Net Neutrality: Treating the Symptoms Rather than the Disease

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The debate on net neutrality is poised to intensify as the FCC considers the President’s request to regulate broadband as Title II common carriage and as it evaluates CMCSA’s proposed merger with TWC. We see merit on both sides of the issues as advocates argue past each other from very different premises. Net Neutrality is a Myth – The internet has a long history of companies paying for superior performance, and outlawing the practice would destroy a market feedback loop that, theoretically, drives investment and ensures value to the consumer.  Broadband is a Monopoly – 60% of Americans have no choice, and most of the rest have just 2 choices for broadband service. This concentration has already yielded unusually high prices and poor service quality, and carriers have begun to exert their market power to extract potentially egregious rents from internet content providers. Consequences – Market valuations assume that broadband operators will NOT face constraining regulation or vigorous competition. This is likely true in the next 2-3 years, although it is possible that the FCC will accede to the White House and reclassify broadband. Longer term, rising prices, content throttling outside the paid “fast lane”, and continued poor service and investment, could yield consumer unrest and strengthen support for regulation. Moreover, we continue to believe that wireless could be a viable alternative by the end of the decade. As these outcomes become more likely, the narrative for stocks like CMCSA, TWC, CHTR, VZ and T will turn gloomy.

Net neutrality in the headlines. The FCC’s 5 commissioners are appointed by the President but it answers to Congress and must have no more than 3 members from the same party. Thus, Chairman Tom Wheeler is not beholden to follow Obama’s recent request to regulate broadband providers as “common carriers”, particularly given the anti-regulation sentiment in the Republican controlled House. Still, public sentiment appears firmly behind rules to keep cable operators and telcos from throttling access to sites unable or unwilling to pay “fast lane” tolls. The commission is expected to reveal its net neutrality strategy soon, with possible approaches ranging from Title II reclassification to voluntary self-regulation. In the same timeframe, the FCC is evaluating CMCSA’s plans to acquire TWC.

Arguing different questions. Opponents of net neutrality correctly point out the internet has always featured “fast lanes” and that these agreements can spur investment and give consumers better service for high-value and technically demanding services like streaming media. Heavy handed regulation could stifle innovation. Advocates counter that broadband is uncompetitive, and that left unregulated, operators will seek monopoly rents from both consumers and content providers while holding back capital investment, all at levels that would price out the poor and the small while thwarting the development of the digital economy. Both views have significant merit but ignore the bigger picture.

The net has never been neutral. The public internet works by facilitating the delivery of data across multiple private networks. Historically, data speeds were regulated by the ability of small networks to negotiate direct connection to the largest networks for a fee – otherwise, connection was via low performance public exchanges. With time, internet protocols gave carriers the ability to prioritize some data packets over others, and services were offered to commercial customers for “fast lane” service. On the consumer side, high volume content providers began to negotiate the co-location of servers directly with distribution networks to speed delivery. Opponents of net neutrality are concerned that innovations like these, which have clearly benefitted consumers, would be stifled by regulation.

Cable has won broadband and is poised to exploit its market power. Cable broadband is the only option for 60% of US households. For most others, their telco offers a viable alternative but does not compete aggressively on price. The result has been broadband bills growing at over 6% to $51/mo. in 2014, a ~30% premium vs. Western Europe at 30Mbps. Significantly greater value is delivered in US cities with vigorous competition, like Kansas City or San Francisco. We also note that cable companies’ capital spending has run far below operating cash flow in recent years, belying the assertion that the light regulation stimulates investment. Comcast’s much hyped Xfinity X1 service is installed in just 11-12% of its customer households more than 2½ years after introduction. It is easy to see the risks inherent in allowing cable MSOs to exert their market power against internet-based services as well as consumers.

Strong regulation would crush the cable investment narrative. If the FCC designates broadband providers as Title II common carriers, it could require service pricing and content provider connection fees to be approved by the commission, perhaps holding operators to a modest return on investment and mandating upgrades for underserved geographies. In this scenario, assumptions of extraordinary future cash flows would almost certainly be false, and the CMCSA/TWC merger would be impossible.

Mild regulation is built into current expectations. Consensus expects 4-8% cable sales growth and margin expansion across the industry. P/E ratios hover around 20x, reflecting expectations for strong long term earnings growth. Given that broadband is a growing 30% of industry revenues and nearly 2/3rds of its profits, analysts are not anticipating risk to broadband in their cable market forecasts. With FCC Chairman Wheeler dithering, a Republican Congress, and upcoming Presidential elections, the status quo is a plausible outcome. While we expect fixed wireless broadband to offer real competition by 2020, this risk is not yet well appreciated and cable stocks could be expected to perform well.

Compromise regulation and future wireless competition is realistic. We expect reality to play between the extremes. One proposed solution could see Title II designation imposed, but with wide forbearances and significant pricing leeway. Such a move would have little impact on current operations, but would give the FCC a vehicle to act quickly should it perceive more egregious exertions of market power. In this scenario, the CMCSA/TWC merger seems unlikely to be approved and analyst models of unfettered long term growth in broadband pricing are overoptimistic.

Cable MSOs/incumbent telcos likely overvalued. The range of regulatory outcomes is wide, and while there are plausible scenarios where cable and telco valuations are reasonable, we believe that risks outweigh potential rewards. We believe that the advent of real competition is upon us in wireless, and see TMUS, and possibly S, taking share and pressing prices for market leaders T and VZ. We continue to believe that the best opportunities for internet-based businesses will accrue to scale players with strategic moats, led by GOOG, AMZN, FB, NFLX, TWTR and others.

For our full research notes, please visit our published research site.

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