Investment theme: Net neutrality

dreamstimemaximum_17769332-cm-resaerch-theme-net-neutrality-smThe rules governing net neutrality in the US are poised to change. This could significantly increase earnings for some US broadband providers such as Comcast, AT&T and Verizon whilst simultaneously reducing earnings for heavy internet bandwidth users such as Netflix, Google, Facebook and Amazon. Moreover, there could be a ripple effect around the world if telecom regulators in Europe and some Asian countries – notably India – follow the US’s lead by clobbering successful US internet companies with additional charges.

Net neutrality rules are associated with the founding principles of internet regulation. They stipulate that telecom operators should not favour internet traffic from specific content providers. Comcast’s recent bid to take over Time Warner Cable has prompted the FCC, America’s telecom regulator, to review its stance on net neutrality.

At CM Research, we have long argued that net neutrality was an untenable policy and would eventually collapse as internet traffic grew faster than operators’ ability – or willingness – to carry it. Click here to see what we said about this investment theme in June 2011. For three years, however, we were wrong about net neutrality and timing is everything in equity markets. But in 2014 our theory that the US net neutrality regulatory regime is near collapse suddenly looks more plausible. On 14 January 2014, a US Appeals Court overturned a decision allowing the FCC to impose net neutrality rules on broadband providers. Then, yesterday, the Wall Street Journal reported that the FCC is poised to propose new rules that allow internet service providers to charge content providers extra for priority access.

Why is net neutrality collapsing?

Regulatory policy, by definition, distorts markets, often for a “higher purpose”. But, like all market distortions, there can be unintended side effects. When net neutrality rules were originally introduced in the US back in the early 1990s, the market distortion was that telecom operators were effectively forced to subsidise the fledgling internet sector; the higher purpose was to turn a nascent internet sector into an innovative growth industry for the US and promote openness and freedom around the world; the unintended side effect was that telecom operators cut back on investment in high speed broadband networks because they were prevented from receiving a decent return on their investment through charging commercial rates to heavy internet bandwidth users such as Google or Netflix.

The policy worked. Today, the internet is free, open and innovative. It is also highly profitable. Indeed, internet companies like Apple, Google and Facebook – who benefited most from net neutrality – are now worth more than most telecom operators. But now it has become a victim of its own success.

Back in 2011, we argued that the US net neutrality regime would collapse because politicians would ultimately be forced to accept that in order to encourage more investment in high speed broadband networks – an area that the US and Europe were in danger of falling behind Asia on – regulators would have to free operators to charge commercial rates to all parties that used their networks, including internet companies. We argued that this need not result in the end of a free and open internet because a tiered charging structure could be introduced in which smaller internet companies could be exempt completely.

What does it mean for investors?

The FCC’s reported actions due to be announced later today take us closer to the collapse of net neutrality. The primary investment implication is that this may be the beginning of a gradual shift in the balance of power from internet companies like Google and Netflix to internet service providers like Comcast or Verizon. It is too early to say exactly what will happen until we know what the FCC is proposing. An initial consultation paper is due out on 24 April and a final decision will take several weeks.

But our initial take is that AT&T, Verizon and Comcast look set to be beneficiaries whilst Netflix, Facebook Google and possibly Amazon would be losers. Once the US moves on this, it is likely other countries will follow. Many countries are irate that US internet companies tend to legally avoid local taxes. By using net neutrality arguments, domestic regulators can shift some of the profits from the domestic internet away from US internet companies towards their domestic telecom operators, thereby increasing tax revenues. Net neutrality could thus morph into one of the most significant investment themes of the decade. Watch this space.

Guest post by Cyrus Mewawalla, Independent Investment Analyst at CM Research