Quick Thoughts: Netflix and Comcast – Friends with Benefits

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– Netflix and Comcast’s multiyear peering deal comes as a surprise, amidst reports that broadband distributers have been hampering streaming performance.

– Comcast’s proposed merger with TWC likely gave it an impetus to be on its best behavior under regulatory scrutiny, skewing deal terms in favor of NFLX

– Peering agreements fall outside of previous agreements on net neutrality, but this deal sets a precedent and will clearly impact future regulatory policy.

– We don’t expect this deal to have a major impact on NFLX’s bottom line, but expect NFLX will use the terms for negotiations with other providers

Over the weekend, Netflix and Comcast surprised investors announcing a peering agreement whereby NFLX will pay for unimpeded connections to Comcast broadband subscribers. Over the past several quarters, NFLX streaming customers have been frustrated as Comcast, Verizon and other ISPs have refused to expand the bandwidth of connections between the popular content provider and their distribution networks. As a result, average streaming speeds for NFLX users have declined more than 25% at Comcast and more than 15% at Verizon since February 2013, according to the company. Given the burgeoning popularity of the service – NFLX draws 31.6% of all downstream Internet activity in North America according to Sandvine – the deteriorating performance due to the peering conflict is a significant risk to the company. Comcast’s newly signed agreement settles the problem on its network, and eventually on Time Warner Cable, assuming that the announced merger is allowed to proceed. This deal expands the net neutrality limitations that Comcast agreed to in its 2011 consent decree, and will likely be a precedent for further deals with other streaming providers and between streamers and other ISPs. Given Comcast’s obvious interest in courting approval for its TWC merger with an FCC skeptical of the deal’s possible impact on broadband competition, the terms are likely favorable to Netflix.

The peering deal is not without precedent as GOOG, FB, MSFT, and YHOO all have similar agreements paying ISPs for more direct access to their networks. Peering doesn’t come under the guise of net neutrality in that these companies are not paying for more preferential access in the last mile of coax/fiber/waves to a consumer’s device. Peering is essentially a more direct connection to an ISP. By peering, NFLX gets more optimal routing with fewer router hops, leading to lower latency and more reliable service. NFLX has typically offered to connect its servers to broadband providers free of charge to improve quality for consumers. While it has had success getting the likes of Cablevision and Google Fiber to sign on, major providers like Comcast and Verizon have balked and demanded compensation. NFLX typically relies on and pays third party backbones like Cogent Communications to connect to the holdouts. With the deal, NFLX is basically paying Comcast rather than Cogent. Not surprisingly after the deal was announced, Cogent shares were down -6.79%.

For NFLX, direct links to ISPs are critical to maintain service levels to drive subscriber growth. NFLX CEO Reed Hastings learned painful lessons from consumer backlash in the summer of 2011 when the service split the streaming and DVD by mail business units. This time, backlash from even several hundred consumers experiencing spinning hourglasses and buffer errors is enough for Hastings and Company to act. With Comcast’s proposed merger with Time Warner Cable likely opening a Pandora’s box of  regulatory scrutiny, the timing for Netflix is fortuitous. Media outlets reporting the deal noted that terms were more favorable than Comcast’s previous offers, with some even speculating that NFLX is paying Comcast the same fee per unit of traffic it pays Cogent. If this is the case, NFLX is only reallocating some of it networking expenses. With broadband providers in the crosshairs of regulators and potential new competition from the likes of Google Fiber and fixed wireless broadband, draconian scenarios of massive access fees from NFLX to ISPs are unlikely to play out.

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

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