Netflix (NFLX) the Winner in Comcast Deal, Analysts Explain

February 24, 2014 11:33 AM EST
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While conventional thinking on today's Netflix (NASDAQ: NFLX)/Comast (NASDAQ: CMCSA) deal would suggest Netflix "crumbled and capitulated before King Comcast, sheepishly agreeing to pay for what previously had been a free and inalienable right," MoffettNathanson analysts Craig Moffett and Michael Nathanson have a different take.

The duo ask "... why in the world Netflix would choose to capitulate now, when Comcast’s merger with TWC is hanging in the balance?" Bullying Netflix would open Comcast to charges of anti-competitive behavior and raised eyebrows at the DOJ. They argue that Netflix was at a moment of unprecedented leverage and its smart-as-a-whip CEO Reed Hastings took advantage.

Media reports suggest Comcast presented Netflix with more attractive terms than it had previously offered. In other words, Comcast wanted the Netflix problem to go away and Netflix just wanted a good deal. They said it sounds like Netflix "got precisely what they wanted."

The analysts said to understand what happened requires an understanding of peering. They explain:

"Years ago, in the dark ages of the Internet, the large backbone ISP network providers – companies like AT&T, MCI, and the now long-gone UUNet – agreed to form what they called a Tier 1 peering club. The idea was simple. Since the precise amount of traffic one network was handing off to another wasn’t accurately measurable at the time anyway, this small group of carriers simply agreed to pretend it was all a wash, and that no money need change hands for all of this traffic exchange since it would be conveniently assumed that the amount of traffic one handed off to another would end up being roughly symmetrical anyway. The Tier 1 peering club exists to this day. Telecom operators like AT&T, Verizon, Comcast, NTT, Deutsche Telekom, TeliaSonera, Level 3, and Cogent fall into this category.

Today, with traffic volumes easily and routinely measured, settlement-free peering generally requires that traffic imbalances don’t exceed 2 or 2.5 to 1, depending on the policies of each of the parties involved (there are no hard and fast rules; click here for Comcast’s as an example). But here’s the thing: Not all ISPs are created equal. As an edge provider (that is, as a company that serves end users), Comcast naturally receives far more traffic than it sends. Conversely, as a backbone and hosting provider that doesn’t serve end users, a company like Cogent sends far more than it receives. (Verizon and AT&T are somewhere in between; they serve end users, but they also have sizable wholesale and hosting businesses as well.)

When these asymmetries become too extreme, the sending party loses its Tier 1 status. That’s what happened when Level 3 took over Netflix’s hosting (CDN) account in 2010. They bid on Netflix’s business under the assumption that they would be able to deliver it to peer networks (like Comcast) for “free” (using their Tier 1 peering status) but when they alerted Comcast to the expected volumes, Comcast demanded payment on the grounds that the traffic flows were now so asymmetrical that the loose Tier 1 peering rules had been violated. (Comcast and Level 3 finally settled that dispute in 2013 by entering into an undisclosed commercial agreement.)"

The analyst said the deal has nothing whatsoever to do with Net Neutrality. They explain: "The concept of Net Neutrality refers to the non-discriminatory treatment of traffic within a given carrier’s network. The concept of peering relates only to the point at which different carriers’ networks interconnect and the volume of traffic that is exchanged."

Also, the deal has nothing to do with paying for speed or network access. Rather, they explain, it is simply a commercial payment to Comcast to open up additional ports to allow traffic to flow in excess of the settlement-free ratio. Explaining further, the note: Imagine two rooms (Comcast and Cogent, Netflix’s connectivity provider) connected by a door (a port) and filled with people wanting to move between the two (traffic). So long as people move back and forth between the rooms in roughly equal measure, the owners of each room would be willing to install new doors between the rooms to facilitate the movement of people. If lots of people start wanting to move from one to another, however, the owner of the room receiving more people would want to be paid to build a new door such that it can accommodate the flow rather than split the cost. Congestion results when the door is not large enough to handle the flow of people. Paying for peering is thus tantamount to paying for a new door (leasing ports).

Now, rather than paying Cogent to hand off the traffic to Comcast, Netflix will simply hand it off themselves (perhaps they will even continue to do so over Cogent’s network; we don’t know). But in reality, the agreement between Comcast and Netflix is not especially momentous. Edge providers like Comcast commonly receive payments from content providers like Google and Microsoft. After all, that’s what networks do; they charge for transport."

All in all, a closer reading of the events suggest that Netflix rather than Comcast got the better of this deal.

After staring the day lower, shares of Netflix are up 2.5% to $443 mid-day as Wall Street agrees with this thinking and adjusts shares accordingly.

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