Last month, the Obama era
Net Neutrality rules were overturned.
The narrative on this
piece of legislation has long been that these rules preserve the openness and
freedom of the internet (hence the common political ploy to give something a
name suggesting that it is so obviously a good thing and if you oppose is a
sign you are evil, don't fall for this, there are always two sides to every
story); however, I would make the argument that Net Neutrality is an attempt to
fix a tragedy of the commons problem that is inherent in any large piece of
infrastructure that must be shared by many people and companies.
To illustrate this point
I will give a simple example. There was
once an ancient lake that was shared by two villages located on opposite sides
of the lake. Both villages depended on
the lake for their lifeblood - water, fish, recreation, and mud for
construction. Over time, the northern village developed superior boats, fishing
techniques, and social systems which allowed it to prosper economically and
expand. The expansion of the northern
village was not without its difficulties; eventually their society grew so
large and required so much of the lakes resources that the village to the south
was threatened. These two villages both
began fishing the lake as much as possible because there was no reasonable way
to allocate this shared resource.
Eventually all of the fish in the lake were killed and eaten and a
phenomena called eutrophication began to take place rendering the lake useless
for anyone except the algae which flourished in this fishless environment (Eutrophication)
With the resources of
the lake now fully depleted all of the remaining resources were next: the
trees, fish, and animals in the region were decimated and both villages were
quickly brought to ruin. The main point
of this story is that when there is a public resource and no way of allocating
the use of the public resource; all users will be incentivized to use as much
of it as possible and eventually it will be depleted in its entirety (Tragedy of the
commons). This; however, is an example. The reality is much more complicated and this
example from classical economics can be mitigated through proactive long-term
planning.
So how does this apply
to net neutrality?
There are two main
points that need to be considered from this example as to how they relate to
net neutrality:
1.
Over the short term,
the infrastructure needed to communicate information over long distances is
fixed in quantity (yes tech people I realize I'm way over simplifying this but
roll with it). It takes an act of god in
today's regulatory environment to build new infrastructure necessary for
expanding capacity of communication infrastructure (this is likely to be easier
under a republican administration but will still be subject to traditional
NIMBY factors).
2.
Over the long term,
additional infrastructure can be built out to improve speed and functionality;
however, in the interim, without an effective mechanism for allocating the
fixed resource, rational actors will be incentivized to utilize as much of this
public good as they possibly can to maximize profits.
The repeal of the
existing rule; (aka if you support the previous net neutrality legislation)
generally provided that no priority could be given to any content providers
over another content provider, repealing this rule (aka if you support the new
legislation) attempts to provide a pricing mechanism for allocating this
limited resource to unlimited demand, and it's probably not perfect or even
close to it.
Common arguments
against the repeal of net neutrality
1.
Big players will
prioritize traffic to their own properties
2.
Small players will be
shut-out of the market
3.
Big players will have
monopolies
I completely agree
with these concerns. The new framework
will give large internet infrastructure owners more power and will incentivize
smaller and less competitive providers to break themselves up and sell (some of
these may in fact go bankrupt due to inefficient corporate finance decisions
made in the past which I'll get into later).
This will also give original content creators more pricing power;
however, their access to distribution could be limited due to the additional
power of the large service providers and they might need to incur higher costs
for distribution. One big unknown from
all of this will be any action taken by the government to limit the power of
large telecom providers or content owners through the powers at the Department
of Justice and their trust busting.
I believe there are
some important implications to valuation of publicly traded technology
companies which I will walk through in the next section:
1.
Comcast
2.
Disney / Fox deal
3.
Amazon
4.
Netflix
5.
Century Link
1.
Comcast (CMCSA)
Comcast is a company that frankly most people
hate. There are many things Comcast does
which annoy me but generally they are the best option I have in my market for
fast internet. Other folks are beginning
to offer competing services in my home market including Verizon; however,
Comcast is the top dog. In addition to
their dominant position in the infrastructure side of broadband, they have been
working on improving their position in content ownership through deals in which
they wholly own NBC Universal (Acquisition
of NBC Universal by Comcast) and own a stake in Hulu (Hulu). How
does this relate to net neutrality?
Well, now Comcast can charge content creators a higher fee versus having
to previously give everyone the same pricing; and they can benefit from this
higher pricing by not having to charge these fees to their in-house properties.
2.
Disney / Fox Deal (DIS
and FOX)
On December 14th, 2017, Disney and Fox
announced their intent to join forces.
Disney will issue 0.2745 shares for each share of Fox (this ratio was
established based on an estimate of deferred tax liabilities at the time, so
there may be some movement on this due to the tax plan). Disney will also be incurring debt of
approximately $8.5B and those proceeds will be used to fund a dividend to
Fox. The deal is expected to provide
roughly $2B in synergies by year 2020 with the deal estimated to close in
2021. Disney wants to consolidate their
pricing power for content in the face of increasing amounts of cord cutting
which has put immense pressure on ESPN[1] and their Marvel
properties are arguably getting to the end of their useful lives. No doubt the Department of Justice will be
all over this given the concerns with monopoly power this transaction raises;
however, my view is that in the long run Disney is getting much too big to be
reasonably managed as a profitable entity and likely will need to start selling
off pieces of their company.
3.
Amazon (AMZN)
I love Amazon; but an investment in their
publicly traded equity scares the living daylights out of me; and their
investors should be concerned by the repeal of net neutrality. They will likely
start incurring higher costs for the broadband their Amazon Web Services consumes;
which by the way, makes up most of their actual cash flows (sidebar, most of
Amazons cash flows from operations come from a depreciation add-back which
doesn’t bode well for them in the future if growth slows down or they are
forced to write-down any of their assets).
Amazon is a prime candidate for being broken up as discussed by
Professor Scott Galloway from NYU in this brilliant lecture: https://www.youtube.com/watch?v=6NyFRIgulPo&t=3s. I highly recommend watching this for anyone
interested in the future of technology.
If you think Amazon will rule the world their stock may make sense as an
investment but if you think Professor Galloway’s points make sense you should
be very concerned about the current valuation of Amazon.
4.
Netflix (NFLX)
Netflix, the company that is responsible for Amazon Web Services
existing in the first place, and the company that is responsible for an
estimated 30% of broadband usage in the United States, and a company that is
desperately trying to develop their own content to avoid getting hit by a
tsunami of consolidation by big media and resulting price increases. Net neutrality will hit them in two ways:
1.
They will be spending
a lot more going forward related to their back-end infrastructure
2.
They will be spending
a lot more going forward for their content
Netflix owns very little of their content and has entered into agreements
to license most of their content providers (Their recent 10Q as of 9-30-2017
showed over 80% of their content is coming from licensing arrangements)[2]. These agreements are subject to price changes
down the line. Netflix is undoubtedly
going to get hit by these price increases as cord cutting becomes the norm and
content creators, owners, and distributors continue to be able to access
markets outside of normal distribution channels by going direct to consumers
and avoiding cable and bundled streaming services like Netflix. For example, HBO now offers a service that
you can go direct to HBO over the internet and avoid any middle-man. Disney is also likely to be pulling their
content from Netflix[3]. Other original content providers like the NBA
and NFL continue to see stratospheric pricing for their content licensing
deals. This is very bad news for
Netflix. In addition, the shows that
Netflix does originate in-house, these are often paid for up-front before
Netflix knows if they will be a hit or not.
Consumers are already getting tired of Netflix’s dated lineup of movies
and shows and are their subscriber growth is likely to slow down in the face of
tougher economic conditions and an aging and expensive content library.
From a valuation perspective, the biggest adder to Netflix
operating cash flow is a line item called “amortization of streaming content
assets” which is essentially the amortization of the dollars they have been
spending to aggregate content. The more
money they spend, the more money they make; the SEC should be asking a lot of
questions about their methodology for accounting for this which is fully
described in notes to their financial statements on “streaming content”.
5.
Century Link (CTL)
I believe the common stock of this company will go to zero
before the end of February. Century link
has made very poor decisions with their investor dollars, spending it on
stadium sponsorships, dramatically overpaying for acquisitions, and other
proverbial bridges to nowhere. The
timeline for this analysis gets complex but a good place to start is to read
the Company Wikipedia page and then assessing their cash on the balance sheet,
cash flow statement, cash needs, and how that relates to the assets capitalized
on their balance sheet.
From a financial accounting standpoint, Century Link is a basket
case. Their operating income is barely
capable at covering their debt service $1,887M versus $1,320M. These figures can be compared to an
enterprise value of $55,749M and cash flow from operations of $3,796M. At first glance the $3,796M of cash flow from
operations relative to the $55,749M enterprise value shows a payback period of
roughly 14.7 years which isn’t terrible but it’s not great; however, closer
analysis reveals that $3,699M of the total $3,796M of the operating cash flow
is coming from a depreciation add back.
This is problematic. Depreciation
is a non-cash charge, so the reality is that 14.7-year payback period is much
closer to never. Further, they are also
raising money from financing activities by selling off investments and
borrowing money. The nail in the coffin
is that as of September 30, 2017 the company had a cash balance of $160M but
will be expected to pay a dividend of $291M which they will either be unable to
pay or will have to jump through some hoops to find cash to make this payment. The company also has had a consistent
receivables balance of $1,900M over the past several quarters but as I will
detail below this is not translating into actual cash flow generation (I
suspect this balance is overstated as well given the significant lack of actual
cash generated by this business).
What does all this mean?
Well, it is reasonably probable that Century Link is both overstating their
revenue, their fixed assets are overstated, their operating cash flows are
overstated, they will need to cut their dividend, and even some debt holders
will not be paid back (which implies the publicly traded equity is worth
nothing). Years of overpaying for
acquisitions and failure to garner meaningful cash generation from their large
fixed asset and acquisition investments have boxed Century Link management into
a corner and the SEC has taken notice. The
SEC has been sending Century link cryptic letters such the one from as the one
from June 15, 2017[4]
which stated:
“Dear Mr. Ewing: We have completed our review of your filings.
We remind you that the company and its management are responsible for the
accuracy and adequacy of their disclosures, notwithstanding any review,
comments, action or absence of action by the staff”
The company launched an internal investigation into allegation
of “cramming” which was concluded on December 7 and found no support for the
allegations[5]. Channel checks confirmed that cramming in
certain markets did take place and there is a reasonable chance that Century
Link has overstated their revenues.
Author may hold positions in securities mentioned in this
article.
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