Netflix Inc. (NFLX) announced Thursday that it has signed a multi-year deal with Level 3 Communications, Inc. (LVLT) for Level 3 to become a primary content delivery network (CDN) provider for the online movie rental company. This announcement raises concerns for Akamai (AKAM), which is seeing its core business areas challenged by competitors like AT&T Inc. (T), Level 3 and Limelight Networks Inc. (LLNW).
Level 3 is doubling its storage capacity to accommodate Netflix and future growth by adding 2.9 Terabits per second (Tbps) of global CDN capacity in addition to the 1.65 Tbps it added in the Q3 2010. By adding CDN capacity, Level 3 can store and deliver online content like media, videos and e-commerce information more quickly.
Revenue Impact Limited
Based on our estimates of Netflix’s streaming traffic for 2010, Akamai would earn close to $25 million on an annualized basis if it handled most of its traffic. If Akamai retains at least 20% of Netflix’s data after this deal, this amounts to annual revenues of close to $10 million – about 1% of total Akamai’s revenues.
Pricing and Revenue per Customer a Worry
We believe that pricing and potential sweetheart deals could be the reason Netflix and others might choose to add Level 3 as a provider or direct more traffic its way. Netflix stated that its decision was not performance driven, and we feel that Akamai has best in class performance. This leads to pricing concerns which we discussed in a recent article.
According to industry chatter, Akamai won Netflix’s contract earlier this year by offering lower prices compared with Level 3 and Limelight, but only for first two months. The pricing subsequent to the initial two-month period was to return to prices higher than those offered by competitors. This gives us a glimpse of pricing and business strategies that CDN providers might use to win business.
As CDN providers like Level 3 continue to invest in capacity while trying to win new customers, we believe Akamai might need to respond by also lowering its pricing, adversely impacting Akamai’s gross margins. If its media vertical gross margins were to decline to 60% by 2016 compared to 75% currently, our price estimate drops by 5%.
Margins are only one part of the story. As competition heats up for smaller customers or as customers choose to increasingly split traffic among several providers, Akamai could also see a decline in revenue per customer across its different verticals including online shopping, media content, software & gaming, and government & NGO. This can add further downside to our estimates.