We view risk as the permanent loss of capital, and we manage risk to minimize the chances of a permanent loss of capital. In our view, risk generally falls into three broad categories – valuation risk (price that you pay), balance sheet risk (financial leverage) and business risk. While important, we believe that valuation and balance sheet risk can be mitigated through a disciplined investment process. Business risk, on the other hand, is more complex and covers many facets including competition, regulation, management execution, and capital allocation. As industry specialists, our job is to determine the attractiveness of individual securities by thoroughly understanding our respective companies and quantifying in detail the opportunities and risks of each. In this piece, we walk through an example of how we have quantified the regulatory risk of net neutrality for Comcast Corp. (CMCSA) in our estimate of its intrinsic value.
Regulatory Risk of Net Neutrality
A day rarely goes by with no news on net neutrality. The flurry of media activity started with President Obama’s November 10, 2014 letter to the FCC, which proposed that the FCC regulate broadband service under Title II of the Communications Act of 1934. In addition to the widespread media coverage, the public has also weighed in by sending millions of comments to the FCC expressing their support on the issue. In response, the FCC approved and issued an open internet order on February 26, 2015 that is scheduled to go into effect soon. As a result, a narrative took hold in the market that regulation is a major risk for the cable industry, and Comcast in particular, adversely impacting the stock prices of industry participants. This happened because investors generally do not like uncertainty and often tend to reflect the worst-case outcome in the stock price.
For those unfamiliar with the topic, net neutrality essentially means that the owners of the internet’s last mile infrastructure (i.e. cable companies including Comcast) should not be allowed to abuse their dominant position at the expense of either internet services companies or the consumer. Opponents of net neutrality point to the level of investment that has gone into creating and maintaining our broadband infrastructure and the impact that regulation could have if there are not enough incentives for cable companies to invest in their network. Opinions on this issue are plentiful as evidenced by the number of comments that the FCC received. However, the purpose of this piece is to explain how we estimate the risk of net neutrality to Comcast, not to discuss where we stand on the issue. I remember what Diamond Hill portfolio manager Chuck Bath once said – “Focus on what will happen and not what should happen”.
The FCC’s open internet order essentially regulates broadband under the Communications Act of 1934 albeit with a light touch, applying some, but not all, aspects. According to the rules, Comcast cannot throttle or block any internet service, and it cannot create fast lanes for some internet companies, in return for an economic benefit, that might degrade internet performance for everyone else. It is important to note that none of this is happening right now. Comcast has not created fast lanes for anyone nor does it block or throttle any service, and we do not account for any future revenue benefit occurring to Comcast from fast lanes in our investment model. Thus, the open internet rules do not currently impact our intrinsic value estimate for the company.
Potential Adverse Scenarios and Impact
Why are Comcast and others looking to pursue legal action against the FCC if the open internet order is not likely to have a major negative impact? On a recent earnings conference call, Comcast CEO Brian Roberts said the following: “We are absolutely for a free and open internet. We even agree on what President Obama and (FCC) Chairman Wheeler say should be in the rules, transparency, non-discrimination, no blocking, no throttling and no paid prioritization. The disagreement boils down to what legal authority the FCC should use to put in place these rules.” It seems that the industry and the markets are concerned that regulating broadband, even in a “light touch” way, will leave the door open to rate regulation in the future. A common view is that this might impact broadband pricing power, one of the key tenets of our investment thesis on Comcast.
If history is any guide, it could be many years before we get clarity on the FCC’s authority to regulate broadband. The FCC’s first attempt to introduce open internet rules in 2010 was largely struck down by the district court in the Verizon vs. FCC case in 2014. In this case, the district court asserted that the FCC did not have the authority to regulate broadband. While the FCC may have a better case this time, it will take many years for this issue to be resolved in the courts. We believe it is helpful to frame an adverse scenario in cases where the outcome or the timing cannot be accurately predicted. In the case of Comcast, an adverse scenario might be the FCC introducing rate regulation if the FCC’s legal authority to regulate broadband is upheld by the courts. We assume 3-4% annual price increases over the next five years, which we believe are reasonable given the increase in bandwidth consumption and the level of investment needed to support it. In our opinion, it would be hard for the FCC to make a case that Comcast should not be allowed price increases in that range given the ongoing investment needed to support broadband consumption. Thus, even in the adverse scenario, we believe the impact on Comcast’s pricing power would be marginal. Considering that this is just one of the potential outcomes with a low probability of transpiring over the next five years, we believe the impact on our estimate of intrinsic value should be minimal.
In addition, it is worth mentioning that there is one aspect of the cable delivery infrastructure to which few people pay attention. The cable pipe is sectioned into separate “lanes” – a traditional TV service lane, an internet lane, and a “managed IP services” lane which is dedicated to delivering specialized services such as fixed telephony and On Demand TV. This lane distinction is important because when a customer watches an on-demand show on Comcast’s platform, the streaming travels over this third lane, not on the internet lane. As per the FCC, all services delivered via this third lane are considered Non Broadband Internet Access Service (Non BIAS) and do not fall under the purview of current internet rules. A few months back, there was media speculation that Netflix and Comcast had discussions on including Netflix’s service on Comcast’s X1 platform presumably via this third lane. At a recent investor conference, Charter Communications CEO Tom Rutledge said, “I’ve had discussions with them (Netflix). I find them to be a service that attracts people to us because they like our broadband network and they like their product. And I’m perfectly comfortable if I can find the right way to present it and putting Netflix in my user interface and making it work”. If such contracts become common in the marketplace and if Netflix’s service, which is the biggest driver of internet traffic, were to move to this third lane, wouldn’t the performance of other internet services improve? Isn’t this contrary to the rationale behind net neutrality? In our opinion, it is quite possible that further discussion and analysis on this topic will ultimately undermine many of the arguments favoring net neutrality, and the scope and impact of the open internet rules might become greatly diminished.
As industry specialists we perform in-depth research to identify and quantify opportunities available to and threats facing each of our holdings to estimate what a business is worth. This discipline helps us look beyond the short-term market narrative and gain conviction in our investments. At a time of increased regulation when the market is worried about Comcast’s ability to maintain broadband pricing power, we believe that nothing in the current open internet order will impact the economics of the company’s broadband business. In our opinion, rate regulation remains a low probability event in the near term, and even if it were introduced, it would be hard for the FCC to deny modest price increases given the increased broadband consumption and the investment needed to maintain it.
Originally published on June 17, 2015
The views expressed are those of the research analyst as of June 2015, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.