Why End of Net Neutrality Is a Game Changer For Netflix

Shares of Netflix (NASDAQ: NFLX  ) tumbled almost 5% on Jan. 15, as the Street worries about a federal appeals court's decision to strike down the Federal Communications Commission's net neutrality rule, which prohibits wireline service providers from discriminating against certain types of data traffic.

Internet service providers such as Verizon (NYSE: VZ  ) have been lobbying hard to do away with net neutrality, as this would allow them to charge higher fees for services that consume heavy bandwidth. This could force providers of web streaming services, such as Netflix and Amazon (NASDAQ: AMZN  ) , to change their pricing models, and either lose customers or see their margins hurt. How much could the end of net neutrality affect Netflix? What can Netflix do to avoid losing customers if it's forced to change its pricing strategy?

The end of net neutrality
In 2010, the FCC told Comcast to stop installing technology that blocked specific Internet interactions. Later that year, the FCC approved new rules banning cable and telephone service providers from preventing access to competitors, or certain websites related to heavy bandwidth consumption, such as Netflix. The rules were based on the principle of net neutrality, which states that Internet service providers, or ISPs, should treat all data on the Internet equally, and not charge differently by user, application, content, or platform.

Needless to say, ISPs were not happy about the FCC's new set of rules. In particular, Verizon started a legal fight against the FCC, arguing that the FCC did not have the authority to demand "net neutrality." On Jan. 14, we learned that Verizon had finally won the case over the FCC, and although net neutrality isn't exactly dead, carriers are allowed to charge extra fees for speedier delivery of online content. 

The consequences
With the restrictions lifted, ISPs are free to charge higher fees to Internet companies for preferred treatment. On the other hand, Internet companies like Netflix, Hulu, and Amazon are bound to face a serious dilemma: either they assume the cost of higher fees, or they pass some of it on to consumers.

Both Netflix and Amazon are not famous for strong profitability. With more than 40 million members, Netflix generated $1.1 billion in revenue in the last quarter. However, the company managed to transform only $32 million into net income, due to the elevated costs of content acquisition. Likewise, Amazon, which together with Netflix and Hulu are bidding up the price on library content, saw its revenue increase an amazing 24% in the third quarter. This was not enough to break even, as the e-commerce giant posted a net loss of $41 million. Of course, this is a small part of Amazon's revenue structure.

If broadband providers install a pay-for-use model, the consequences for Netflix's already weak profitability could be in trouble. According to Wedbush analyst Michael Pachter, who thinks Netflix will underperform, each hour of SD and 1080p video streamed by Netflix to 40-50-inch TV sets respectively consumes 1GB and 6.5GB of data. 

The shift from content provider to content creator
The change in regulation could hurt Netflix's profitability severely in the short run. However, the company's business model could still work in the long run, with some modifications. First, to achieve differentiation and stop bidding up the price on library content, Netflix should invest more on content creation. Despite being new in this field, the company showed investors it can move successfully into original TV shows and movies production. The fact that the company's earlier series House of Cards became the first Internet TV series to win a Primetime Emmy Award, shows that the future of Netflix isn't just streaming.

Netflix can also speed up geographical diversification, as currently 31 million subscribers are domestic. The company's also paying enormous attention to developing a top-quality internet recommendation system, which could give the company an edge in the fierce battle for the Internet TV market. Also, investors should note that Netflix developed technology that stores copies of its most popular content to deliver faster video streams, the Open Connect server. All Netflix needs to do is to press ISPs more to incorporate this piece of technology. Finally, the FCC could appeal the ruling to the full appeals court or to the U.S. Supreme Court, potentially changing the whole scenario. 

Final Foolish takeaway
The latest change in regulation could add pressure to Netflix's operating margins, and eventually, to its stock performance. However, the company still has plenty of ways to avoid losing customers and neutralize the effect of higher fees.

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