UPDATE: The FCC voted to approve Net Neutrality Thursday, ruling in favor of governing the internet like a public utility.
Consumers love data, particularly in the form of movies. Netflix (NFLX) streaming video data account for about a third of peak internet traffic in the U.S. Traffic has to flow along a road, and roads need to be built for that traffic to flow. Both consumers and producers have a strong interest in a good road system — since without it, they couldn’t buy or sell any goods.
The question is: who will pay for the roads that make commerce possible? In the case of the interstate highway system — one of the foundations of post-WW2 U.S. prosperity — the answer is simple. They’re public, since it would make no sense to have competing privately-run interstate highway networks. So we have funded them through taxes.
This same question — who will pay for the infrastructure? — is the driving force behind the “net neutrality” debate. As internet-delivered applications get more data intensive, and as consumer demand for them grows, settling that question becomes more contentious. There are many parties involved — digital content providers, regional and national internet service providers, companies that manage the internet’s backbone, and content delivery networks that help move internet traffic to its destination. All of these parties see the regulatory environment as something that can help them or hurt them — and all of them are struggling to shape that regulatory environment in a way that protects and promotes their interests.
The net neutrality debate is generating more heat than light. The appeals made by all sides are emotional and are intended to provoke a response, rather than inspire careful thought. The very term “net neutrality” itself is not neutral, but is intended to shape the thought of the public in a particular way.
What Do They Mean By “Net Neutrality”?
To understand what “net neutrality” means, you need a broad picture of the internet’s structure.
Consumers think of the internet mostly in terms of their own “last mile” provider. If the internet is a highway system, the last mile provider is the road that goes from the off-ramp to your driveway. This provider is your internet service provider (ISP) — either a big national company like Sprint (S) or AT&T (T) , or a regional company like Cox, Frontier (FTR) , or EarthLink (ELNK) .
However, the trip that data takes from a “content provider” like Netflix to your last mile provider can be complex.
If your ISP is a big national company, it might carry the data all the way to you from its point of origin.
These companies provide last mile service as well as operating national networks. Alternately, the data may pass through a “backbone” company, a national network which doesn’t provide last mile service to any customers.
Some big content providers are building connections directly to local ISPs. And in between, there may also be “content distribution networks” (CDNs) — companies who buy servers and position them strategically to carry clients’ data to its destination more efficiently.
In its original meaning, net neutrality referred to “last mile” provision. In short, when it comes to that final
stretch from the internet’s highway into your home, your provider should treat all the data equally and not give preference to data originating from a content provider with whom they have a special relationship (financial or otherwise).
Muddying the Waters
Those on both sides of the “net neutrality” debate are guilty of muddying the waters. The issue of the “last mile” service provider is only part of the story — and there is broad agreement that in that restricted “last mile” sense, net neutrality should prevail.
The other part of the story is the deals that happen and the conflicts that arise as players further upstream negotiate with one another, jockey for position, and try to get someone else to build the infrastructure to deliver the ever-growing torrent of data that consumers want and producers want to sell to them.
This area, where backbone providers, content delivery networks (CDNs), and national ISPs interact, is called “peering.” In the past, big networks have agreed to carry each others’ traffic reciprocally without payment, since such an arrangement eased the transit of traffic to consumers, made consumers want to buy more, and made money for everyone involved. That worked as long as the amount of data carried into and out of each network was comparable.
Now data streams have gotten bigger and more asymmetrical, and big network peers are sparring over who should pay to build the pipes.
Jockeying For Position
The argument goes something like this. Content producers, like Netflix, talk to the national ISPs and CDNs and say, “Retail customers are demanding our content. When they signed up with you, you promised to deliver all the content available on the web — so you should pay to build the pipes and deliver it to them.”
In response, the people who build and run the internet’s backbone turn the demand around, and say to the content providers: “Retail customers are demanding your content. Your content has gotten much more data intensive, so clearly you should pay to build the pipes that take it to them.”
You could look at either argument and think, “That’s a reasonable position.”
It’s a Tussle, Not a Debate About Principles
An old German saying says, “When there’s fire in the heart, there’s smoke in the head.” The two sides arguing here are trying to encourage an emotional response in their audience — and that makes it harder for people to think clearly.
Our job as investors is to think clearly.
If content providers like Netflix are prohibited from paying the various data transit companies, then the burden of building out infrastructure capable of handling ever-increasing data streams will fall on those transit companies themselves, if they want to keep the customers who demand the data. So of course, content providers have a motive to convince the public that something nefarious would be going on if they had to contribute more directly to the infrastructure that makes it possible for their products to reach consumers.
Likewise, the transit companies like AT&T or Sprint make a similar pitch to the public and to legislators – but theirs is about property rights. They want convince the public that something nefarious would be going on if they were the ones who had to pay the price for infrastructure expansion. “Net neutrality,” to them, means that theycan’t accept payment from content providers to help them build out the infrastructure. So they say, “It’s our system — we can make whatever arrangements with content providers we want to. That’s our right as property owners!”
All we’re witnessing is a tussle between the two sides — and we’re watching as they make emotional appeals to the public and to lawmakers to try to get a regulatory regime that’s more economically friendly to them.
So as an investor, put it to bed. Realize that in this particular debate, there are no great matters of principle being determined. Look at what the various outcomes may be, and who might benefit from them.
Likely Outcomes and Beneficiaries
Which outcome would be best for consumers — a win for “net neutrality” or a defeat? We’re not sure; we suspect that innovation in this space will continue, and will continue to provide unexpected twists, no matter what happens.
With the President weighing in behind net neutrality, there’s a headwind for the transit companies. The prospect that they may be placed under Title II of the 1934 Communications Act will worry investors, since it entails the prospect of closer regulation, as well as government control of rates — although Mr Obama and other “net neutrality” advocates say they don’t want to do that.
However, we note that during the last “net neutrality” scare in 2010, the correction in transit companies’ stocks was transient, and followed by a strong rally. We believe there may be a similar over-reaction now — with the markets getting anxious and then calming down as they determine that any changes won’t be earth-shattering.
Likewise, the prospect of “net neutrality” regulation is a tailwind for content providers (such as Netflix, Google (GOOG) , or Apple (AAPL) ). (GIM owns AAPL and GOOG for some clients.) They won’t have to compete with one another to pay transit companies to take their data to customers… and those customers’ demand will make sure the transit companies get the job done themselves, lest they lose out to competitors.
Investment implications: Keep an eye on the “net neutrality” debate as it heats up. Pay no attention to the emotional appeals made to matters of principle. Realize that the outcome is probably not going to represent a truly substantive shift in the landscape — so watch for groups getting punished by negative market sentiment as possible buying opportunities. If and when the dust settles, look at the shape of legislation to see which groups may incrementally benefit.
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