Telebomb

The Truth Behind the $500-Billion Telecom Bust and What the Industry Must Do to Recover

Author: John Handley
Pub Date: 2007
Your Price: $24.95
ISBN: 0814408338
Format: Hardcover

• Telebomb
• Chapter 8
• Table of Contents
• Request an Evaluation Copy, INSTRUCTOR ONLY!

Chapter 8
LOST OPPORTUNITIES BY THE CABLE COMPANIES

The cable companies were in a much better position to compete with the RBOCs than the CLECs and even the long-distance companies. The cable companies already owned a connection into most homes in the United States, they had the local bandwidth that the rest of the industry (including the RBOCs) needed, and they had new voice and video products to sell. But they were too distracted by mergers and acquisitions to finish implementing the new services.

The cable companies were able to find $90 billion between 1996 and 2002 to invest in upgrading their networks. The strongest of the cable carriers were able to borrow on good terms; the others resorted to the junk bond markets. In the end, however, every major cable company took on significant debt to finance its contribution to the telecom investment boom. The building binge that followed amounted to a complete overhaul of the cable infrastructure in the United States. The rebuild gave the cable companies a huge technical advantage over the RBOCs in delivering new, innovative services to consumers. The cable companies weren't able to maintain the initiative, though; they were too busy getting bigger.

The RBOCs merged with regularity during the late 1990s, but the Bell-on-Bell mergers required relatively little in the way of integration work since the RBOCs had similar management structures, information systems, and technology. More significantly, very little cash traded hands in the Bell transactions. The cable companies, however, spent immense amounts of cash bidding up the price of a cable subscriber to unsupportable heights. There were more than twenty transactions within the cable industry in which a minimum of $1 billion worth of subscribers changed hands.

Before the telecommunications boom, cable franchises traded hands at approximately $2,000 per subscriber. Even with all the great new services that the cable companies offered as a result of the Internet and the cable network upgrades of the 1990s, it was still hard to justify a price higher than about $3,000 per subscriber. Against that backdrop, the major acquirers of cable systems bid the prices up, mirroring the unsupportable prices paid for dot-com stocks. AT&T's purchase of MediaOne in 2000 set the top of the market at $9,000 per subscriber.

Once the hype met reality, AT&T and many other cable companies felt the financial strain of the cable system purchases. AT&T spun off its cable operations. Adelphia Communications went into bankruptcy, and the other cable companies had difficulty servicing their debt. The operating model of the cable industry had always depended on high debt levels, but the use of expanded debt to finance mergers instead of the aggressive pursuit of new revenue caused the cable companies to miss an opportunity to steal a march on the rest of the industry. And the hangover from the acquisition binge will be felt at some cable companies for years to come.

The bottom line for customers of the cable companies is that the high and continuing interest payments required of the companies will force upward pressure on their rates for some time to come. Cable rates regularly increased through both the boom and the telebomb. With no new competitors on the horizon, that trend is likely to continue.


EFFECTS OF THE TELECOMMUNICATIONS ACT ON CABLE

Overall, the Telecommunications Act of 1996 was a positive event for the cable industry. The act didn't add significant constraints or new threats to the cable business other than its support of DBS video services. Perhaps the worst item in the act for the cable companies was a provision making it easier for individuals to put satellite dishes on their property. DBS services are the biggest competition for the cable providers in the provision of video services to the home.

One of the positive aspects of the act was that the procompetitive changes made it easier for the cable companies (and, indeed, all carriers) to offer a broad range of additional communications services. In one of the few purely deregulatory sections of the act, prices for the cable companies' advanced video services were deregulated. At a time when the Internet was just beginning to show the promise of new but untried services, the cable companies had an expansive view of the possibilities. They summed these possibilities up in one word: convergence.


EARLY CONVERGENCE

To the cable industry, convergence meant offering many different kinds of new services (voice, video, data, and images) over one integrated network. Perhaps the biggest and most publicized early effort at convergence was Time Warner Cable's Full Service Network (FSN) project in Orlando, Florida. FSN was designed to provide advanced interactive services including video on demand, interactive shopping, and video games, in addition to normal broadcast video.¹ The project covered four thousand customers in Seminole and Orange Counties and provided television set-top devices that included advanced software and a color printer (for printing coupons and other online content).

The FSN service was rolled out in late 1994 and was generally a hit with customers. However, it was a financial disaster for Time Warner. The expensive set-tops (Time Warner wouldn't admit to a cost figure) couldn't pay for themselves with the small amount of additional revenue they generated. The advanced network was shut down in 1997, with the usual declarations by Time Warner that the project was a success and many valuable lessons were learned.² The FSN, like other cable companies' efforts at mastering convergence, ended up becoming an expensive demonstration project, whether or not that was the original intent.

Like AT&T's bets on computers connected to a closed information distribution network (see Chapter 2), the FSN was directionally correct and technically feasible, but still economically flawed in that the costs were too much for any one company to bear. Developing the services and offering them to a relatively limited set of subscribers over a closed network led to a cost position that was untenable. The ability to offer services developed by others over an open network made more sense. The broad commercialization of the Internet would finally make the hoped-for opportunities realistic, albeit in a different economic model.

Other services, such as telephony and advanced digital video, also appealed to the cable companies as possible candidates for bundling together. (Virtually all the customers of the cable companies were individual consumers rather than businesses.) The ability to bundle many services for sale to consumers also appealed from the competitive standpoint of being able to beat the ILECs. Remember that as late as 1998, the RBOCs were still considered to be a credible threat to the cable companies' video market.

The rub for the cable companies was that for all the new services to work, the cable network had to be upgraded to two-way digital transmission, not an inexpensive proposition. In order to complete the upgrades, the cable companies, always strapped for funds, needed additional financial strength. Given their chronic lack of cash, they would need near flawless execution to pull off the upgrades and get the revenue from these new services flowing quickly. One way to gain the required financial strength necessary to attract outside investment was to become larger, which they did. The fact that all the cable companies had similar financial structures that size alone couldn't change was beside the point. This was the 1990s after all and the cable companies joined the RBOCs and WorldCom in the belief that size matters.

But first, let's look at why the cable network technology had a leg up on the telephone network as the Internet age approached.


CABLE'S ADVANTAGES

Despite the mixed results of the FSN, the cable companies had a more convincing argument than did the ILECs that their networks could handle converged services. As mentioned in Chapter 2, the cable networks' constant need for rehabilitation was historically a drag on their financial performance and customer satisfaction scores. That problem played in their favor, though, when it came time to add high-speed Internet access services. The services were added as part of the normal upgrade cycle over a seven- to ten-year period (roughly 1994 to 2002). It would take the Bells much longer (thirty to forty or more years!) to add broadband as part of the normal replacement cycle for their network.

The cable companies' new services were developed on the same basic transmission technology that they had used for years to deliver video signals. This relatively stable network platform delivered much higher bandwidth to individual users than that of the ILECs. The ILEC network depended on much older designs. The engineering principles used in the telephone network first came to practical use before the 1930s and were intended to support a single voice path to each home in a service area.

Cable plant, on the other hand, has always been designed to deliver multiple, higher-bandwidth channels-or carriers, as they are known in the cable business-to each home. The original engineering work for the cable network was completed more recently (the 1950s and 1960s) than that of the phone network. Also, the newer hybrid fiber-coaxial cable systems used from 1994 on were of much higher capacity than traditional cable plant and modern telephone networks.

While both networks (phone and cable) were originally designed to transmit analog signals, it is easier to assess their relative capacity in the modern telecommunications network by comparing their digital equivalent capacity. The analog voice network is designed to carry voice circuits of roughly 4 KHz. As first digitized, voice circuits require bandwidth of 64 Kb/s (64,000 bits per second). So as designed and later upgraded to digital, the phone network can deliver 64 Kb/s without further network engineering-or "line conditioning" as the engineers call it.

Cable networks, on the other hand, are generally designed to carry 120 video channels, each taking up about 6 MHz of analog spectrum. Each 6-MHz carrier on a cable network can be digitized to carry about 27 Mb/s (27,000,000 bits per second) of bandwidth. Thus, the cable network can deliver almost 3.25 gigabits per second (120 x 27,000,000 - 3.24 Gb/s) to an individual home versus 64 Kb/s for the phone network. (This example is based on a 750-MHz system, the most typical capacity today. The example assumes digitization of the entire system, which is not typically seen.)

The cable network delivers its bandwidth to homes in a service area via one single network path. Each of the 500 to 750 homes in a typical modern service area taps into the same stream of bandwidth and, thus, can view the same programs. By contrast, the phone network generally maintains a separate network path for each line it serves. There is a separate pair of wires installed in the network for each telephone line. The bandwidth delivered on one telephone line is dedicated only to that line.

To make a more accurate comparison of the relative capacity between the two networks, the cable bandwidth should be divided by the number of homes it is designed to serve. The final comparison is 3,240,000,000/750 - 4.32 Mb/s per home for cable versus 64 Kb/s for the phone network. Even with an upgrade to DSL, the phone line is rarely capable of greater than 384 Kb/s and tops out at 1.5 Mb/s. And DSL can only reach about half of the ILECs' subscribers without additional line conditioning.

The cable design not only delivers more bandwidth per user; it allows different users to take more than their pro rata share of the bandwidth at times, making the cable technology more accommodating for common Internet tasks such as downloading graphics or large files.

This analysis is simplified in many ways; nevertheless it shows how the cable network can offer more services on its existing network than can the phone network. The digital upgrade of the cable network meant more (and cost less) than the comparable upgrade to the telephone network. However, the cable companies still needed to find the cash to roll out the promised new services.


THE URGE TO MERGE

"If the dream is big enough, the facts don't matter."
-DEXTER YAGER, AMWAY SALESMAN AND MOTIVATIONAL SPEAKER

Given the potential advantages of the cable network, the cable industry was a natural place to invest. But where to start? In general, the strongest competitors in any industry are able to attract the most capital at the most attractive rates. Since combining businesses was seen as a way to gain financial strength, merger and acquisition departments across the industry were put to work.

Most of the large cable systems in the United States have changed hands at least once since 1990. Some have changed hands four or more times. All the mergers resulted in a rapid consolidation of the cable industry. In 1994, the ten largest cable companies (known as multisystem operators, or MSOs) controlled systems serving 32,055,000 cable subscribers. By 2003, the ten largest MSOs served 59,574,000 subscribers, an 86 percent increase. Comcast led the pack with a 702 percent increase in subscribers, having sucked up the cable systems of three of the other 1994 top ten (Continental Cablevision, TCI Communications, and Jones Intercable). Adelphia Communications (365 percent) and Cox Communications (255 percent) also had significant increases. Charter Communications, which didn't even exist in 1994, acquired enough systems to become the third-largest MSO.³

Another way to explain the concentration in the industry is that in 1994, the top ten MSOs served 53 percent of the basic cable subscribers in the country. By 2003, the top ten served 83 percent of basic cable subscribers. By comparison, at the end of 2001, the RBOCs served 87 percent of the telephone lines in the United States.⁴

The cable industry started its bout of mergers before the RBOCs, in part, because of regulatory freedoms (they didn't have to worry about the restrictions of the MFJ) but also because a more fragmented industry structure made for more numerous merger candidates. The pace quickened as the RBOC mergers went into full swing. The cable industry understood the trend toward larger competitors and wouldn't be left out. The increasingly easy money made available as the U.S. economy eased into the euphoria of the dot-com era also greased the way for many buyouts of cable franchises.

The cable industry consolidation included many junk bond offerings to raise cash needed to complete transactions. Some deals were all stock or a mix of stock and cash, but many of the deals included a large cash component to induce the sellers to enter into the transactions. The indebtedness incurred to complete the mergers added to an industry structure that already included significantly more debt than the ILECs carried. By contrast, each of the RBOC mergers was an all-stock transaction. Since no cash traded hands, the RBOCs didn't have to hang out in the bad neighborhoods where junk bonds are sold. The RBOCs didn't have to raise large sums of cash to buy anyone out.

There was a mania of sorts in the pattern of these mergers. The dot-com era was in full swing, and the possibilities seemed limitless. So, too, were the prices that would be paid for brick-and-mortar businesses, such as cable franchises, that could claim a connection to the Internet. Figure 8-1 shows the per-subscriber prices paid for cable companies during the dot-com era. Both the price per subscriber and the frequency of the deals accelerated at the same pace as volume and prices on the NASDAQ. The top prices paid neatly follow the level of the NASDAQ index through the investment boom and telebomb.

Each of the largest cable companies joined in the feeding frenzy except Time Warner, whose ownership structure was so complex that it was not conducive to complicated merger transactions. A comparative analysis of Time Warner's cable business and financial statements was attempted for this book, but complex ownership structure and continual reengineering of the corporate structures above the cable entity over time made that all but impossible.

Figure 8-1.
Per-subscriber prices paid in major cable mergers and acquisitions, 1994 to 2002.

PROFILES OF TWO MAJOR MSOs

To help you understand how the cable companies operationalized "size matters," this section profiles two major MSOs that grew larger over the past decade: Comcast and Charter. Assessing the differences in their strategies and results gives a hint about what is likely to happen to the cable industry giants in the future.


Comcast: Running with the Big Dogs

By 1996, Comcast was well on its way to becoming a diversified telecom carrier, owning interests in local networks (Teleport Communications Group, or TCG), cellular (Comcast Cellular), and PCS (through its Sprint PCS partnerships), as well as its cable franchises. During the mid-1990s, Comcast conducted several deals that added more than a million subscribers to its business. The deals (with MacLean Hunter Limited and E. W. Scripps) were completed at prices of about $2,000 per subscriber, the norm at the time.

In 1997, Comcast began raising cash and selling noncore businesses to prepare for a push to become a much larger cable company. The first large increment of cash came in June 1997, in the form of a $1 billion investment from Microsoft, whose CEO, Bill Gates, understood the power of broadband networks. Microsoft was investing in making its popular software titles more Internet friendly. But it also saw the synergy of broadband with its software business. The Internet was perceived by Microsoft as an additional marketing and sales channel as well as a way to guard against piracy by tracking licenses through always-on Internet connections.

After the Microsoft investment, Comcast began selling off its interests in other communications businesses to raise cash and clear the decks for the bigger deals to come. TCG was sold to AT&T in 1998. Comcast Cellular was sold to SBC in 1999. The partial ownership of Sprint PCS was also sold.

Comcast's move to become the largest cable company in the United States began in earnest in 1999 with its purchase of Jones Intercable and the announcement of Comcast's acquisition of Lenfest Communications. Those two mergers, along with several smaller ones in 1999 and 2000, increased Comcast's subscriber base by two-thirds in less than two years.

The per-subscriber prices paid in Comcast's 1999 and 2000 cable acquisitions showed a steady acceleration, partly in reaction to the increasing pressure that AT&T was putting on the buy side of the market and partly in reaction to Comcast's desire to cluster its cable franchises together to gain operational efficiencies. Clustering is a cable industry buzzword for operating systems in contiguous geography. This rationale was used by Comcast to explain the extreme price of more than $6,000 per subscriber paid in the Lenfest acquisition. Lenfest's cable systems were located in the greater Philadelphia area, which Comcast considered its home turf. The earlier Jones deal, not necessarily a clustering play, was done at $3,288 per subscriber.

Comcast's biggest deal, however, was the merger with AT&T Broadband in 2002. Once AT&T admitted that its broadband acquisition binge wasn't sustainable, it sought a buyer for the business. Comcast was the obvious choice, having been a significant bidder for MediaOne back in 2000. It was also the largest cable company after AT&T itself and Time Warner (which wasn't in a position to make such an acquisition). Comcast, which more than doubled in size in the transaction, picked up the AT&T Broadband business for less than $4,000 per subscriber in stock and debt acquisition. While that price seems a bit steep now, it was more than $1,000 per subscriber less than the net amount AT&T paid for the business.

At the close of the transaction, Comcast became by far the largest cable company in the United States, with 21.3 million subscribers, nearly 30 percent of the cable subscribers in the country. It also had nearly $35 billion in debt, more than $1,600 for each of Comcast's subscribers. By contrast, the RBOCs averaged less than half that amount of debt per subscriber.

Including the AT&T deal, Comcast's subscriber numbers increased at an average annual rate of 31.3 percent between 1993 and 2002. It is interesting to note that, taking out the effect of the mergers, Comcast's core subscriber numbers grew at only 2.2 percent per year, on average. In the face of competition from direct broadcast satellite, merging was the only way to get larger.

During this period, however, Comcast was able to significantly increase not only its overall subscriber numbers but also its average cable bill. Its revenue per subscriber increased, on average, 8 percent per year from 1993 to 2002, growing from $34 a month to $60 a month. Both rate increases and the addition of new services helped Comcast's top-line (revenue) growth.

The buildout required to offer the new services took its toll on Comcast's operating margins, however. (The analysis of operating margins in this chapter uses earnings before interest, taxes and amortization, or EBITA. The measure includes depreciation in order to reflect the critical nature of capital expenditures in maintaining the network. It does not include taxes because corporate tax rates are often reflective of factors well outside the operations of a cable network. Likewise, amortization is not included. Many of the merger and acquisition transactions included significant amounts of "goodwill" in recognition of the price paid above the asset value of the business. The amortization of this goodwill, particularly as the companies adopted SFAS 142, had the ability to skew financial results dramatically [Time Warner is the poster child for goodwill gone bad] and reduces the comparative value of financial statements for the purpose at hand.) From EBITA margins of 24 to 28 percent in the late 1990s, Comcast's margins dropped to the teens before the AT&T Broadband acquisition. The addition of AT&T Broadband, which was a significant money loser for AT&T, depressed results in the short term for Comcast. The extent to which Comcast can rebuild its EBITA margins to pay down the debt piled up over the course of more than a dozen significant acquisitions will determine its ability to survive, or thrive, or not. With debt service (interest expense plus current debt repayment obligations) that amounts to nearly $20 per month per subscriber in 2004, Comcast was vulnerable to any unfavorable economic factors including competition or increased interest rates.

After selling off most of its noncable assets to finance the expansion of the 1990s, Comcast needed to look for other new sources of cash. In February 2004, it made a bid for The Walt Disney Company, an embattled and undervalued entertainment company with a saner debt/revenue ratio and diverse assets, many of which could be monetized. The Disney bid was a large and risky proposition that was clearly more necessary for Comcast than Disney. Investors knew that Disney's stock was undervalued and quickly factored a higher price for Disney by bidding Disney's stock up 15 percent and Comcast's down 8 percent. The proposed merger later unraveled when Comcast was unwilling to increase its bid.


Charter: A Classic Roll-Up

Charter Communications was started by Microsoft cofounder Paul Allen in 1998. Its stated mission was to be a classic roll-up, buying underperforming assets and turning them into world-class operations. Charter's entry into the buy side of the market for cable franchises at the same time as AT&T and Comcast contributed to the steep increases in cable franchise prices between 1996 and 2000.

Charter entered into more than twenty significant system purchases and swaps over the next four years. It went from essentially zero subscribers in 1997 to 6.5 million at the end of 2002.

The prices that Charter paid for the systems, although not outlandish compared with prices being paid by AT&T and others, were still high given the traditional value of such franchises. Charter paid more than $4,000 per subscriber in some cases, particularly odd for a company whose stated strategy was to buy undervalued assets.

Through the purchase and operation of these franchises, Charter amassed $17 billion in debt. Because it had large cash needs and no track record operating cable franchises, it ended up going to the high-yield debt markets. Charter sold its junk bonds at an average interest rate of more than 10 percent. Even if Charter turned the cable properties it bought into world-class operations, that much high-yield debt would still be a major drag on the company.

Joining the likes of Enron and WorldCom, Charter went through its own legal issues regarding inaccurate financial statements. Charter engaged in aggressive accounting tactics in which it counted more revenue than it should have and deferred expenses to later periods in order to improve its current financial results. Charter subsequently fired CFO Kent Kalkwarf and COO David Barford in the midst of the accounting scandal and restated its financial results for 2000 and 2001.

Charter was successful at increasing revenue in its new franchise areas. Its revenue per subscriber increased 15 percent on average from 1999 to 2002, outpacing gains at Cox and Comcast. Unfortunately for Charter, however, revenue was gained but operating income did not follow. Its EBITA margins averaged less than 10 percent, among the lowest in the industry. Specifically for Charter, slim margins meant that little money was left over after operating the business to make principal and interest payments on the debt gained in the acquisition process.

Although Charter's total debt in 2003 was less than Comcast's, it represented more than $2,600 for each subscriber. At 10 percent interest, the annual interest bill (not counting debt repayment) amounted to $260 per subscriber. That meant $22 from each subscriber's monthly bill was required just to pay interest on the mountain of debt.

Without a significant reduction in total indebtedness, it is unlikely that Charter will be able to survive in its current form, much less prosper from the opportunity to gain revenue by offering new services. Until the right solution is found, it is likely that majority investor Paul Allen will prop the company up.

DELIVERING NEW SERVICES

From 1996 through 2003, the cable industry spent nearly $90 billion in capital expenditures, upgrading its facilities to deliver the latest services, according to National Cable & Telecommunications Association (NCTA) industry statistics. The construction binge amounted to almost a complete overhaul of the cable network in the United States. The companies' finances took a beating during this time from construction outlays as well as merger-and-acquisition costs. By the companies' historical financial standards, it was just business as usual. The cable industry is used to taking much bigger bets than both the ILECs and the traditional long-distance companies.

The network upgrades came in the wake of earlier, more far-reaching experiments in convergence that failed to live up to their potential. Like the Internet after the dot-com bubble, the emerging reality of convergence was more practical. The services that the cable companies added fell into three categories:

1. Digital video services

2. Voice telephony

3. High-speed data


Digital Video Services

With the rebuilding of the cable networks, the cable companies gained the ability to provide digital video. Digital video offers higher picture quality as well as capacity for more channels. By adding two-way capabilities, the upgraded network can also support pay-per-view and interactive video services.

The upgrades were important more as a competitive reaction to DBS services than as a revenue enhancer. Even with the addition of the improved video services, take rates (the number of customers who subscribe to the service divided by the total number who have the service available to them) were stuck at about 20 percent of subscribers in upgraded areas at the end of 2003. The cable companies saw only marginal increases in revenue from digital service tiers. The digital services require an upgraded set-top box to decode the digital services. Customers who receive a set-top box rarely commit to purchase significant additional services. For the cable company, though, the digital set-top box represents an investment of several hundred dollars per customer in the digital revenue stream, further eroding margins.


Voice Telephony

The cable companies were slow to offer voice services. Only Cox and the former AT&T Broadband equipped a significant number of their systems for telephony services by the end of 2002. The take rates were initially high for the cable systems that offered the service but leveled off once price competition set in among the local service providers. Even with a rollout schedule slower than cable modems, cable telephony was in place for 2.2 million customers across Cox, Comcast, and Charter by the end of 2002.⁵ That represented more than 1 percent penetration of the landline telephone market in the United States and about one-third of the non-ILEC lines installed in the United States. Competition kept that number from climbing substantially in 2003.

Beyond the investment constraints inhibiting rollout, another major reason that telephony services are not more widely available on cable systems is rooted in the technology used to support the service. Initial implementations of telephony over cable plant were circuit switched, meaning that for every phone call placed, bandwidth was allocated between the subscriber's phone and the cable companies' local phone switch. This bandwidth was available only to that call, and not released for other uses until the call was disconnected. This type of network looked and worked much like certain types of equipment in the traditional phone network. No surprise, then, that it also had a similar cost structure.

It is easy to enter a market with undifferentiated technology (technology that is the same as competitors offer), but it is harder to provide a compelling offer or establish a competitive edge without better technology or a lower-cost position.

The potential for a lower-cost position was offered by using packet voice (generally VoIP) technology. This technology takes voice conversations, digitizes them, and breaks the digital signals into groups, or packets. The packets can then be sent over the existing IP network used to support cable modem services. Additional savings are also offered because the process of breaking the digital signal into packets allows silence to be compressed or eliminated, saving bandwidth. Whereas circuit-switching technology has been in the cable network for a number of years, the packet voice technology was placed in the network more recently and was only considered robust and reliable enough to be used for voice calls as of 2002.

The incumbent telephone carriers, who have been building regulated phone networks for more than one hundred years, have built networks that are extremely reliable. The cable networks must approach (but not necessarily meet) this level of reliability before consumers will accept them. Among the technological hurdles for the cable networks to surmount to increase reliability was the mundane issue of how to power their telephone systems. When the power goes out at a consumer's home, phone lines provided by an ILEC generally still work. This reliability has come to be expected, particularly when phones are relied on for services such as 9-1-1 calls. Cable networks, on the other hand, were never designed to work when the power is out because cable's video signal is of little value if you can't turn on your TV.

Packet voice technology could be a disruptive technology that beats the RBOCs' voice offerings. It enables a lower-cost position and approaches the services of the ILECs' networks. If it can approach the reliability provided by the incumbent carriers, VoIP is likely to be a valuable addition to the cable companies' bundle of converged services.

It is, however, likely to be only an addition to a converged bucket of services rather than a service sold by itself for two reasons. First, local dial tone is considered a commodity by most users. It is expected to work and it is expected to be cheap. Years of regulatory guidance toward subsidized residential service have conditioned users to expect inexpensive, reliable phone service. Thus, margins on the service are low and only attractive in combination with other services. Second, the incumbent phone companies already offer a low-cost, valuable (if commoditized) service. The cable companies do not have an opportunity to offer significant discounts below the incumbents' subsidized commodity rates.

Unfortunately for the cable companies, in the ten years it has taken them to add telephony to their converged bag of tricks, the incumbents have become much smarter. The incumbents have long-distance approval, and they have the resources to spend on marketing, including win-back campaigns. If the cable companies had focused on cable telephony while the RBOCs were preoccupied with proving that their markets were open to competition, cable telephony could have a much larger market share now. If they had deployed new services more aggressively, they might also have had fewer opportunities to get in trouble in the junk bond markets looking for fast cash fixes to score their next acquisition target.


High-Speed Data

High-speed data service offered via cable modem is much more common than cable telephony services. The idea of using the cable network to distribute data was discussed in the industry as early as 1993. The cable network already acts as a common network to distribute signals to all connected, just like the Ethernet technology used in local area networks. Allocating bandwidth to data services was not difficult. Early cable modem services were even able to use the old coaxial cable plant before it was upgraded to modern hybrid fiber-coaxial plant. The cable upgrades of the late 1990s and early 2000s markedly improved raw data capacity, but the service still needed to be packaged and priced for the consumer market.

The cable industry rallied around a standard (called DOCSIS for "data over cable system interface specification," first published in 1995) to offer cable modem service. Technical standards like DOCSIS create a common song sheet for all suppliers to the industry. When the manufacturers of network gear can make and sell the equipment to a larger number of carriers, they can lower their price points because some of the cost of preproduction R&D is borne by the carriers and because the fixed costs of production setup can be spread across many units. The cable industry was thus able to offer its version of high-speed Internet access sooner and at lower cost than the RBOCs. The RBOCs wrestled with DSL standards for much longer, not settling on de facto standards until nearly five years after the first DOCSIS specification was published.

The combination of low price and high speed became very successful in the market, almost immediately pulling customers away from dial-up connections to the Internet. Cable modem services also compared favorably with the ILECs' DSL service, offering higher bandwidth and wider availability.

Broadband Internet access services (both cable and DSL) became water for the desert traveler at the turn of the twenty-first century. Anyone who was a more-than-casual user of the Internet in the 1990s grew frustrated by dial-up connections. The supposed advantages of the Internet were hard to justify during those long moments while users waited for Web pages to download. During those long waits, the increased cost of broadband became easier and easier to justify. Broadband access solved many of the problems of dial-up connections: pages loaded faster, file downloads were accomplished in seconds rather than minutes or hours, and worries about the size of e-mail file attachments all but disappeared.

Broadband was the final missing piece of the puzzle in the democratization of telecommunications services. The combination of fast, last-mile access to the Internet combined with cheap long-haul rates put all telecommunications services into the realm of possibility for both consumers and small businesses. Broadband enabled the Internet for the masses by offering consumers an option for access to the Internet that rivaled the access already enjoyed by businesses and universities.

Included in the benefits of broadband was the ability to support widespread telecommuting for the first time. Until broadband became available, telecommuters were also hampered by slow, expensive dial-up connections. Once access to e-mail and corporate files was enabled (and secured) over high-speed, open connections, the location of many U.S. jobs became irrelevant. Once location became irrelevant, the work could be done at home, or even in another country. As high-speed Internet connections became more prevalent and less expensive around the world, offshore outsourcing became a trend in corporate America.

Cable modems will be pointed out by supporters of the cable companies as a shining example of their product innovativeness, but the cable modem was in fact a marginal development that ran on top of existing cable technology. The digital upgrade made it better, but it would still have been a competitor for DSL without the upgrade. Because of dot-com machinations and the ever-changing ownership situations, cable modem services were not rolled out as aggressively as they could have been.

It is true that cable modem services handily outpace the incumbent telcos' DSL technology in providing broadband Internet access to consumers, but that is more attributable to the telcos' inactivity than to anything brilliant about the introduction of cable modems.

The ILECs were slow to invest in rolling out the electronics that supported DSL service. But even once the electronics were deployed, fewer than half of their subscribers could receive the service without upgrading the network, making broad rollout of DSL service much more time-consuming and expensive than for cable modems. With cable, once the network was upgraded and the electronics to support high-speed Internet service was deployed, essentially 100 percent of the customers were eligible for cable modem service.

Although cable modem service has been offered since 1996, it has begun to contribute meaningfully to financial results only since 2001, reaching 15 percent of revenue at Cox in 2003. Cable modem services have been a financial success for the cable companies. Other new services offered on the upgraded networks have yet to find as broad a market. A look at the market for telecommunications services gives a clue about how the additional services might contribute to future revenue.


WHAT DO CUSTOMERS BUY?

Eight years into the new environment created by the Telecommunications Act, the variety of new services, marketing channels, and provider choices has increased. With all the investment and attempted expansion, what did customers actually buy? A look at the changes in customer spending behavior can be broken into two parts: changes in spending on existing services and spending on new services.


Basic Services

Overall spending for traditional services has remained flat, growing at 7 percent overall (less than 1 percent per year), through the period following the Telecommunications Act. That overall stability masks significant changes within the categories. Local telephony has maintained its slow-growth pace while cable rates have climbed much faster, increasing at an average rate of 8 percent per year. Keep in mind that the average monthly household expenditures increase through both increased take rates and increased prices. Long-distance rates have, predictably, dropped. Table 8-1 shows how spending for these basic services has changed since the passage of the Telecommunications Act.


New Services

Several new services took off in the late 1990s. To say that these services were introduced or broadly deployed based on the provisions of the Telecommunications Act, however, would be a stretch. Particularly in the cases of the wireless and Internet access business, both existed before the act, but neither was strongly influenced by the act. Digital video, though, was specifically deregulated by the act. That deregulation has not guaranteed success, but has given consumers the opportunity to try the new services and the cable companies the opportunity to raise rates. Table 8-2 shows how the market for these new services has developed.

Each of the new services has seen dramatic growth, with wireless service being the leader. Ironically, wireless is a corner of the telecommunications market that the cable companies sold out of to raise cash for their landline investments. Internet access has shown dramatic growth, also. Digital video services, deregulated by the Telecommunications Act, have not proven to be a significant revenue generator.

Overall Spending

Figure 8-2 shows the total average each household spends for all telecommunications services. Based mostly on increased take rates for services like Internet access and wireless phones, the average U.S. household now spends 68 percent more per month on communications services than it did in 1996. Assuming that consumers perceive additional value in the marginal dollars spent (otherwise, why would they spend the money?), the industry has increased its usefulness and reached its goals of bringing new products to market. On a segment-by-segment basis, however, the investments required to achieve those gains were not always in proportion to the revenue increases. How well a company matched its investments to the services it wanted to offer in large part determined its success in the market.

Figure 8-2.

WHAT IS A CABLE SUBSCRIBER WORTH?


"2 is not equal to 3, not even for large values of 2."
-GRABEL'S LAW

None of the cable companies were able to realize the potential value that led them to pay $4,500 to $9,000 for a cable subscriber. Mergers in the cable industry were not a way to create value. The cable companies spent more time and money on merger-and-acquisition activity than on product development. It is extremely hard to provide a cogent story as to why cable systems reached such stratospheric prices, particularly when the mergers cost the cable companies an opportunity to steal a march on the RBOCs.

The escalating valuations were based in part on dot-com-era hype about convergence. If you believed in convergence, it was logical to believe that the cable companies were in a position to capture some of the existing telephony revenue as well as revenue for new services such as data and advanced video. But if you add up all the potential revenue the cable companies could reasonably have hoped to gain from the telecom spend of the average American, it is still impossible to support a $9,000-per-subscriber valuation.

Services generally offered or within easy reach of the cable companies are:

* Basic cable

* Digital cable

* High-speed Internet access

* Local telephone service

* Long-distance telephone service

Basic cable and local telephone service are well-known commodity services. Their prices are subject to extensive study and regulation. They are unlikely to increase at rapid rates. Long-distance telephone service is less regulated but no less a commodity, thanks to the second racers. Its price, particularly in a bundle of services, is decreasing, not increasing. High-speed Internet access is also subject to some competition, with DSL and other offerings in the same markets. In addition, if the cable companies want to replace dial-up Internet access, they must find price points closer to those of America Online (AOL) and the Microsoft Network (MSN) as they draw more customers away.

Digital cable is a largely unregulated service, but it offers little differentiation from direct broadcast satellite services, so pricing in this market is also competitive. Neither the take rates nor the revenue from these services has met the expectations of the cable companies.

Table 8-3 provides a look at the revenue potential if a high-end customer were to take all of the potential services offered by the cable company. It is based on the average amount that customers pay for these services, not the most that a customer pays. Obviously, heavy pay-per-view users and international callers, for example, will be well above these numbers.

Operating margins (EBITA) in the industry are unlikely to return to their historic norms, but they can return to about 20 percent across the industry. At that level, a high-end customer could be generating $27.40 in operating income per month, or $328.80 per year. Using 10 percent cost of capital as a discount rate, that subscriber is worth $3,288 ($328.80/.10 - $3,288).

Although the cable companies are getting closer to the Holy Grail of the $100-per-month cable bill, inflation and competitive pressure on pricing have reduced the attractiveness of that proposition. In the real world of 2003, average cable bills were still about $65, less than half of the high-end customer's bill. Given current operating margins for the cable operators, the average customer is worth less than $1,500.

The perfect storm that hit the telecommunications industry also hit the cable sector. Once it became clear that cable property values were not rising to the levels promised by $6,000 and $9,000 per-subscriber prices, the merger-and-acquisition deal velocity cooled down just like the dot-com mania. Not only were the prices asked for by the few sellers in the market unrealistic; competition from the major acquirers dropped out of sight. AT&T was busy retrenching. Charter was overextended. Comcast was busy digesting its acquisitions.

The weight of periodic interest payments on the mountain of acquired debt became enough of a drag on the cable companies that they were unable to acquire more or to capitalize on the increased strength that size gave them. For the issuers of junk bonds, this effect has been accelerated by the high interest rates paid on their bonds. The cable network rebuilding frenzy also cooled down, having peaked in 2001, according to the NCTA. So the acquisition of more debt was unlikely. The question remains: Which companies can live with what they have?

"I had great difficulty figuring out how the South, having won every battle, could possibly have lost the war."
-COLGATE DARDEN, FORMER GOVERNOR OF VIRGINIA, ON HOW THE CIVIL WAR WAS DISCUSSED IN THE SOUTH IN THE EARLY DAYS OF THE TWENTIETH CENTURY

The cable companies won the battle to upgrade their networks to handle modern services and to have enough carrying capacity to satisfy modern telecommunications (that is, Internet) demand. But the distractions inherent in their frequent mergers and high debt levels left them exhausted after the battle and unable to continue on the initiative. If the next battle were only among the cable companies, as in the days of the walled gardens, then a competitive stasis would have been reached by the end of 2003 for all but the most overextended carriers. But the cable companies' performance as a competitor and as an investment is no longer solely compared with the other cable companies but also to their direct competitors, the RBOCs, the CLECs, and other companies in the industry. Winning the broadband battle was important. Winning the overall competitive war is still a long way off.

The ability of the large cable companies to establish themselves on firm financial ground by shedding debt gathered in the wake of the Telecommunications Act will be the prime determiner of their ability to become effective competitors in the telecom business. And cable subscribers will be footing that bill. Looking at which companies have less of a mountain to climb in 2004, Time Warner and Cox could see the top of the mountain; Comcast and Charter couldn't see the crest yet.

NOTES

1. "Show Home to Feature Full Service Network," Orlando Sentinel, February 17, 1995.

2. "Time Warner Cable to End FSN Test," Orlando Sentinel, May 1, 1997.

3. "Cable Television Developments," National Cable & Telecommunications Association (NCTA), December 2002, www.ncta.com.

4. "Trends in Telephone Service," Industry Analysis and Technology Division, Wireline Competition Bureau, FCC, August 2003, p. 7-4.

5. Telephony subscriber data from company reports to the SEC on Form 10-K for the year 2002.

© 2005 John Handley.
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