People are angry. With Netflix's (NASDAQ:NFLX) highly publicized paid interconnection deal with Comcast (NASDAQ:CMCSA) earlier this year, people think that the very fate of the open Internet is at risk. Shortly thereafter, Netflix would ink a similar deal with Verizon, adding even more fuel to the fire.
These paid interconnection deals undermine net neutrality, and potentially represent a massive barrier to entry that may hinder potential entrants and lead to less competition and innovation, they believe.
Trolling the FCC
Over the past few months, public debate has escalated and most recently culminated in a segment on Last Week Tonight with John Oliver, which prompts Netizens to complain directly to the FCC. It's easy and tempting to jump on the bandwagon because the above reasoning does make sense topically.
Sure, lots of people hate Comcast. It's not hard to demonize a company that's part of an oligopolistic industry, exercises its pricing power, is attempting to get even bigger, and generally has horrendous customer service.
I'm not here to defend Comcast, though. The economic reality is that for Netflix, making a paid interconnection deal with Comcast is simply a necessary evil. It's nothing more than a cost of doing business and it's how Internet infrastructure works. In fact, these types of deals have been around in some form or fashion behind the scenes for at least a decade. They're not new. They've just gotten a lot of attention lately as Netflix goes on a public crusade against them.
Widely followed industry analyst Dan Rayburn has tried to set the record straight with a series of blog posts that detail how interconnection deals actually work. I spoke with him the other day about Netflix's big push against interconnection deals. He has regular conversations with executives at all of the companies involved in these types of deals, including Netflix.
Peeking under the hood
Up until 2012, Netflix primarily relied on third-party content delivery networks, or CDNs, such as Limelight Networks, Level 3, and Akamai to deliver content. In 2012, Netflix rolled out its own CDN called Open Connect. This is when things got tricky. Operating a CDN means you have to buy transit from multiple providers to connect to ISP networks.
Netflix uses a handful of these transit providers, with Cogent Communications being one of its main flames. These transit providers can only pass a certain volume of traffic into an ISP's network before fees kick in. Since Cogent refuses to pay ISPs when it goes over these thresholds, that has contributed to Netflix's recent performance woes. Part of the reason why Netflix was relying on Cogent as its largest transit provider is because they're cheap, according to Rayburn. There were also other alternative transit providers that Netflix could have used but chose not to due to higher costs.
The whole reason why Netflix is choosing to ink interconnection deals with Comcast and Verizon is because it wants to cut out the middlemen (transit providers) and directly connect its CDN with ISP networks. So really these fees aren't new additional costs -- they're just displacing fees paid to transit providers as Netflix becomes more vertically integrated. They are simply growing pains, as Netflix customers had no performance issues when it was using third-party CDNs.
Netflix still uses a combination of Open Connect and third-party CDNs, so its recent performance problems are not universal. By the end of this year, Netflix should phase out all third-party CDNs in favor of Open Connect, which also implies more paid interconnection deals.
After everything is said and done, Netflix should actually see a net decrease in costs in the long-term. Netflix is getting wholesale pricing (which is cheaper), and it just locked in rates for 5 years, says Rayburn. Financial terms around Netflix's paid interconnection deals are not public, but Rayburn estimates that Netflix will end up paying Comcast around $10 million this year. That's an estimate with some wiggle room, but it's effectively a rounding error to Netflix's total $3.1 billion in cost of revenue last fiscal year.
Content licensing costs comprise the bulk of Netflix's cost of revenue, and are much more meaningful compared to content delivery expenses (also included in cost of revenue). Rising licensing costs are what investors should really be watching.
Net neutrality still matters
None of this is to say that net neutrality is unimportant. Quite the contrary, net neutrality is of absolute importance to future innovation. Rather, the point is that interconnection deals and net neutrality are not directly related. Since these deals have been around for years, they've actually helped fund infrastructure investments that have brought the Internet to where it is today.
Furthermore, we're not talking about an awful lot of money. Just 0.1% of Comcast's revenue last year came from interconnection deals, which translates into just $30 million to $60 million. That includes all paid interconnection deals that Comcast has inked with a variety of companies, large and small. To construe these as a significant barrier to entry is misplaced.
All industries have barriers to entry. In the case of wired telecommunications companies like Comcast, networks costs tens of billions of dollars to deploy. Next, maintenance costs and ongoing upgrades as technology evolves come into play. For content companies, they have to either pay third-party CDNs for delivery service or invest heavily in building their own CDNs. Any entrant would simply choose the former. That's all in addition to far more significant costs associated with building a content business.
The threat that interconnection deals represent to net neutrality is commensurate with their size, which is to say the effect is minuscule. Paid interconnection deals are also subject to market forces. If cable companies are asking too much, no one will pay them. The market has a way of keeping itself in check most of the time. In fact, interconnection fees are on the decline thanks to said market forces.
Netflix knows that these deals aren't ultimately that meaningful to its business, but it would still prefer them to go away if possible. Many companies pay them without a peep, but Netflix sees an opportunity to reduce its costs even farther. Hence, the public spat.
According to Rayburn, the terrifying irony is that if Netflix gets its way and everyone is suddenly allowed free access to ISP networks, performance will likely deteriorate across the board. Interconnection deals come with guaranteed levels of performance. Make it free and those guarantees go away. You get what you pay for, after all.
Evan Niu, CFA owns shares of Apple and Netflix. Evan Niu, CFA has the following options: long January 2015 $460 calls on Apple and short January 2015 $480 calls on Apple. The Motley Fool recommends Apple, Google (A shares), Google (C shares), and Netflix. The Motley Fool owns shares of Apple, Google (A shares), Google (C shares), and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.