At CES, the FCC signaled that it opposed any effort by Congress to give the FCC policy direction or to establish any checks and balances on the FCC in authorizing incentive auctions of prime TV broadcast spectrum.

See my Forbes Tech Capitalist post “FCC Seeks Unbounded Spectrum Auction Authority” to see why the the FCC’s lack of regulatory humility here is so stunning.

 

Netflix’ Uneconomics

September 6, 2011

Netflix’ continues to exhibit serious difficulties grasping basic economics, competition and value.

First, Netflix is lowering its value to customers.

  • Netflix now charges its subscribers’ 60% more in September in return for lots less premium content available for subscribers in February, as Netflix just lost Starz, its top premium content provider, which supplies 22 of Netflix’ top 100 movies.

Second, Netflix is shifting its costs to its customers.

  • Netflix used its abrupt and controversial 60% price hike to force many of its core users away from the DVD model that many prefer and have the viewing technology for (but costs Netflix more), to the streaming model, (which Netflix prefers because it costs them less) even if it costs many of their DVD customers to spend lots more to upgrade their viewing technology to view the streamed content in the way they can currently view DVDs. 

Third, Netflix is chasing away the premium content its subscribers demand.

  • Netflix’ abrupt and careless business model pivot from a value DVD business to streaming, signaled loudly to content providers (on which Netflix depends) that Netflix took them for granted in the wake of the demise of Blockbuster’s store business model.
  • It appears that Netflix imagined its perceived market power could force premium content suppliers, like Starz, into a accepting a new online business model that would profoundly devalue their premium content franchises long term.
  • In effect, Netflix wants its premium content suppliers to acquiesce to its demands that they accept a permanent change from a time-limited usage content model (DVD rental), which enables premium content to extract premium value for its content, to a commoditized unlimitedaccess content model where their content reaps no benefit from being premium and being viewed repeatedly.
  • Starz wisely told NetFlix: “No.”
    • Starz and other premium content providers understand that Netflix will not be the only online game in town for their premium content, as Amazon, Apple, WalMart, Dish/Blockbuster, Google-YouTube, and others increasingly compete for premium content with premium content-friendly deals that can be more transaction-based and more remunerative for premium content.
    • Netflix apparently does not grasp that, as essentially a cloud-based video streamer, they face lots of new entrant competition from deeper-pocketed competitors who are likely to be more willing and able to pay more for premium content to provide content differentiation to their online streaming customers — than Netflix.
    • In a nutshell, Netflix has exhibited broad uneconomic hubris, and over time competitive forces will teach Netflix lessons about economics, competition and value. 

Finally, Netflix is claiming entitlement to regulatory subsidies from its main suppliers.

As previous pieces in this Netflix series have documented (see links below), Netflix imagines that the FCC’s net neutrality policy, embodied in its December Open Internet order, should entitle Netflix to operate in a competitive environment where its actual or potential competitors cannot charge competitive usage-based pricing, for competitive bandwidth services.

  • Netflix continues to forum shop for corporate welfare from regulators when the FCC’s December order supports usage-based pricing and both the FCC and FTCChairmen have publicly endorsed usage-based pricing for bandwidth to ensure the nation’s broadband infrastructure remains economic and sound from an operational and investment perspective.
  • As the single largest bandwidth cost-causer in streaming more video than any entity, Netflix needs to become a better steward of Internet usage and invest in much more network management and content caching closer to its customers — as Google-YouTube responsibly did before them when faced with this legitimate bandwidth hogging criticism.
  • Netflix’ naive uneconomic approach to its business seeks to have regulators force its suppliers to subsidize Netflix with uneconomic flat rate unlimited bandwidth, at the same time:
    • Netflix’ competitors are adapting competitively by managing their networks much more efficiently; and
    • Netflix is cost-shifting to its customers and trying to cost shift to its content suppliers.

Conclusion

Netflix, in myopically focusing on subscriber growth, and largely ignoring competitive economics and competitive value creation, has exposed enormous competitive weaknesses long-term.

  • In their its-all-about-Netflix world, Netflix has taken most everything for granted: its customers, its value proposition, its suppliers (content & bandwidth), and its potential regulators.

As I pointed out several months ago at the beginning of this research series, Netflix’ nosebleed stock price growth would not last forever.

  • Given that Netflix is 28% off it high in July, it should answer this wake up call, and stop behaving like a hubristic hot dot.com “it” stock.
  • Netflix should start competing in the real world of focusing on the customer, providing differentiated content, paying competitive prices for competitive inputs, and competing in the free market that is only going to get a lot more competitive with the ramp-up of other cloud-based video-streamers: Apple, Amazon, Walmart, Dish-Blockbuster, Google-YouTube, Microsoft-Skype, etc.

At core, Netflix’ fits of uneconomic behavior are a blinking warning sign that Netflix could have much deeper business problems than the company is letting on. 

***

Previous Netflix posts:

Netflix continues to throw stones at the common economic practice of usage-based pricing, to which broadband carriers are naturally migrating, all while Netflix stands inside a glass house filled with mis-managed usage pricing practices.

Netflix as Stone Thrower:
In a concerted campaign for net neutrality regulation that would ban broadband usage caps or pricing, Netflix has generated a:

Netflix as Glass House:

  1. Netflix has long priced and capped its DVD business based on consumer usage.
    • ~60% of Netflix’ users, or 15m of Netflix’ 25m customers, are still subject to Netflix usage caps and pricing, the practice Netflix claims is anti-competitive, if other companies do it.
  2. Netflix’ recent whopping 60% basic price increasefrom $10 to $16, affects 60% of Netflix’ customers and must be paid in order to continue to get the same service as before, whereas in contrast, the bandwidth pricing caps Netflix objects to as anti-competitive represent a small price increase for the few percent of bandwidth-hungry broadband customers who choose to consume extraordinarily high amounts of bandwidth.
  3. Netflix understands that market and technological changes require Netflix to abruptly change their business model 180 degrees, from a mainly a DVD subscription business with a fast-growing streaming business, to primarily a streaming-only business with a deceasing DVD subscription business, but in contrast, Netflix can not or will not understand how the explosion of bandwidth-intensive video traffic strains Internet network infrastructure and requires an incremental adjustment in the broadband business model from unlimited bandwidth for everyone, to effective bandwidth pricing caps for a small percentage of bandwidth-hungry customers.
  4. Netflix has mismanaged its business so much that it must force 60% of its customers to suddenly pay as much as 60% more for the same service as before, when in contrast, the broadband industry is managing its  businesses responsibly with a long term glide-path pricing transition that affects only a small amount of customers and that enables those customers affected to manage their own costs to avoid the effective price increase if they do not want to pay it.
  5. Netflix is effectively forcing their customers to pay as much as 60% more to effectively fund Netflix’ own major infrastructure upgrade to stream video to 43 new countries (when U.S. customers paying for the price increase will get no benefit from that new international expenditure), when in contrast, broadband providers raise investment capital via stock or debt offerings from capital markets in order to pay for their infrastructure upgrades without disrupting most all consumers’ monthly bills.
  6. Finally, Netflix’ is attempting to falsely frame broadband usage pricing and caps as anti-competitive and a violation of net neutrality, when the FCC formally approved broadband usage-based pricing, and when other leading net neutrality proponents support usage-based pricing.
    • FCC: The FCC’s December Open Internet Order said in para 72: that the FCC “does not prevent broadband providers from asking subscribers who use the network less to pay less,and subscribers who use the network more to pay more.“…  “prohibiting tiered or usage-based pricing and requiring all subscribers to pay the same amount for broadband service, regardless of the performance or usage of the service, would force lighter end users of the network to subsidize heavier end users. It would also foreclose practices that may appropriately align incentives to encourage efficient use of networks.
    • Tim Wu, former Chairman of FreePress and the person credited with coining the term “net neutrality” told the Washington Post: “…if you are cranking Netflix all day and downloading 10 gigs, I’ve never thought it unreasonable to have to pay more. That’s a billing question, not a net neutrality question. There is no constitutional right to unlimited bandwidth.”
    • Gigi Sohn, President of Public Knowledge, blogged the following about usage caps in 2008: “For the past two years, we have been telling broadband Internet service providers that rather than kicking off heavy bandwidth users from their networks without notice or interfering with bandwidth-intensive traffic a la the Bit Torrent-Comcast controversy, they should instead charge consumers a flat fee for a certain amount of bandwidth, and then charge a per-bit metered rate for usage that goes beyond the limit. This would be similar to the cellphone model to which Americans have become accustomed – you pay a flat fee for a certain amount of minutes, and then a per-minute charge for every minute thereafter. This model makes sense for several reasons. First, it provides both transparency and certainty – the customer knows what their limits are. Second, it makes unnecessary controversial “network management” decisions like Comcast’s decision to throttle Bit Torrent.”

In sum, Netflix cannot credibly claim that broadband usage based caps and pricing are anti-competitive when Netflix, the largest video subscriber service in the United States, engages in relatively much more severe capping of video DVD usage, for much more of its customer base, and for a much higher relative increase in price… especially when the FCC permits the practice, and staunch leading net neutrality proponents also support broadband usage pricing and caps.

 The facts show that Netflix is throwing stones from a glass house.

Previous Netflix posts:
Fact-Checking Netflix’ Net Neutrality WSJ Op-ed;
Netflix’ Open Internet Entitlement Hubris;
Sinking Level 3 Seeking FCC Internet Regulation Bailout;
Level 3-Netflix Expose their Hidden Agenda; and
Level 3 & Net Neutrality Ignorance Unleashed.

 

The Net Neutrality Debate in Europe is Over” per an excellent commentary by Ben Rooney in WSJ TechEurope.

  • Mr. Rooney chronicles the evolving public position of EU Digital Commissioner Neelie Kroes from an original pro net neutrality regulation mindset, to now the opposite — a more pro-competition mindset where “the commissoner’s position now [is] that a competitive market should be able to deliver an Internet to which everyone has access.

For those who follow history, it is truly ironic, surprising, and just plain bizarre that Europe is more pro-competition on Internet policy than the U.S. FCC.

How can this be? To understand this wierdness, look at this remarkable development through the lens of industrial policy.

I posit the reason for this European policy outcome is the fact that Europe does not have a Silicon Valley lobby — with an aggressive corporate welfare agenda seeking government special treatment, regulation of their competitors, and implicit bandwidth subsidies — like the U.S. does.

The stark and ironic contrast between the FCC’s European-style, interventionist, regulatory approach, and Europe’s more American, non-interventionist, competitive approach can only be explained by the presence of the potent lobbying force of U.S. industrial policy national champions (Silicon Valley — Google, eBay, Amazon, IAC) in the U.S. — and the absence of European national champions seeking net neutrality in Europe.

Simply the U.S. FCC Open Internet order is all about picking Silicon Valley as market winners and broadband and paid content as market losers, whereas in Europe there is no European parochial interest in picking U.S. companies — with unsurpassable leads in their markets — as market winners in Europe, and European broadband and paid content as market losers in Europe.

The ominous warning sign and lesson here for Silicon Valley is that the more successful they are at feeding at the U.S. industrial policy trough of the FCC and tilting the playing field in their favor via U.S. government regulation, the less hospitable the Silicon Valley U.S. national champions will find Europe.

  • Whereas the FCC may have a political interest in policy redistributionism to take economic growth potential and opportunity from traditional communications sectors (i.e. telecom, cable, DBS, wireless, broadcasting, and newspapers) and redistribute economic growth potential and opportunity to the uber-politically-connected California Silicon Valley Internet sector — there is no comparable interest in Europe to redistribute European economic growth and opportunity to U.S. Internet monopolies like Google and eBay, at the expense of European based businesses.

In sum, given the fact that the Europeans did not back net neutrality regulation, and given the fact that the American people also did not back net neutrality regulation (candidates formally supporting net neutrality in the U.S. midterms went 0-95 in the election), the only political force to explain why the FCC passed such controversial net neutrality regulation is the lobbying and uber-political-influence of California’s Silicon Valley Internet industrial complex.

 

It appears as if Netflix’ rocket stock and nosebleed market valuation has infected Netflix’ CEO, Reed Hastings, with a bad bout of dot.com hubris fever complete with hallucinations that Netflix is somehow a needy online video provider entitled to new massive subsidies under the FCC’s Open Internet order.

  • In his recent letter to shareholders (see p. 9 under “Challenges)” Mr. Hastings launches a grandiose diatribe on what prices and pricing models competitive broadband ISPs should and should not be able to charge Netflix in the competitive market place.
    • Mr. Hastings dreams Netflix is entitled to “no-charges” from ISPs for dumping more concentrated asymmetric Internet traffic on them than any entity has ever before generated, despite the fact that Netflix’ proposed approach is completely contrary to the way that the Internet backbone peering marketplace has operated for over fifteen years.
    • Mr. Hastings also dreams about what pricing models and prices competitive broadband ISPs should be allowed to charge their customers.

Alarm bells should be going off among Netflix’ sophisticated shareholders.

  • Netflix’ CEO is naively and implicitly positioning Netflix to investors as a regulatory arbitrage model dependent on FCC regulatory favors for its growth model to add up.
  • Mr. Hastings is unwisely spotlighting that Netflix’s model cannot support market pricing for key inputs, but expects to depend on the subsidies of ongoing heavy-handed FCC price regulations to succeed going forward — the hallmark of an unsustainable dot.com-like business model.

Netflix is greedy not needy.

The irony here is that Netflix wants subsidy entitlements from the FCC when it has zero real need or justification for corporate welfare from the FCC.

Did you know:

  • Netflix has more paying subscribers, 20m, than every multichannel video programming distributor (MVPD) in the U.S. except one, Comcast with 23m?
  • Netflix has more paying subscribers than DirecTV’s 19m, Dish’s 14m or Time Warner Cable’s 13m?
  • Netflix even has more paying subscribers than all of these MVPD providers combined: Cox, Charter, Verizon, CableVision, AT&T, Brighthouse, SuddenLink, and Mediacom?
  • Netflix accounts for 22.7% of peak Internet usage per a Sandvine report, which is about what Google-Youtube, BitTorrent and Flash produce combined?
  • Netflix’s stock tripled in the last year making it more valuable than Dish Network?
  • Netflix’ revenues grew 34% last year, 30% faster than Google’s?

In sum, Netflix is obviously not needy yet it still seeks big corporate welfare subsidies from the FCC — via heavy-handed Open Internet price regulations.

  • What Netflix’ bout of dot.com fever signals is that Netflix believes it is entitled to subsidies from others to maintain its torrid subscriber growth rate.
  • The cold reality is that with $2.1b in revenues, $600m in gross profits, $300m in free cash flow, $350 million in cash, and by far the lowest subscription price offering in the video business by far, Netflix has the business and pricing flexibility, and the financial wherewithal to grow fast and profitably without a dime of corporate welfare subsidies from the FCC.

Shame on Netflix for its dot.com-like hubris that fantasizes that their temporary nosebleed valuation somehow entitles it to corporate welfare and to the FCC price regulating a competitive industry for Netflix’ convenience.

  • What goes up must come down and Netflix’s bubble valuation won’t last.
  • They would be wise to build their future around sound economics and market pricing while they still can and not count on opportunistic regulatory arbitrage that is likely to crater when the FCC’s Open Internet order is overturned in court.
  • If Netflix’ CEO was wise, he would not bet his company’s future and valuation multiple on the FCC order being upheld.
    • That’s a losers bet.

 

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