Is Netflix Playing A Game Of Chicken?

| About: Netflix, Inc. (NFLX)
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Netflix is strategically building leverage to compete with ISPs.

Company is focusing on selectivity, capacity and shifting competencies to grow its subscriber base.

International growth will be key for Netflix.

Netflix (NFLX) reported faster streaming for its Comcast (NASDAQ:CMCSA) customers for February, after the online video streaming company agreed to pay the cable company for direct access to its networks. While the financial details of the deal were not disclosed, Netflix is apparently buying what Comcast calls "non-transit access". Reading the tea leaves between the undisclosed lines of the deal reveals a lot regarding the aggressive business strategy Netflix is pursuing. By raising the barriers to entry, Netflix is "strategically building leverage" through selectivity, capacity and competencies.

Investment community has had long debates over this deal, expounding this move as the latest evidence of a shift in the balance of power in favor of internet service providers. Some have hailed this deal between the two companies as a sign of continued health of this largely unregulated market. Meanwhile, the Verge interprets this deal as the behemoths like AT&T, Comcast gaining more control over the consumption of the internet in United States. In the book titled "Captive Audience" author Susan Crawford states, "Cable's response in this game of chicken means that investors in Netflix may be discouraged by the deeply contingent nature of Netflix's plans", referring to the monopolistic power which Comcast uses in the competition for sharing resources with Netflix.

One prevalent aspect of cable and media industry is the presence of "negative" network effects; for example, in networks with congestion, the value of using a network may decrease with additional users. These frictions affect who use the network, overall transaction volume and ultimately the efficiency of the market. Netflix management realized this business risk and stopped the quality deterioration before it started affecting membership growth. Management has also confirmed that the company is not paying Comcast significantly more for direct access to its networks than it was previously paying to providers of content delivery networks. According to an estimate by Wed bush securities Netflix is likely paying between $25 and $50 million per year for this deal. By signing up this deal, Netflix is essentially subsidizing broadband service costs for its customers. Credit card industry makes identical pricing decisions where companies only charge a transaction fee on one side of the market (merchants) and subsidize the costs to consumers. The affect is to encourage consumers to use credit cards more often. Netflix can now use behavioral retargeting marketing strategies to regain those subscribers who had used its service before.

Netflix has emerged as the closest thing to a viable online competitor to Comcast's video services. However, the fact that Comcast feels the need to play catch-up with Netflix speaks of a deeper threat. To neutralize the cord cutting induced by the growth of Netflix, Comcast can introduce "usage-based billing" or "consumption billing" - which purely is a way to raise revenues under the disguise of solving the problem of network congestion. Usage-based billing caused a public furor in Canada forcing Canadian regulatory agency CRTC to reverse its ruling on approved rate structure in 2011. If other internet service providers who have voluntarily opted for Netflix's Open Connect program, see this deal as a door opener - stand to lose the broad public support for net neutrality and do want to galvanize government action.

In the last few years, with the slowdown in growth for the pay TV industry, cable operators kept passing along higher programming costs to the consumers. To capitalize on declining customer satisfaction levels with cable operators, Netflix approached cable companies to provide quick access to the company's streaming service via cable set top boxes. What if Netflix decides to subsidize the monthly broadband fees for customers who sign up for Netflix service, along with payments to internet service providers for direct access to their networks? On surface, it appears as a big wager, but the upside payoff potential for Netflix is gigantic. Here is my rationale behind it:

  1. Online landscape has shifted dramatically in the last several years, became content rich with expanded use of video content. As people adopted to higher speed networks, pricing for internet services has increased dramatically for consumers. Subsidizing this cost should help content creators such as Netflix to lure in customers and lock them in long-term deals. It's no secret what wireless companies did with subsidy-based business model to grow customer base. It can hurt the business' profit margins in the short term but when you are in business initially you have to incentivize the customer to sign up for the service.
  2. To mitigate the cable operators risk of losing video TV consumer, Netflix can work with them to provide a la carte option combined with Netflix service to cost conscious consumers. Even though there will be big resistance to a la carte options by cable operators, it will unquestionably put the brakes on declining subscriber base.
  3. If Netflix wins the battle for adding its streaming services via cable set up boxes - it will be a big win for the cable companies as well. Netflix can help in analyzing viewing habits for cable TV customers, recommend customized solutions. This should help in generating more advertisement-based revenue for the cable TV operators.

Netflix has quietly been sowing the seeds of latent demand in 15-24 year old age groups via smart sampling, content and habituation. By charging a single price per household and allowing multiple users per household to use Netflix free, they have let millions of teens and young adults enjoy the benefits of Netflix. After some point in time, these young consumers will habituate to the benefits of Netflix. Unmet content consumption needs for this demographic would grow streaming market potential further. According to Pacific Crest Securities, "Netflix can reach 134 million global streaming subscribers: 64 million in the U.S. and 70 million in international markets".

Employing best technical arrangements in the industry and through value enhancing original programming, Netflix has increased its competitive advantage over its competitors such as Amazon Prime, Hulu, and HBO. Anyone with a Netflix account understands that they have among the most advanced use of analytics. Armed with information on consumer's viewing habits, they can provide consumers with an amazingly granular set of suggestions based on viewing history. Netflix gathers information about the viewing habits, analyzes it, and presents a unique page of customized suggestions just for you. It is truly the ideal of customer experience management, to serve up content to the individual viewer based on what you know about them. Success of their original series "House of Cards" attests to the use of big data in its original programming and business decisions that the company makes.

Huge growth potential for Netflix coupled with its capability to meet the content demand of its current and future subscribers is something, which cable operator's lack. In my opinion, Comcast will need Netflix more than Netflix needs Comcast as declining subscriber growth under the cloud of regulatory overhang, creates more challenges for Comcast.

Netflix has revolutionized the way we consume our media, but it is a lousy stock investment at current price levels. I plan to write a follow-up article to estimate fair value for Netflix, quantify the market-based risks, growth risks and identify the price levels, which will offer investors the future growth at a reasonable price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.