Netflix Talks About Comcast Behind Its Back

Netflix (NASDAQ: NFLX  ) and Comcast (NASDAQ: CMCSA  ) may be partners, but their relationship is anything but friendly. Just days after Comcast announced a $45 billion merger with Time Warner Cable (NYSE: TWC  ) , Comcast and Netflix announced an interconnection deal that would stream Netflix directly to Comcast subscribers, bypassing the middleman and providing faster service to Comcast subscribers.

Despite the amicable announcement, Netflix and Comcast are at each other's throats, with each arguing that the other has too much market power. Netflix CEO Reed Hastings is actively speaking out against the Comcast-Time Warner merger, saying it gives the company too much control over the Internet. Comcast rebuts Hastings' claims by arguing that the interconnection deal is demonstrative of how much market power Netflix has. No matter which side is right, sparks are sure to fly in 2014.

Source: Netflix

Deal gives Netflix faster connection
In the months leading up to the interconnection deal, Netflix streaming speeds for Comcast customers had slowed by more than 25%. Comcast blamed the slowdown on intermediaries that transport data from Netflix to Comcast; it said the intermediaries were trying to send too much bandwidth over infrastructure that could not handle the load. As a result, Netflix arranged to directly connect to Comcast, bypassing the middlemen and speeding up Comcast customers' streaming speeds.

Although details of the agreement are not known, a source cited in The New York Times said Netflix agreed to pay Comcast "several million dollars" per year for the direct connection. Given that Netflix generates more than $4.3 billion in annual revenue, the deal as described by the Times source may not have a significant impact on Netflix's cost structure. However, Comcast's ability to extract payment from high-bandwidth websites could lead to higher payments down the road -- especially if its merger with Time Warner goes through.

Netflix tries to block merger
Although it was the middlemen, not Comcast, that delivered Netflix at slow speeds, Comcast and other consumer broadband companies have a tremendous amount of power over the intermediaries. Traditionally, the intermediaries would pass Netflix traffic to Comcast, reaping a small fee from Netflix without being charged by Comcast. However, high-bandwidth websites like Netflix cause congestion on the Internet infrastructure, so Comcast now charges the middlemen that deliver Netflix traffic for the extra bandwidth.

Comcast's ability to charge intermediaries to accept higher bandwidth is effectively a fee on high-bandwidth websites; if Netflix wants to stream its content at high speeds, it either has to pay intermediaries more to deliver its content or pay for a direct connection with Comcast.

Comcast's market power is central to Netflix's opposition to the Time Warner merger. Netflix's Hastings argues that Comcast and Time Warner control more than 60% of U.S. broadband subscribers; the combined company could charge enormous fees for the privilege of serving high-speed content to U.S. homes.

In a response to Hastings' comments, Comcast released a statement Monday saying that Netflix demonstrated tremendous market power by cutting out the middlemen to extract a more favorable arrangement from Comcast.

Source: Netflix

Netflix's opposition will bring added scrutiny to the merger, which has few powerful opponents. Antitrust expert Allen Grunes tells Reuters that Netflix's opposition is significant because the Justice Department nearly blocked Comcast's 2011 merger with NBC Universal due to concerns about equal access to high-bandwidth websites. In its defense of the NBC Universal merger, Comcast argued that competition from Time Warner would keep it from exercising excessive market power. Netflix can argue that the removal of Time Warner as a competitor would give Comcast unprecedented power.

What's at stake for Netflix and Comcast
Both companies have a lot to gain and a lot to lose based on the outcome of the merger. Although Comcast and Time Warner are gatekeepers to the majority of U.S. broadband subscribers, Netflix is responsible for nearly one-third of Internet traffic during peak hours. In order to serve high-speed Netflix content to its subscribers, Comcast has to build and maintain expensive infrastructure to carry the bandwidth. If it does not charge Netflix to carry its content, all of Comcast's customers would essentially be subsidizing Netflix subscribers.

On the other hand, a post-merger Comcast would have tremendous power. It could extract enormous concessions from high-bandwidth websites, threatening to close off the website to 60% of U.S. Internet traffic if it does not comply.

Foolish takeaway
There is no clear good guy or bad guy in the fight to stop the Comcast-Time Warner merger. Netflix clearly benefits from being able to stream its content over Comcast's infrastructure for a relatively small fee. Comcast would clearly benefit from increased bargaining power if the merger goes through. If the merger goes through, Netflix may have to raise prices to offset costs -- leading to fewer subscribers or lower margins. If the merger does not go through, Comcast will be able to boost margins via its newfound market power. For now, investors just have to wait and see what happens.

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