May 19, 2015 12:33 PM

Who Profits from Keeping Your Favorite Content Off the Internet?

In the last post, we discussed how the broad new regulatory framework that the FCC's Net Neutrality/Broadband Reclassification Order imposes on ISPs is predicated on a few, demonstrably erroneous, presumptions about the incentives of broadband ISPs.  Contrary to the FCC's assumptions, the evidence demonstrates that broadband ISPs have a powerful economic incentive to efficiently increase output of their most profitable product--broadband Internet access.   

But, incentives--and their impact on how consumers receive content today, vs how consumers would like to receive that same content--could use some further fleshing out.  After all, if someone didn't have an incentive to keep your favorite content off the Internet--you wouldn't be paying the same company two fat bills--for TV and broadband Internet--every month, would you?

Internet Consumers Love Content, and ISPs [Don't] Love to Sell It

While consumers love the high quality content that broadband providers offer through their MVPD service, TV distribution is not a profitable service for many broadband ISPs and is not the most profitable service for any broadband ISP.  See, e.g., this recent AP article, citing SNL Kagan figures, that cable companies earn 60% cash flow margins on broadband service vs. 17% on video service.   

But, even though most wireline ISPs would rather not be in the pay-TV business, there is a strong correlation between consumers that purchase pay-TV service and those that purchase broadband Internet service.  In the AP article cited above, Comcast says that about 70% of its video customers also purchase broadband Internet service.  For non-incumbent cable companies, the correlation may be much higher.  See, e.g., Randall Stephenson, Statement to House Judiciary Committee, June 24 2014, at 3 (More than 97% of AT&T's video customers also purchase another AT&T service.)  The fact is that broadband ISPs believe they must offer pay-TV service in order to compete for the best broadband Internet customers. 

Big Content Loves Consumers' $$ . . . Just Not Consumers

As noted in the last post, the big content companies do not seem to be as responsive to consumer demand as broadband ISPs.  In fact, companies like CBS, Comcast, Disney, Fox, Time Warner, Viacom, and various cable/satellite-owned regional sports networks generally don't make their "linear" (sports, news, and primetime) programming available online at any price, unless the customer is also a TV subscriber.  

And, it's not cheap to be a TV subscriber.  In its most recent Video Competition Report the FCC notes that, in 2012-2013, the price of the most popular tier of channels increased at a rate 3x the rate of inflation for the same year. 16th Annual Video Competition Report, table 5.  (5.1% vs. 1.7% inflation)  Comcast recently disclosed that its programming costs increased by almost 7.8% in the past year--almost 10x the inflation rate!  According to Nielsen, consumers now purchase an average of 189 channels per month, but watch only 17.

The FCC [Still] Doesn't Understand that Incentives = Profit

It's clear that, despite the evidence, the FCC still believes that, for most ISPs, it's more profitable to distribute programming for "Big Content" than it is to produce and deliver their own broadband Internet access service.  That's the only explanation for why Chairman Wheeler would offer this counsel to ISP/MVPDs at NCTA's recent INTX show:  

History proves that absent competition a predominant position in the market such as yours creates economic incentives to use that market power to protect your traditional business in a way that is ultimately harmful to consumers. . . . Your challenge will be to overcome the temptation to use your predominant position in broadband to protect your traditional cable business.
Remarks of Chairman Tom Wheeler, NCTA-INTX 2015, (as prepared) at 6. 

Chairman Wheeler points out that MVPD's spent $26 billion on programming in 2013, but he doesn't mention that as this number grows, MVPD profit declines.  Wheeler Speech at 3.  According to data relied on by the FCC, programming costs (as a percentage of revenue) were the highest in 2013 that this expense had ever been. 16th Annual Video Competition Report, at ΒΆ 89.   Meanwhile, also in 2013, the same companies invested even more in the means of production for broadband Internet service ($28 billion (according to U.S. Telecom data) vs. >$26 billion (which includes non-ISP DBS firms' spending on content).

If Profit = Incentive, Who Profits from Keeping Content Off the Internet?

Chairman Wheeler is correct in his (implicit) premise--that the parties that benefit most from the status quo do not tend to willingly embrace disruption of the status quo.  But, the Chairman is mistaken about who benefits from maintaining the inefficient, and artificial, separation of the function of content delivery into the "MVPD" business and the "broadband Internet."  If the FCC ever thought to ask itself why these two businesses were still separate businesses at all, the Commission might want to "follow the money."

Profit Margins ISPs v Big Content3.jpgThe table above compares profit margins (income/sales) of the largest ISPs and the largest providers of MVPD content over the past 4 years.  Looking at the relative profitability of content distribution, versus broadband Internet/MVPD--and recognizing, as noted earlier, that the ISPs would be more profitable without their MVPD businesses--then there's really no question that the group which benefits most from the "traditional cable business" is not the ISPs/MVPDs, but rather, Big Content.  

But, even though Chairman Wheeler's assumptions about ISP's incentives are mistaken, he correctly observes that,

      The Internet will disrupt your existing business model. It does that to everyone.

Wheeler Speech at 6.  But, if you're a big content guy, at least he wasn't talking to you--you still get to distribute your content through the free-from-Internet-competition biosphere of the federally regulated MVPD model.  It could be worse, look at Netflix's profit margins . . .
Netflix Profit Margins 3.jpg
The graph above was part of a Seeking Alpha article by Amit Ghate.  Of course, the Big Content companies would probably expect to earn much better profit margins than Netflix, because they have more--and better--content.  But, still, how much better? 

Until now, the Big Content companies have been lucky that the FCC thinks their content needs to be protected from the ISPs.  At some point, though, its always possible that the FCC--or Congress--could start questioning whether parts of the existing pay-TV regulatory scheme are insulating content from the disruptive forces of the Internet.  If I was a content company, though, I would only get worried when they stop inviting me to secret meetings about MVPD mergers. 




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