Research Notes

Netflix Q3 shareholder letter reveals PR tactics to shakedown telco and content industries and to influence regulators

There is more to Netflix’s success in being the world’s leading on-demand over the top (OTT) video service than good content and cool technology. To grow to more than 50 million members in more than 40 countries requires a shrewd public reations (PR) and policy game to paint itself as the fragile underdog to regulators, journalists and the public while it fiercely lobbies for regulation against the telecom and content industries.

Netflix’s recent 3rd quarter financial letter to shareholders provides salient examples of its powerful double-talk. The company notes that even though it missed some of its numbers for the US, “There is no change to our view on the long term attractiveness and US market size of Internet television, and no change to our view of the ultimate size of our US membership.“ We find it interesting that the company that so maligns broadband providers has managed to build a successful, profitable and growing business on top of their networks. Indeed if broadband networks were not up to speed in the US and around the world, Netflix would still be a DVD-by-mail company.

Bogus speed index to shame and fame operators
A key part of the Netflix strategy is its bogus ISP Speed Index. Proffered as a consumer tool to select an ISP, the monthly “speed report” is nothing more than a shakedown tactic to cajole operators to participate in its OpenConnect content delivery network (CDN). Netflix knows that the quality of its streaming has largely to do with Netflix itself; that’s why the company invests in a variety of technologies and platforms to differentiate itself amongst its OTT competitors. Regardless of whether a user has a gigabit connection or DSL, Netflix will stream at approximately the same speed. The differences of ISPs around the world vary no more than 2-3 Mbps in the Netflix report, negligible from a user experience perspective. In fact Netflix discloses that the ranking is not a measure of ISP speed but rather “variety of encodes Netflix uses to deliver the TV shows and movies as well as the variety of devices members use and home network conditions.”

In any case the pseudo-transparent report is potent lever in the high-stakes game of public opinion and policy, and Netflix uses the report game ISPs against one another both in the same countries and internationally. It also uses the report to help it win a favorable baseline when it launches in a new country, as it deployed against Telenor in its Norwegian launch. Telenor, which covers Europe’s the longest country with next generation networks and CDNs, offered to cache Netflix content for a negotiated, market-based fee. Netflix countered that Telenor connect to its nearest exchange in Sweden run by competitor Telia or use its relationship with transit partner Level3, known in the industry as the low-cost, low-quality provider. Both options entailed costs for the parties, but the locally deployed solution in Norway by Telenor ensured a better experience for Telenor customers. When Telenor declined, Netflix threatened to expose the company as having a slow network with no CDN in place. Telenor called the practice blackmail and refused to comply. Netflix published its Norwegian ISP speed report, putting Telenor in last place.

Hijacking net neutrality for its business advantage
Netflix’s letter to investors noted its successful launch in mainland Europe earlier this year, adding 66 million households to its potential market. As part of a charm tour to grease the wheels of the company’s rollout, Netflix CEO Reed Hastings went to Brussels to make nice with regulators. There he waxed poetically about the digital commons, net neutrality, and its glowing experience in the Netherlands.

Yet the Dutch are mixed about the “Netflix effect”. Their net neutrality law, which limits operators’ ability to manage networks and recover costs, was meant to herald a flowering of Dutch internet innovation and content. Instead it rolls out the red carpet for the American giant whose traffic ballooned from zero to 20 percent of all downstream network capacity almost overnight with just a small percentage of subscribers. As Netflix grows to its stated goal of one-third of all households, literally the entire network will be taken up by its video streams. See Strand Consult’s report on net neutrality.

If there is any doubt about Netflix’s position on net neutrality and its lobbying activities, read its letter to shareholders: “We continue to focus on strong net neutrality, including interconnection, to prevent large ISPs from holding our joint customers hostage with poor performance in order to extract payments from us, other Internet content firms, and Internet transit suppliers such as Level 3 and Cogent.” The letter continues to describe Netflix’s lobbying activities and its efforts to influence the FCC and stop mergers of competitors.

Particularly galling is Netflix’s statement that controls are needed to prevent ISPs from holding customers “hostage” so that they can extract fees from Netflix, Level3, and Cogent. The evidence largely shows the opposite: Netflix and its partners are willing to misappropriate their customers in a power-play for regulators’ attention. An assiduous review of Netflix’s filings to the FCC notes that the company deliberately slowed its own traffic at key intervals in an attempt to gain favorable regulation. The FCC subsequently opened an investigation on the backbone market, which Netflix had hoped. Separately an independent MIT-UCSD study of congestion in the American backbone networks shows that congestions is not widespread, but when it does it occur, it frequently includes Netflix. The study also looked at Cogent in France and found a similar pattern with the transit provider deliberately attempting to congest ports to win regulatory advantage.

Morever a year long investigation by EU antitrust authorities, conducted with data seized from Telefonica, Orange, and Deutsche Telekom in a raid, found no evidence that operators abused the content or transit markets. This means that arguments made by net neutrality advocates in support of the EU Parliament vote on net neutrality were not based in reality.

Netflix’s heavy lobbying of regulators is all the more disingenuous when compared against its words. Here’s the conciliatory Hastings in Brussels: “Neither side expected that all users would watch Netflix at the same time, and it does generate considerable cost. . . Each should think a little bit about the other because we want a mature and thoughtful dialogue so everybody can prosper in serving the consumer with these great new solutions like on-demand television.”

We doubt that Netflix is interested in sharing. The company certainly expects to charge more for its 4K service. But why should Netflix be allowed to earn a premium for quality, but not operators? When Netflix talks about the “free and open Internet”, they should offer their services for free in support of their rhetoric of “equal access to online content”, but what they really mean is that the cost of network upgrades to facilitate Netflix’s streams should be paid by all internet users, whether or not they subscribe to Netflix.

Fiscal dumping
Netflix’s PR war extends to Hollywood and the content industry. Soon it will release films online on the same day they appear in theatres, effectively destroying the first pay window on which studios rely to recover their costs of production. Netflix denies that the move will kill studio revenues, instead claiming it will “restore choice and options” for consumers. However this strategy may ultimately cannibalize the products that it needs to stock its growing portfolio.

Netflix and OTT video options are forcing regulators to consider requiring cable companies offer channels a la carte, moving to a “pick and pay” model. The strategy could ultimately backfire on European governments. If cable customers are no longer required to buy bundles, they why should citizens be required to pay compulsory media license fees for national broadcasting? Shouldn’t consumers have the choice to decide whether they want to fund national news networks and locally produced content?

There is a high price to paid to get content on the cheap. Part of Netflix’s cost advantage is its ability to arbitrage legal, financial, and regulatory requirements across the countries it operates. By setting up European operations in Luxembourg, a practice called fiscal dumping, Netflix avoids the costly local requirements of taxes, contributions to cultural development funds, and local content quotas. The EU has indicated that it plans to close these loopholes, and Ireland has volunteered to phase out its tax advantaged strategies in five years, but that’s still plenty of time for Netflix to grow. By then, Netflix will have probably entered the sports buying market.

While Silicon Valley may celebrate its disruptive OTT business models, the EU is struggling to deliver social services its citizens expect, namely through taxation. The burden is held disproportionately by local companies that play by the rules, paying taxes and hiring workers. Meanwhile OTT companies can earn revenue in Europe with little to no regulatory costs.

The EU Commission has promised for years to create a level playing, first with Neelie Kroes as Vice President for the Digital Agenda and now echoed by the new Juncker government, but it has yet to materialize. While OTTs should have the same obligations as other providers, we propose that EU remove the antiquated regulations on telcos, adopt a simple framework for all service providers. Then let the chips fall where they may. See the Strand consult Research Note. If the new EU government is serious, then Netflix is on the hook both for taxation and for privacy concerns. Even though Netflix offers a paid service, its data mining practices may run afoul of EU rules.

Transparency for everyone, except Netflix
As for its stock price, Netflix may have taken a short term slap on the wrist, but the company is eminently placed going forward. It disclosed that its international markets including Canada, the Nordics and Netherlands are collectively profitable, adding “contribution margin from our first expansion market, Canada, now approximates the US”, about 40%. This fact was not lost on the Canadian regulator which asked Netflix to disclose information on its revenue and subscribers in the country. It is estimated that Netflix earns $400 million -$650 million annually on some 4 million Canadians. In an unforgettable display of insolence at a regulatory hearing (see here and here), Netflix, which pays no taxes nor employs anyone in Canada, refused.

The company that praises the virtues of the Open Internet has a low regard for its own transparency. Unsurprisingly it came in dead last in the 2014 CPA-Zicklin Index of Corporate Political Disclosure and Accountability. For all their talk about openness, the Open Internet, and open platforms, OTTs are tipped lipped about their lobbying activities. Lobbying by the the OTT sector has exploded in recent years, with firms such as Netflix, Google, and Facebook active in Washington and Brussels.

Netflix’s letter to shareholders is bullish. It notes goals of achieving a 40% contribution margin across the board in five years, saying “This increase in our domestic contribution margin gives us room to increase content spending as we grow, as well as substantial domestic profitability. . . Operating income nearly doubled y/y to $110 million despite our investment in international expansion.”

Netflix, already larger than any cable company in the world by subscribers, is not a company in need of corporate welfare. It’s time to stop Netflix’s abuse of the political and regulatory system.

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