Cable's Vision

Voice Clear Money Maker in Cablecos' Field of View

The telephone business "is a much bigger business than the cable business," noted Michael Willner, president and CEO of Insight Communications Co., the ninth largest cable company, and chairman of the NCTA. "So we have a whole lot to gain here."

Willner acknowledged DBS has taken 23 percent of the multichannel video market but suggested that should not come as a surprise to anyone. "When a monopoly business is challenged by a challenger, they're going to get up to 30 percent market share at some point." DBS could do better than 23 percent before things stabilize, Willner added. But he and virtually everyone else addressing the topic stressed that cable, after spending about $65 billion on network upgrades, is positioned to fight back.

"We have an interactive platform that really gives us the ability to deliver multiple services, which I think is an extremely effective way of stemming losses," Willner said. "There's another side of that 30 percent rule, and that's that we go into the telephone business."

Brian Roberts, president of Comcast Corp., which is in the process of becoming the largest cable company with the acquisition of AT&T Broadband, echoed the point. "AT&T, Cox (Communications) and others have been aggressively rolling out circuit switched telephony, and the take rate is essentially no different from what's happened with satellite's experience against cable. People want choices."

Of course voice is but one option cable has when it comes to generating new revenue streams and not the first option of preference on the part of most MSOs (multiple system operators), given the steep learning curve they face in moving into telecommunications. But, right now at least, there's a considerable amount of investor skepticism focused on the other two leading options -- digital TV and high-speed data. The problem is that today's market valuations of cable already account for revenue generated so far by the rollout of digital and data. Notwithstanding the more than respectable penetration rates each has achieved, there's considerable uncertainty as to how much upside is left in either category.

Most cable companies reversed an early 2001 downward trend in new services growth, as measured in revenue-generating units, or RGUs, during the third quarter. However, top cable companies AT&T Broadband and AOL Time Warner still were generating iffy numbers with the release of their first-quarter 2002 results. AT&T's digital subscriber additions slowed to 250,000 for the quarter, down from 335,000 additions during the fourth quarter, although the company showed an uptick in the number of new high-speed data customers. And Time Warner Cable was below revenue expectations with barely any gain in total basic subscribers over the previous quarter, notwithstanding a revenue gain of 19 percent for the quarter (see chart, page 12). Despite strong first-quarter showings by Comcast, Insight and Charter Com- munications and the best quarterly basic subscriber growth in five years by Cox, the cumulative results from seven of the top nine companies with numbers available at press time showed a net loss of 113,000 basic subscribers for the quarter.

People questioning the upside potential in digital subscriber revenue note the early leap to 25 percent penetration of basic subscribers by digital services reflects a shift of existing premium service subscribers from analog to digital tiers. Future gains will have to depend on getting people who have long resisted pay TV service to opt for digital, skeptics note.

Cable leaders take great issue with the skeptics, noting that now the industry is rolling out video on demand that can be accessed via most digital set-tops in the field there's a much greater incentive to subscribe to the digital tier than there once was. "It's easy to go in and sell the customer on the concept of VOD and full VCR functionality and 300 movies in the server," Willner said. "They understand that; they know they don't have to go out and rent the movie." He said where Insight has introduced VOD, voluntary churn rates (the percentage of subscribers who disconnect service for reasons other than moving or failing to pay their bills) are half what they are compared to the churn rate for one-way digital services.

Still, Wall Street is not impressed, noted Niraj Gupta, managing director specializing in video at Salomon Smith Barney. "New products and services are on investors' minds a lot this year, a year when the sustainability of cable's growth story has come into question," he said. "And the obvious question is why."

The Wall Street perception is that "digital is slowing, churn remains too high," Gupta said, although the first quarter was "pretty good for digital." Basic subscriber growth has come under pressure, and video on demand probably isn't the anecdote, he added.

"VOD is being viewed, at least today, as more of a value enhancement to digital cable as opposed to a revenue enhancement," Gupta added. VOD, while it may not be a big revenue generator, differentiates cable's digital offering from that of DBS. Gupta predicts cable will be generating two VOD buys per digital subscriber per month at $3 per purchase by 2005.

How unimpressed Wall Street is can be seen in stock values of the leading MSOs (see chart, page 12), which, on average, are 53 percent off their 52-week highs. In fact, all but two companies were trading at no more than $3 above their 52-week lows at press time, and those two, AOL Time Warner and Comcast, were just more than $3 higher. While industry cash flow has been rising at 12 percent to 14 percent during the past two years and is expected to grow at the same pace through 2003, investors say they've run out of patience waiting for cable to turn a profit.

Richard Greenfield, cable and media analyst at Goldman Sachs & Co., summed up the issue at a recent Paul Kagan & Associates-sponsored financial seminar in New York. With debt ratios that range from three to eight times cash flow and an absence of free cash flow in most instances, the question investors are trying to answer is, "What are these companies worth?" Greenfield said. Speaking at the same conference, John Tinker, partner in Steamer Capital Corp., noted with DBS grabbing "nine out of 10 subscribers, a lot of them in larger markets," investors want to know "how strong is the core business?" To many operators there's a lot more upside in digital than just movies on demand. For example, Roberts said Comcast is talking with TV program producers about being able to offer news, sports and other programming not suited for repeat broadcasts or syndication on an on-demand basis with commercials intact, so there's no added cost to viewers. This would be a "win/win" for everyone in terms of convenience for the viewer, enhanced service value for the operator and more ad revenue for the programmer. Tabulate "the ratings once the ratings people figure out how to track it, and there's no cost," he said.

But such applications, amounting to a network-based version of the set-top personal video recorders (PVRs) offered at retail and in conjunction with DBS services, are only in the planning stages. They require major new investments in VOD infrastructure to handle the volume of programming that would be generated over and above the storage of a few hundred movies, not to mention development of a new business structure among programmers, cable operators and advertisers. "No company can do this alone," Roberts said.

How cable goes about driving to higher levels of penetration and revenue on the high-speed data side of the new services equation is equally uncertain. AOL Time Warner president and CEO Richard Parsons noted "11 million Americans have stepped up to high-speed broadband service," including DSL and cable. "It's inevitable, inexorable, it's going to happen," he said. "The question is time and what will drive it."

So far, the people who have taken high-speed service are the heavy users who "are looking for speed. ... But essentially what you get in broadband right now is what you get in narrowband faster," Parsons added. "And what has to happen, and what we're going to be focused on in our company over the course of the next year, is developing new kinds of offerings and functionality that are unique to broadband."

With more than 2 million subscribers on its broadband Road Runner service, AOL Time Warner has enough penetration to justify content development.

Finding a Voice

But that will all take time. Meanwhile, voice is a fully understood and essential service ready to be deployed. Generally speaking, that hasn't been factored into the cable stock valuations. Gupta predicts that within the next three years or so, 13 percent of industry cash flow will come from data service, 12 percent from digital and 7 percent from voice. But, with data already at 7 percent, digital at 10 percent and voice at just 1 percent, it's voice that will be adding the most to industry cash flow in these projections.

By 2005, industry per-subscriber revenue from the existing service base will average $79 per month compared to $58 at the present time with cash flow up about 44 percent to $34 per month or about $400 per year per subscriber, Gupta predicts. This number would be higher when new services such as HDTV, personal video recording and commercial voice and data are added, he said. "In the markets of Omaha and Orange County, Cox (which offers voice services there) is doing about $400 right now. So it's certainly a number we think the industry can get to."

Consumer voice service is not the only part of the ILECs' turf that cable needs to pursue if it's to capitalize on its biggest growth opportunities, Gupta said. Aside from consumer voice, data and digital video, the biggest upside potential cable has right now is in commercial data and commercial telephony, he asserted. "We think it's a pretty big opportunity." He added that two thirds of the small businesses in any given market are passed by cable plant. "There's clearly an opportunity here to undercut the RBOC on price and, hopefully, service."

Whatever cable does next, it has to get to free cash flow, which is to say, a substantial amount of net profit after payment of capital expenditures, interest, taxes and operations costs, said Lara Warner, director of equity research at Credit Suisse First Boston. That means cutting back on capital spending, which hit $14.3 billion in 2001, and indebtedness, which stands at $75 billion industry wide. "I think investors were expecting to start to see declines (in capital spending) this year, and we are seeing some marginal declines. But, by and large, this is a question that's still been left outstanding for the industry to answer for investors."

The good news for cable is that with upgrades largely complete and the industry moving out of the heavy ramp up period of new services, the industry can pursue its triple-play services agenda and still expect to see overall capital spending fall by 25 percent in 2003 and level out at about $10 billion per year thereafter, Warner added. Getting there and, as revenue grows in the out years, keeping capital spending to a level of about 15 percent of total revenue is crucial to creating the upside to today's cable stock valuations that investors are looking for, Warner said. Higher capital spending combined with dramatically rising program costs, could erode that upside quickly, resulting in investor assessment that stocks are fairly valued at today's very low levels, she added.

Generating revenue and cash flow projections like Gupta's, Richard Bilotti, managing director in the cable space at Morgan Stanley Dean Witter, said capex and programming costs likely will be low enough to support a valuation on cable in the range of $5,600 to $6,000 per subscriber three years from now, or about 13 to 14 times a cash flow level of $430 per sub per year. "If these stocks trade at 13 times forward EBITDA in 2005, they will have returned close to 30 percent per year for three years, which by anybody's estimation will be a home run in the equity markets," Bilotti said.

With all such calculations depending on cable getting into the voice business, the voice service financial results reported by companies already in the game were music to the ears of NCTA convention goers. AT&T Broadband, for example, has about 1.15 million voice subscribers on its cable networks and, during the first quarter, crossed over into cash flow positive performance on its voice infrastructure, said Gregory Braden, executive vice president for strategy and corporate business development at AT&T Broadband. "We're doing just a little over $54 per telephone sub per month," he said.

Not only are there "great margins on this business," said Braden, but the company is seeing a 40-percent to 50-percent reduction in churn among customers who take voice, video and data in comparison to traditional core video subscriber churn rates. Meanwhile, there's been a 20-percent to 30-percent reduction among customers who take voice with one of the other services. Industry churn typically runs at 5 percent or higher.

Earlier this year, AT&T officials reported the MSO's voice services had achieved 20 per- cent or higher penetration in 20 franchises, with its Chicago and Salt Lake City networks topping 25 percent. The company intends to be in a position to offer voice service across its metro footprints by year's end in Boston, Chicago and San Francisco.

AT&T's aggressive expansion is benefiting Comcast's target market base as well. Comcast, which had said it would wait for IP voice technology to mature before moving into voice services so as to avoid the costs of circuit switches, will be able to move more aggressively into voice by virtue of the AT&T acquisition, officials said. They note the AT&T switches are in reach of about 80 percent of Comcast's subscriber base.

Cox, too, reports surging voice subscriber numbers and big improvements in reducing churn. "We have more than half a million residential customers across the country," noted Greg Bicket, vice president and general manager for the New England region at Cox. "We also have some 50,000 commercial customers."

Voice penetration, depending on how long service has been marketed, ranges between 18 percent and 40 percent of homes marketed, Bicket said. "It's staying on some early trend lines, which is very promising." Bicket is especially upbeat about the business market, which he describes as being "very, very receptive to cable-delivered telephony." Other Cox officials report the churn rate among residential customers taking the bundle of video, data and voice services is well below 1 percent.

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