Will The Comcast Internet Toll Test The Netflix Business Model?

As was mentioned briefly yesterday, and all Netflix longs had hoped it would be promptly dead and buried, Comcast has begun imposing a fee on Internet middleman Level 3 Communications Inc., one of the companies that Netflix Inc. has hired to deliver movies and TV shows to Web customers. Bloomberg adds: "Comcast, the largest U.S. cable TV company, has set up an Internet “toll booth,” charging Level 3 whenever customers request content, the Broomfield, Colorado-based company said in a statement yesterday." This could very well be the end to the Netflix business model which so far has had the benefit of near-free streaming content distribution. Of course, this move was inevitable as Netflix is rapidly stealing traditional cable subscribers from precisely the likes of Comcast, whose premium on demand services are unable to compete with the Netflix model (which is based more on marginal churn retention than anything, and as such has very little barriers to entry). Furthermore, traditional distributors of content are also starting to scratch their heads at the cost-benefit analysis of their Netflix relationship. As such, as more and more gates are imposed, and as the cash breakeven suddenly surges for Netflix, what will likely be impaired is not only the firm's cashflow (which as we described recently has been rapidly declining) but to its long-term growth prospects. In a word: nothing good.

More from Bloomberg:

Level 3 plans to complain to U.S. regulators who may enact so-called net-neutrality rules next month. The Federal Communications Commission is seeking to bar phone and cable providers from interfering with legal traffic on their networks. The rules are backed by President Barack Obama and companies led by Google Inc., EBay Inc. and IAC/InterActiveCorp. Phone and cable companies say rules aren’t needed and may hurt investment.

“This action by Comcast threatens the open Internet and is a clear abuse of the dominant control that Comcast exerts in broadband access,” Thomas Stortz, Level 3’s chief legal officer, said in the statement. “With this action, Comcast is preventing competing content from ever being delivered to Comcast’s subscribers at all, unless Comcast’s unilaterally determined toll is paid.”

Comcast, which is seeking regulatory approval to acquire majority ownership of NBC Universal, defended the fee in a statement, saying it is based on “long established and mutually acceptable commercial arrangements” with Level 3’s peers.

Comcast however is not taking this quietly:

Level 3 is preparing to more than double the traffic it puts on the cable provider’s network and has tried to pressure the company into accepting it for free, Joe Waz, Comcast’s senior vice president for external affairs, said in an e-mailed statement.

Level 3 announced on Nov. 11 that it will carry films and TV shows for the Web streaming service offered by Netflix.

Eventually, this will likely mean an FCC ruling on net neutrality:

FCC Chairman Julius Genachowski, in proposing net neutrality rules last year, called for a principle of non-discrimination by Internet-service providers. The FCC will meet on Dec. 21.

“This means they cannot block or degrade lawful traffic over their networks,” Genachowski said.

Public Knowledge and the Media Access Project, two Washington-based advocacy groups, backed Level 3 yesterday. The groups said the request for payment to carry Level 3 traffic shows the need for stronger net neutrality legislation and more scrutiny of Comcast’s NBC deal.

Therefore the question now becomes who has more clout and pull at the FCC: the movie studios and the legacy cable providers, or nascent companies which have carved out a niche which however has no barriers to entry. While the outcome is uncertain, all it takes is for some weakness at NFLX to be taken advantage of by some other companies which has better relationships with content providers, and can provide the same service for a comparable cost. At best, this will be precisely the customer retention test that NFLX bulls claim the company will be able to pass with flying colors. At a forward multiple that is completely meaningless, they better hope they are correct.