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Verizon’s Victory Over FCC Rules Seen as a Loss for Netflix

By Scott Moritz and Cliff Edwards
January 15, 2014 12:04 PM EST 82 Comments
Netflix
Netflix

Verizon Communications Inc. (VZ)’s legal victory over the Federal Communications Commission lets the carrier charge extra fees for speedier delivery of online content, potentially increasing costs for Netflix Inc. (NFLX) and other Internet companies.

The U.S. Court of Appeals in Washington decided in favor of Verizon yesterday, striking down the FCC’s so-called net-neutrality rules. The regulations would have required Internet service providers to treat all online traffic equally, rather than giving preference to companies willing to pay extra fees for faster service.

With the restrictions lifted, carriers like Verizon, AT&T Inc. and Time Warner Cable Inc. (TWC) could be free to charge Internet companies higher rates for preferred treatment -- expenses that may ultimately be passed on to consumers. Netflix, Google Inc.’s YouTube and Amazon.com Inc., meanwhile, face higher costs of doing business, changing the industry’s economics. In Netflix’s case, the expenses could climb into the hundreds of millions of dollars a year, according to Wedbush Securities.

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“Goodbye, open Internet,” said Jennifer Fritzsche, an analyst at Wells Fargo & Co. in Chicago. “There’s definitely a risk that Netflix customers will have to pay more, though it will probably take at least a year for it to take effect.”

Carriers have argued that the biggest bandwidth hogs should share in the costs of sending their content to customers. The idea is to charge Netflix or Google the equivalent of first-class handling, so that “House of Cards” or YouTube videos can get guaranteed quicker delivery.

‘Two-Sided Market’

Verizon wants a “two-sided market,” involving payment for Internet service by subscribers and by companies that want to reach them, Helgi Walker, a lawyer for the New York-based carrier, told the appeals panel.

“I’m authorized to state from my client today that but for these rules we would be exploring those types of arrangements,” said Walker, working at the time for the law firm Wiley Rein LLP.

Streaming services have contributed to Internet congestion, putting a strain on networks. Monthly traffic over phone and cable lines has more than doubled over the past year during peak hours, according to Sandvine Inc., a provider of data-management software. Netflix, the world’s largest subscription video-streaming service, accounts for about 32 percent of all peak traffic in North America, Sandvine estimates.

Joris Evers, a spokesman for Los Gatos, California-based Netflix, declined to comment on yesterday’s ruling.

The company’s shares fell 4.5 percent to $322.60 as of 12:02 p.m. in New York today.

The Little Guy

Smaller providers of Internet content -- say, a video-sharing service or a nonprofit news organization -- also could suffer because they won’t be able to afford extra fees to deliver their material quickly. That’s raised concerns that consumers may favor content from established companies, shutting out upstarts.

Still, the FCC has an opportunity to tackle net neutrality again. The court decision threw the issue back to the agency, which may now attempt to rewrite the rules. The FCC also will consider appealing yesterday’s decision, Chairman Tom Wheeler said.

“The FCC has the authority -- and has the responsibility - - to regulate the activities of broadband networks,” Wheeler, a Democrat, said in a blog post last night. “We will have ample opportunity to debate ways and means, to consider specifics in specific cases as they arise.”

New Charges

Cable and phone companies have already been exploring different approaches to pricing, aiming to wring more revenue out of broadband networks.

The cable industry, the biggest provider of broadband service in the U.S., has looked at applying monthly data caps -- an approach that’s already common with wireless carriers. But that would punish consumers, said Michael Pachter, an analyst at Wedbush in Los Angeles. Companies would rather approach Netflix, ESPN and other bandwidth heavyweights to strike revenue-sharing agreements, he said.

“The correct capitalist response would be to charge the end user, but no vendor wants to go to the customer to hammer them if it can be avoided,” Pachter said. “The elimination of net neutrality means they can go to Netflix and squeeze them instead.”

Estimated Fees

Netflix currently charges $7.99 a month for streaming movies and TV shows. The company could ultimately have to make monthly payments to broadband providers of 80 cents per user for standard definition video, Pachter estimates. For higher-definition content, which requires more bandwidth, the rates could rise as high as $4.80, depending on the quality of the stream, he said.

That could amount to as much as 10 percent of Netflix’s annual revenue, he said. The company generated an estimated $4.37 billion in sales last year, according to analysts’ estimates compiled by Bloomberg.

Even so, a faceoff between broadband providers and Internet-content companies may not be imminent. While Verizon said it agreed with the court’s decision, the carrier isn’t planning any immediate changes to its practices.

“One thing is for sure: Today’s decision will not change consumers’ ability to access and use the Internet as they do now,” Verizon General Counsel Randal Milch said in a statement.

Comcast -- the biggest U.S. broadband provider, with more than 20 million broadband customers -- agreed to operate under open Internet rules after it acquired NBCUniversal in 2011. So it won’t be able to take advantage of yesterday’s ruling. The terms of that agreement with government regulators ends in 2018.

‘Open and Vibrant’

The Philadelphia-based company pledged yesterday to keep the Internet “open and vibrant.”

“We are absolutely committed to deliver that experience,” said Executive Vice President David L. Cohen.

Time Warner Cable, the second-biggest cable company, said it will remain focused on providing customers the best possible service, “including unfettered access to the Web content and services of their choice.”

“This commitment, which long precedes the FCC rules, will not be affected,” Eric Mangan, a spokesman for the New York-based company, said in a statement.

While such remarks leave the door open to new fees, broadband providers will probably take things slow, said Don Bowman, chief technology officer of Sandvine.

Nothing Sudden?

“The court of public opinion weighs heavily here, which means we probably won’t see any sudden, rash actions,” he said.

Netflix has worked to lessen the burden of its streaming service on networks. As part of that effort, the company has been trying to persuade Internet service providers to install its Open Connect server within their network infrastructure.

The server stores copies of Netflix’s most popular content, helping deliver smoother, clearer streams of movies and TV shows. The system also saves cable providers money on transport costs and reduces the strain that occurs during prime-time viewing hours, according to the company.

Broadband providers also increasingly view the streaming service as a tool to attract and retain customers. Netflix has been in discussions with U.S. cable-TV companies to add its application to their set-top boxes, making it easier for subscribers to access the service, people with knowledge of the situation said in October.

Still, some large cable operators have balked at using Open Connect, saying it sets a precedent that could make negotiations with other Web content companies more difficult, the people said.

Different Approaches

The friction between content providers and broadband companies stems from their different business models, Bowman said. While consumers pay largely in units of time, broadband carriers are charged based on volume at peak hours.

AT&T sparked fresh debate over net neutrality earlier this month with the introduction of its Sponsored Data effort. Under the program, companies that want to reach mobile customers with videos or applications can pay for those users’ data charges. Critics said the move would tip the playing field toward deep-pocketed companies, making life harder for organizations with less resources and visibility.

“The uproar over AT&T’s Sponsored Data service is a good example of how net neutrality regulation is a constant threat to carriers’ ability to try new things,” said Jan Dawson, an analyst at Jackdaw Research in Provo, Utah.

Going after Netflix and other Internet companies also is likely to raise eyebrows, he said. That’s why it probably won’t happen overnight.

“If Verizon or Comcast were to explicitly say directly to Netflix they wanted to charge them more, that would cause a huge fuss and would be a fundamental shift in the business model for the Internet,” Dawson said.

To contact the reporters on this story: Scott Moritz in New York at smoritz6@bloomberg.net; Cliff Edwards in San Francisco at cedwards28@bloomberg.net

To contact the editor responsible for this story: Nick Turner at nturner7@bloomberg.net

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