Mark May and Kevin Allen of Citigroup comment on the Netflix, Inc. (NASDAQ:NFLX), Comcast Corporation (NASDAQ:CMCSA) agreement.

Following press reports earlier in the weekend, Netflix, Inc. (NASDAQ:NFLX) and Comcast Corporation (NASDAQ:CMCSA) issued a joint release this morning stating that the two have entered “a mutually beneficial interconnection agreement that will provide Comcast Corporation (NASDAQ:CMCSA)’s U.S. broadband customers with a high-quality Netflix video experience for years to come”. This agreement follows recent data suggesting performance at a few large ISPs has deteriorated in recent months, and this deal would presumably improve the quality of Netflix’s video streams to its subscribers who use Comcast Corporation (NASDAQ:CMCSA)’s broadband service.

Without knowing the financial terms of this reportedly 10-year paid peering agreement, it is difficult to fully judge if this is an incremental net positive or negative for Netflix. That said, we see four possible positives and one possible negative. On the positive side, assuming the financial terms are reasonable, we’d highlight:

Google Trends  Netflix, Inc. NFLX

 Netflix, Inc. (NASDAQ:NFLX), Comcast Corporation (NASDAQ:CMCSA) four outcomes

1)    With the recent court decision regarding net neutrality and the related uncertainty about the future of an ‘open Internet’, this agreement potentially removes an uncertainty concerning service levels and costs for Netflix;

2)    Comcast Corporation (NASDAQ:CMCSA) currently counts 27% of U.S. broadband subs as customers (51% of cable broadband) and that percent could rise to 43% if the Time Warner Cable Inc (NYSE:TWC) merger closes, which means this deal likely encompasses a significant portion of Netflix’s subscribers;

3)    This agreement could be used as the basis for deals with other broadband providers; and,

4)    Netflix may have received a more favorable deal than what may have been previously discussed given Comcast’s desire to cooperate ahead of the TWC regulatory approval process.

 

The key potential negative could be that Netflix, Inc. (NASDAQ:NFLX)’s cost of streaming in the U.S. could rise for its Comcast subscriber customers as a result of this arrangement. But, to put it into perspective, in 2013 domestic content delivery costs increased $31mn as compared to a $567mn increase in domestic streaming revenue (i.e., a 5.5% incremental cost ratio) and to a domestic streaming contribution margin of 23%. While it’s possible this deal makes it harder for Netflix, Inc. (NASDAQ:NFLX) to hit or exceed its target for a 400bp improvement in domestic streaming contribution margin in CY13, the shortfall if any might not be material.

 

While we continue to have a favorable fundamental view of Netflix and its growth outlook, we also continue to believe the current valuation largely reflects the positive thesis around U.S. and international subscriber potential and pricing power.