. If partners do not update or otherwise modify their devices, our service and our members’ use and enjoyment could be negatively impacted.”

The consumer-centric statement caters to the public net neutrality argument of supposed threats posed by broadband providers but the statement describing broadband providers as partners, in my opinion, captures the reality of the relationship between content providers like Netflix and broadband providers.  The way to look at how a seamless internet service experience is provided is to look at the components necessary for getting digital product to the consumer.  Netflix has to coordinate via contract the prodiuction of content and its distribution.  It has demonstrated that it can and has entered into the necessary agreements with wireline and wireless providers to get its content distributed to consumers.

As a going concern I expect Netflix to take initiative in reducing its costs of delivery but using government regulation as the method for mitigating costs eventually is not in the consumer’s best interest nor in investor best interests.  Broadband providers will pass on the increased costs of traffic delivery and net neutrality regulatory compliance to consumers.  Increased costs of broadband access will cause consumers to look for other cable or wireless platforms, including different tiers of service which will have a negative impact on broadband operator revenues in the longer run.  Netflix may see a temporary bump in profits but as consumers decide to downgrade service, access to Netflix may be one of those services consumers may end up doing without.

 

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Netflix, Tumblr wanted 1995 not 1934

Internet Innovation Alliance’s Bruce Mehlman wrote an insightful blog post last Friday about the second thoughts companies like Netflix are having about the Federal Communications Commission’s decision to reclassify broadband services as plain old telephone service.  Netflix’s befuddlement over the FCC’s decision to use Title II to drop the regulatory hammer on the internet ecosystem has me wondering how much on the same page were these net neutrality proponents?  The push for net neutrality may be an example of how dysfinctional the left can be when it sells a narrative to multiple classes within its big tent and has the manage the disappointment that ironically occurs when it gets what it wants.

Netflix’s insistence that heavy Ttle II regulation was not a part of its end game has me wondering if progressives had really settled down on a definition of a “fair and open” internet.  The left apparently has not.  To Netflix and other Silicon Valley giants, fair and open appears to mean an internet where they can interconnect in a pre-1996 manner; under some bill and keep methodology with any type of technology they deemed appropriate regardless of a broadband provider’s discomfort.

To the end-users, the four million confused members of the masses, “fair and open” was a rallying cry of the democratic wish; that a fair internet will respect their rights to communicate with whatever website of their choice and move data equally to the end-user no matter the source of the content.

Narrative managers like Public Knowledge and Free Press were successful in conflating the two narratives but were probably inept in educating their supporters, like Tumblr‘s David Karp, as to the downside of using Title II as a mechanism for reconciling the two narratives.  Title II, Mr. Karp and the rest of his Silicon Valley cohorts should have been told that their content operations, particularly the agreements that they enter into to connect to broadband networks, were not guaranteed to escape fees for the exchange of data nor was privacy from prying consumer or competitor eyes or noninterference from the government going to be avoidable.

The FCC may find itself a big loser resulting from its participation in a disingenuous conflation of varying narratives.  It must now deliver on a basket of promises to the consumer as it answers complaints from an an ill-informed electorate regarding every perceived slight in service practice and rate assessments.  It won’t be able to tell consumers or the markets that it never intended to regulate rates.  Consumers won’t stand for that because improving their consumer welfare calls for what they believe is a long awaited initiative to regulate rates.

You wanted 1995?  You may have to settle for 1934.

Ajit Pai asks Netflix what gives on net neutrality

Federal Communications Commission member Ajit Pai yesterday wrote a letter asking Netflix to explain why it is not participating in the development of open standards for video streaming and why, according to press reports, the largest generator of online traffic in North America is using its own proprietary software to cache its traffic.

Mr. Pai is curious about the reports that Netflix may be charting its own course for delivering video services including the development of of fast lanes for its own traffic, all while advocating for equal treatment by internet service providers of content provider traffic.

Open standards, as defined in a paper by Ken Krechner, represent common agreements that enable communications.  Open standards help provide interoperabilty on the internet and maximize access to resources.  I guess what drives Mr. Pai’s curiosity is if the concept of net neutrality is based on transparency of management practices and the equal treatment of data, why would Netflix want o use proprietary caching technology to speed up the transmission of its video services at the cost of competition with other content providers?

Mr. Pai has asked Netflix to respond to his letter by 16 December 2014.

 

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If Netflix was attempting rent seeking, any success may be short-lived.

Gerald Faulhaber and David Farber today published a post questioning the need for open internet rules.  The authors expressed a sense of irony that after decades of successfully running a communications platform built on open network architecture that technologists and engineers today would need the help of the Federal Communications Commission in keeping said network of networks open.

Online video distributor Netflix has been documented as thinking that the Commission should be riding to the rescue of content providers by advocating that the Commission implement strong net neutrality rules.  By strong net neutrality rules Netflix means that the Commission should prohibit the payment of tolls by content providers to broadband operators such as AT&T, Comcast, or Verizon. According to Netflix:

“Without strong net neutrality, big ISPs can demand potentially escalating fees for the interconnection required to deliver high quality service. The big ISPs can make these demands — driving up costs and prices for everyone else — because of their market position.”

Netflix tried to invoke a little altruism asking the Commission to imagine the plight of smaller content providers facing the threat of escalating toll charges assessed year of year at an increasing rate by broadband providers.

It appears the real plight that Netflix is concerned with is the uptick in competition resulting from an HBO or ESPN streaming their content.  For example, an analysis last week by Morningstar questioned the long term profitability of Netflix in the face of competition from content owners.  According to Morningstar:

“Video distribution firms (cable, satellite, phone) have suffered from inertia in building out TV Everywhere, which would allow customers to stream current channels on the device of their choice. Aside from HBO GO and Watch ESPN, the ability to stream channels is much weaker than we would have expected in the present day. Still, we view this service as inevitable within the next two to three years and believe the market is underestimating the potential negative impact on Netflix when most cable channels with fresh content can be streamed.”

This competitive threat, in my opinion, has Netflix seeking rents with net neutrality and Title II as the vehicle.  According to Investopedia, rent seeking is defined as when a company, organization or individual uses their resources to obtain an economic gain from others without reciprocating any benefits back to society through wealth creation.  An example of rent-seeking is when a company lobbies the government for loan subsidies, grants or tariff protection. These activities don’t create any benefit for society; they just redistribute resources from the taxpayers to the special-interest group.

Time Warner’s HBO, Disney’s ESPN, and Viacom’s CBS apparently recognize the need to respond to Netflix’s disruptive model with a little innovation of their own, thus their proposed streaming services.

Would consumers of video content via the internet benefit if competing online streaming providers were ensnared by additional regulations flowing from Title II or net neutrality rules?  No, they would not because fewer online content providers would step up to challenge Netflix and consumer welfare would shrink because of reduced access to video content.

The Commission should recognize that net neutrality and calls for Title II regulation are nothing but attempts at rent seeking.  If Netflix and other content providers believe their content or services are of value to the consumer, they will not need the Commission to intervene in this market.