The Rising Cost of Living in Cyberspace

We have a tendency to paint all Internet companies with the same broad brush. After all, the Internet is nothing but code and code is software, which means it costs nothing to make and is lucrative to sell.

Nothing could be further from the truth. Not only are all Internet companies – even those of similar size – not created equally, their business models couldn’t be more different.

Take Google (NASDAQ:GOOG) and Facebook (NASDAQ:FB), for example. They don’t pay for content and make money selling ads. Costs are low and profits are high. It’s a sweet deal.

Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX), on the other hand, pay a steep price to get their products and services into the hands of consumers. And lately, both companies are feeling the squeeze between rising costs and what they can charge customers to maintain market share.

Late last week, Netflix got itself into a pretty nasty shooting match with Verizon (NYSE:VZ). When Internet users experience slow speeds streaming its video content, Netflix has begun showing the following message that suggests Verizon is the problem:

The wireless and broadband giant was not too pleased. Verizon’s general counsel sent a pointed letter to his Netflix counterpart demanding the Silicon Valley company “cease and desist” sending these notices to Verizon’s customers, calling it a “self-serving, deceptive, inaccurate and an unfair business practice.”

Which begs the question, why? Why would tiny Netflix tilt at that enormous windmill – an Internet service provider that controls the last mile of fiber to the homes of millions of Netflix customers? Especially considering that Netflix just cut a deal to deliver streaming video directly over Verizon’s network to improve customer speeds.

The reason is simple: Netflix can’t afford to keep making those kinds of deals.

Netflix now represents up to a third of all North American Internet traffic during peak times. And it costs big ISPs like Verizon and AT&T (NYSE:T) a fortune in equipment and fiber to keep their networks up to advertised speeds – capital expenses they would very much like to share with their biggest user, Netflix.

Internet companies like Microsoft, Google, and Facebook have long-standing deals with broadband giants to ensure their content is delivered with adequate speed. Netflix, on the other hand, pays hefty license fees for nearly all the content it streams. So it’s had to rely on slower, low-cost connections through third-party network providers, a practice it can no longer rely on if it wants to keep customers happy.

That’s why Netflix is pushing back. Chief executive Reed Hastings has called the deals he’s had to make with Verizon and Comcast (NASDAQ:CMCSA) a “slippery slope that gives broadband providers too much leverage,” indicating that he entered into them begrudgingly. Kicking and screaming is more like it.

Netflix’ finger-pointing messages are probably a ploy to get the Federal Communications Commission to step in and disallow those deals as part of its proposed net neutrality rules. It seems to be an act of desperation on the part of Hastings and company.

Not surprisingly, as costs continue to rise, gross margins at Netflix have slid to 30%. But that’s still higher than at ecommerce giant Amazon. At 28%, Amazon’s gross margins are actually lower than Target’s (NYSE:TGT) and only slightly higher than at Barnes & Noble and retail king Walmart (NYSE:WMT).

Again, the culprit is Amazon’s business model. Although China’s Alibaba moves twice as much merchandise as Amazon, Alibaba is just a middleman. It doesn’t make, inventory, or sell any merchandise. As a result, its net income is an astounding 45% of revenue.

In contrast, Seattle-based Amazon barely squeaks out a profit these days. That’s why the world’s largest seller of e-books is currently embroiled in a controversial feud with Hachette Book Group and Bonnier Media. Both sides desperately need a better deal to boost profits.

And Amazon, which recently raised prices on its popular Prime subscription service, would like to keep e-book prices down and maintain its dominant market share. Meanwhile, contracts with HarperCollins and Simon & Schuster are reportedly coming up for renegotiation soon. And so the pressure on Amazon will continue to mount.

For all its glory as a high-profile survivor of the dot-com era; for all its Amazon Prime, e-book, and Kindle clout; for all billionaire Jeff Bezos’ fascination with delivery drones, the colonization of space, and the Washington Post; Amazon is surprisingly no more profitable than brick-and-mortar bookstores and retailers.

No wonder both Amazon and Netflix are working hard to develop their own premium content. No matter where business lives, everyone’s got bills to pay. Even in cyberspace, content is king. And he who controls the content – and sells the ads – makes the big bucks.