- Netflix claims it favors net neutrality even while it saves money buying bits from Comcast.
- Comcast has vertical integration. It owns the bits as well as what they contain.
- This gives Comcast huge advantages over both content outfits like Netflix and phone rivals like AT&T.
Government, activists and investors are all getting scammed on the issue of net neutrality.
First, understand the issue. The Internet was designed as a collection of two-way pipes. Peering is based on the idea that traffic in both directions will be roughly equal, as they are in an office or lab.
But that's not how the Internet has evolved. Instead it's primarily one-way traffic - from core services to client devices. Costs of improving the core are minimal, compared with those needed to improve edge service speeds.
When Netflix (NASDAQ:NFLX) pays to measure the bits it is sending to the Comcast edge and pays for transit, as opposed to buying big pipes that can deliver those bits directly to a local network, it's saving money. Yet CEO Reed Hastings darkly hints that he's being blackmailed, that he's being forced to pay double for content, because consumers pay for Internet access and he pays for Internet hosting.
He's not being blackmailed. He's paying for carriage because he's not peering. He's sending bits to other networks, and not taking bits back. He has to pay for that discrepancy, either by buying big pipes and guesstimating the costs, or by measuring the traffic discrepancy and paying for his costs.
But he is suffering, next to a cable provider like Comcast, because when Comcast pushes many content bits, it's paying that money to itself. Comcast has true vertical integration - it owns the content of NBC Universal - so even if it were paying for carriage, from a central server to a client device, it would be writing that check to itself.
And when Netflix goes looking for programming to sell to its customers, it's increasingly writing checks to Comcast for that programming.
Vertical integration is something the U.S. Justice Department forbade entertainment companies back in the 1950s. By separating the ownership of movies and theaters, it destroyed the big studios, but made the fortunes of people like Lucille Ball, whose Desilu studios eventually took over the plant of RKO, where she had made her film debut in the 1930s.
Gradually, over decades, Justice reversed course. It let TV networks own their own shows. It let them own local stations. This is how Fox (NASDAQ:FOXA) became powerful, through vertical integration. Disney (NYSE:DIS) benefited in the same way.
Ownership of a cable plant - the most efficient means of providing broadband access - doubles this benefit. Owning the infrastructure necessary to transmit large digital files to millions of people, and owning the files, is a super-charged business model. Fox split from News Corp. (NASDAQ:NWS) (NASDAQ:NWSA) mainly because the British scandals concerning its newspapers were distracting from, and eventually preventing, its acquisition of all of BSkyB, which you might consider a DirecTV (NASDAQ:DTV) for Europe, and a powerful piece of broadcast infrastructure.
You can see the power of infrastructure, and vertical integration, by looking at the market for live sports rights. These are big truckloads of programming, with a large, defined audience willing to pay for it. In recent years, infrastructure owners like British Telecom (NYSE:BT) and Comcast have been able to out-bid traditional networks for these rights, because their capital structures, and their control over customers paying big money for access to their infrastructure, made it possible.
Infrastructure ownership makes it possible for programmers to control programming. Netflix is acknowledging this power by doing business in the way it does with Comcast. But it's resisting making the same kinds of agreements with phone companies that don't have control of content, like AT&T (NYSE:T) and Verizon (NYSE:VZ).
The two phone companies are being slipshod in making demands for payment, mainly because they're more accustomed to dealing with government than the free market, and prefer to get a premium for bit scarcity than embrace any business model based on abundance. This is why they were aced out of the Internet access market in the first place.
What's clear from this is that we're entering an era of vertical integration, programmers owning their own pipes to the market, and that content-only companies like Netflix, along with transit-only companies like AT&T, are having trouble getting their arms around this.
In this world, it doesn't matter if customers are running away from cable TV contracts. What matters is that they're still buying bits from the same cable companies.
Cable economics are trumping those of both content providers and content delivery companies, by marrying the capital infrastructure of the latter to the vertical integration of the former. So long as this remains the regulatory status quo, investors will be better with Comcast than with anyone lacking its integration.
Which is why Netflix and AT&T are both running to Washington, crying foul. When someone's getting beaten up, it's best for investors to look to who is doing the beating, and buy them.
Disclosure: I am long CMCSA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.