Netflix, Inc. (NFLX): Comcast Deal Underscores ISP Leverage

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Wedbush analysts Michael Pachter, Nick Citrin and Nick McKay rate Netflix, Inc. (NASDAQ:NFLX) as an Underperform as the company announces a multi-year interconnection agreement with Comcast Corporation (NASDAQ:CMCSA).

Netflix’s interconnection agreement with Comcast

On Sunday, Netflix, Inc. (NASDAQ:NFLX) announced a multi-year interconnection agreement with Comcast Corporation (NASDAQ:CMCSA) to provide the broadband provider’s domestic customers with a high-quality Netflix video experience. The agreement was described as mutually beneficial in the press release, but terms were not disclosed. We expect the agreement to prevent slowing down (throttling) of Netflix’s video streaming service by Comcast. Throttling has become a more high-profile issue for Netflix in the last couple of months due to the recent U.S. Court of Appeals ruling on Net Neutrality (see below) and reports of Verizon slowing down Netflix streaming for its FiOS subscribers. We believe that Comcast and Time Warner Cable, who are currently in merger discussions, represent around 35% of U.S. broadband households. While we believe that the amount to be paid by Netflix to Comcast is likely relatively small, we believe that in the aggregate, payments to Internet Service Providers (ISPs) will be quite large in the next several years.

Netflix management describes domestic ISP

In its Q4:13 Letter to Shareholders, Netflix management described the concept of a domestic ISP impeding a Netflix video stream to get additional fees as a draconian scenario. In response, Netflix, Inc. (NASDAQ:NFLX) said that it would vigorously protest and encourage our members to demand the open Internet they are paying their ISP to deliver. We think that this comment was quite disingenuous, as Netflix was reportedly in talks with Comcast Corporation (NASDAQ:CMCSA) about paying for access to its broadband network at the time it issued its letter. We think that the agreement reinforces the leverage that broadband providers have over Netflix, leaving the latter no recourse other than to open its checkbook (albeit for an undisclosed amount), as service degradation is a real threat now that the Net Neutrality rules have been eliminated. We expect agreements with other ISPs in coming months, also at undisclosed terms, although Verizon appears to be the most likely to seek very high fees from Netflix, given that it was the lead plaintiff in the Net Neutrality challenge discussed below. In our view, Comcast had an incentive to strike a deal prior to public hearings on its proposed Time Warner Cable acquisition, as the company seeks to expand its footprint in broadband service and likely preferred to have Netflix remain silent.

Comcast will likely charge Netflix between $25 — 50 million annually

We think that Comcast Corporation (NASDAQ:CMCSA) likely sought as much as $0.01/GB transmitted, but think that the companies settled for a fraction of that amount. As we stated above, we believe that Netflix’s 33 million U.S. streaming customers consume an average of 100 GB of data per month, suggesting that Netflix, Inc. (NASDAQ:NFLX)’s throughput across all U.S. broadband is 3.3 billion GB of data per month. At $0.01 per GB, we Netflix would be required to pay approximately $400 million per year, over two-thirds of 2014 consensus operating profit. We think that Comcast was motivated to get a deal in place prior to its merger, but do not expect Verizon Communications Inc. (NYSE:VZ), AT&T Inc. (NYSE:T), Charter Communications, Inc. (NASDAQ:CHTR), Cablevision Systems Corporation (NYSE:CVC) or any other U.S. broadband provider to be similarly motivated to strike a deal.

Netflix valuation

Our price target reflects a sum-of-the-parts that values domestic streaming at $140, international streaming at $17 per share, and domestic DVD at $18 per share. We continue to believe that Netflix, Inc. (NASDAQ:NFLX)’s high valuation is somewhat unwarranted given the potential for slowing domestic growth as competition ramps up, coupled with increasing content and broadband access costs.

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