The stagnation and recent decline in cable’s basic subscriber growth are not the aberration some company executives contend, and in fact, underscore the industry’s increasing financial vulnerability to outside forces.
The recent jolt to the basic subscriber foundation-on which cable operators are balancing their hefty debt and rolling out new digital services-is real, and it could get worse before stabilizing in a healthier economy.
Indeed, the slightest erosion of cable’s basic subscriber base represents the same kind of threat that mounting acquisition and upgrade debt levels did to gung-ho cable operators in the late 1990s. At that time, I and other industry observers warned about the dangers of a prolonged gap between cable operators’ weighty investments to acquire and upgrade systems and when they would recoup from new services and increased subscriber revenues.
Today, such a formidable funding gap weighs heavily on cable operators, who now face a laundry list of other challenges.
Having collectively invested an estimated $65 billion in system upgrades during the past five or so years, leveraged cable operators have seen their values diminished in a volatile stock market that has driven down the price of their stocks by 70 percent this year.
There are clear signs that an unstable economy is undercutting discretionary consumer spending on many other subscription-based services even if, as in the case of basic cable, they are linked to attractive premium services such as high-speed data, digital video and telephony.
These services eventually have the capacity to generate huge profits down the road, with high-speed data expected to generate 55 percent margins and digital expected to generate 60 percent margins, compared with 40 percent on analog products, according to Morgan Stanley’s Richard Bilotti. Cable operators’ gross profits should nearly double to $48 billion by 2007, he said.
But for now, high-speed data remains the most robust new service, being tempered by more moderate growth in digital services, which already are hitting their stride. The fear is basic subscribers, who are supposed to be the ones upgrading to these new tiered pay services, may suddenly be at risk.
In the first half of 2002, industrywide basic subscriber growth was a negative 0.2 percent at a time when near-completion of some cable system upgrades at some companies should have stabilized any decline in the face of an economic squeeze as well as intensifying satellite competition.
Basic subscriber losses at AT&T Broadband already have topped 600,000 so far this year, posing a stiff challenge to acquiring Comcast Corp.
AT&T basic subscriber growth fell nearly 4 percent in the third quarter and its video grew a weak 3 percent against a 36 percent gain in data and an overall 8 percent gain in broadband revenue. Even a stellar operator such as Cox Cable, which reported record third-quarter gains in high-speed data subscribers, had slower digital cable growth and lowered its forecasts for basic subscriber growth for all of 2002-still growing at about 1 percent.
Comcast Corp. reported what likely will be the strongest third-quarter showing by any operator across all of its metrics, topped by delivering $270 million in free cash flow for the period, and a total of $660 million in free cash flow so far this year. But that free cash flow strength will be sacrificed in 2003 as the new merged company begins upgrading systems, selling noncore assets and reducing an initial $32 billion debt.
It’s cable’s lingering debt spiral and slower growth that worry Wall Street.
Jason Bazinet of Morgan Stanley says there also is the matter of declining market penetration-the ratio of basic customers to the number of households passed, or covered, by their cable operator systems. Although Comcast maintained a 0.7 percent annual basic subscriber growth rate established earlier this year, its new systems-or households passed-grew a more aggressive 2.7 percent in the third quarter.
But Charter Communications, which may be on its way to going private in response to its weighty financial problems, lost 3 percent of its market penetration during the first half of this year. Cablevision Systems, which is weighing the sale of some assets-including even its valuable East Coast cable systems-to address its funding gap, could face the same subscriber falloff as it dilutes its cable efforts in order to enter the rival satellite business.
“We believe there is an even steeper decline in growth that is masked by the cable sector’s footprint expansion,” Mr. Bazinet said. “Cable’s footprint is passing new homes at twice the natural growth rate of household formation,” so the deterioration in subscriber growth “may be worse than it looks.”
Adding to the growing trepidation is the intensified competition from satellite, which is growing at a steady clip and will become even fiercer regardless of the outcome of EchoStar Communications’ faltering acquisition of Hughes Electronics’ DirecTV. That’s because Rupert Murdoch’s News Corp. more likely than not will step in to acquire either EchoStar or DirecTV, or both, to extend his global satellite reach to the United States.
Cable industry executives and analysts ardently believe that a bundling of compelling interactive digital services-from high-speed data to digital video to telephony-will make cable the ultimate gatekeeper for consumers, advertisers and content providers. The real question is how much erosion it will suffer to its subscriber base and how quickly cable operators can devise and offer competitive new services to counter any of the formidable economic and competitive challenges they face.
Half the revenue growth for video and high-speed at a company like Comcast comes from basic rate increases. If locked in price war with DBS or DSL how can those companies achieve that?
The scramble is on for cable operators to initially roll out and experiment with video-on-demand offerings that will entice their current customers to upgrade while also enticing new subscribers. But that, too, takes time and money.
Even as its $22 billion in debt was being downgraded by Moody’s Investors Service last week, Charter was announcing plans to launch VOD service in nine more markets, for a total of 21, by year’s end in an effort to grow its subscriber base. When the time comes, Comcast will struggle to convert stressed customers who get hooked on its free VOD service to pay customers.
Giant pressures
That puts extraordinary pressure on cable giants to devise or acquire must-have content and services to drive premium subscriptions. Developing the next generation of high-speed data, digital video and video-on-demand content is an absolute priority. And that will cost more money than it already has for cable companies, which will be forced to pay premiums for existing digital channels or platforms, invest an estimated $50 million or more to incubate a new digital channel themselves, or be an equity partner in new content ventures. Such spiraling content costs can be paralyzing.
AOL Time Warner will be able to more cost-effectively tape its own plentiful content to package the compelling programming, information and services it controls. Unless it acquires and enters a joint venture with a major studio or content provider, even giants such as Comcast-AT&T and Cox will be subject to the negotiated pricing ups and downs of dealing with third-party providers, which will have a cost impact.
Layer those costs on top of continued capital spending to upgrade, debt servicing and reduction, and the cost of a harder selling of new services, and cable companies could face an overall cost picture that isn’t much prettier than today. While upgrade costs are declining, content production and acquisition costs are rising.
Cable may be better strategically positioned today than at any time in its history, benefiting from a mostly upgraded, deregulated platform. But the competitive and economic variables and challenges are enormous and must not be underestimated.
Confided one high-level cable exe
cutive: “We all are thinking about, but not as aggressively pursuing, all the content and service moves that will make and keep us competitive. To be honest, right now, everyone is just concerned about making this year’s numbers.”