Monday, April 28, 2014

NFLX: More competition and higher costs; tough times possibly ahead

Netflix (NFLX) is facing a few 'issues' these days that have come to the forefront and pushed the Company's stock down 32% from its YTD high of $458 in less than 2 months.  We've touched on some of these for a long time.  For example, the fact that NFLX is merely a distributor and its subscription-based-only business model is not a good fit with its efforts to also co-produce original content.  We've talked about the bad pricing strategy that NFLX began implementing early on - starting at a low price.  Recently some new issues are banging on NFLX's door.  They include NFLX's streaming causing a 'traffic jam' for ISPs and increased competition from solid companies, with Microsoft (MSFT) being the latest one.

Regarding the 'traffic jam', given that NFLX is an OTT and it has 35.7MM subscribers, and that many of them go on the 'binge content consumption', it is basically slowing down the Internet for all on-line users, even the non-NFLX Internet users.  In order to maintain at least average performance, ISPs have to increase bandwidth, creating additional costs.  

One way to offset such costs is to increase rates for all Internet subscribers, even the non-NFLX users.  Given the already high prices, we do not think this would be welcomed by consumers.

Another way is to have NFLX and other OTTs pay a premium to make sure content is delivered to households at the right speed and without any interruption.  This appears to be a more logical approach.  We view it similar to toll-roads set up on US highways.  Given many different costs associated with expanding all highways for which all citizens will have to pay via higher taxes, toll-roads (via public and mostly private funding) are set-up for drivers that are willing to pay extra to avoid traffic, or more accurately, to hit less traffic.  Costs of constructing and maintaining a few toll roads are less than costs of expanding all highways, in dollar terms and in terms of environmental costs.  At the same time, those costs are covered mostly via private funding and the tolls paid by those willing to pay.  Tolls increase or decrease based on traffic level.

ISPs such as Comcast (CMCSA) are using this approach.  And the FCC may officially ok such method (with huge oversight and likely caps on how much can be charged) later in May.  We note that wireless companies have been doing this for a long time.  Unlike the CMCSA/NFLX deal, wireless companies are forcing consumers to pay more for more data that they consume online; in other word, tiered pricing.  By the way, NFLX will likely implement tiered pricing to its subscribers.

Whether such premiums are charged for the first mile or the last mile of content delivery, is irrelevant in our opinion.  We do not view this as the end of net neutrality, as some so-called 'pro consumers' have said recently.  In fact, this approach actually makes sure that all Internet users get good performance no matter what content or data they are requesting.

And we must say that NFLX initially approached CMCSA with the proposal that NFLX be treated differently just so NFLX content would get delivered to households or mobile platforms without any hiccups.  Of course, as expected, NFLX did not want to pay a premium for such 'special treatment'.

If FCC finally puts all of this in writing, other ISPs will demand NFLX to pay a premium for content delivery, which will not be very good news for the Company.  We note that NFLX is already barking at another ISP, AT&T (T).

Now let's turn to competition.  As it was widely reported over the weekend, MSFT has taken another step to compete with NFLX and other OTTs.

Unlike Amazon (AMZN), MSFT got its foot in the door a long time ago.  According to the Company, it has around 48MM Xbox Live subscribers.  So the hardware is already in millions of homes and MSFT will be working on providing more than just games; it will try to provide original programming.  This does discount the risk associated with MSFT's Xbox - it is a much more expensive hardware than AMZN's Fire TV.  Then again, Sony has been moving down this path too.  MSFT's Xbox Entertainment Studios certainly won't have big-hit original programming over night, but over time, we could see MSFT's Xbox being the gateway to the one-stop-shop for all types of content, or at least we think that has been MSFT’s strategy.  That 48MM figure can attract many content providers.  Of course, Xbox Entertainment Studios has been working on original programming for a while now.  We note that Xbox users already have access to NFLX via the Xbox.

Overall, competition has intensified for NFLX.  As we mentioned before, its only option is to pay more for premium content and pass that cost down to its subscribers.  And this is a tough task given that NFLX initially priced its service very low.  Unfortunately for NFLX, more competition is good news for the content creators as all players will place higher bids for rights to quality content.  NFLX may not be able to throw money at content as easily as AMZN, MSFT, and some of its other competitors; while at the same time its subscribers may begin frowning at the higher price.

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