August 16, 2010 – The conundrum network service providers face in attempting to get a handle on where the business is headed brings to mind the old Dickensian paradox: these are the best and worst of times.
With unemployment stuck north of nine percent, there are long lines at jobs fairs. But there also are plenty of people queuing up – often days in advance – to buy the latest gadgets from Apple. MSOs and telcos have taken significant hits in their legacy areas of market dominance but are seeing strong growth from encroachments into each other’s legacy markets, and, generally speaking, the comparatively newer broadband market has been good for both sides.
These dichotomies make it tough to get a read on the market for cable and telco services. With the U.S. economy in what looks to be a long slog to recovery, it’s worth looking at how the environment has changed as a measure of what may be in store for the next 12 months.
Take adults ages 18-34: Ten percent have moved back in with their parents because of the economy, while another 12 percent moved in with a roommate, according to a Pew Research Center study. That trend shrinks the addressable market for video, voice and broadband because people who otherwise would have had separate subscriptions now share a single one.
“[Residential] subscriber growth is highly dependent on two variables: housing occupancy/market and employment,” says Josh James, an associate analyst at Stifel, Nicolaus & Company. “We’re going to continue to see anemic revenue generating unit (RGU) numbers in terms of growth.”
That has a ripple effect throughout the industry – both a problem and an opportunity. For example, slow growth means network operators are buying fewer set-top boxes and other customer premise equipment (CPE), a problem for vendors that make that gear. But these cutbacks also create opportunities for investors.
“[CPE spending] has come down quite a bit, and that’s led to a lot of the free cash flow growth that you’re seeing now,” James says.
Value in the Eye of the Beholder
Free cash flow is a metric worth watching because it affects mergers and acquisitions, as well as how investors value an MSO or telco. There’s a perception – not a new one – among many MSOs and analysts that Wall Street undervalues cable operators.
Mediacom is a prime example. In June CEO Rocco Commisso announced a bid to take his company private for $6 per share. Commisso has publicly complained about cable’s undervaluation several times, including just months after Mediacom’s February 2000 IPO.
More recently, some analysts and investors cut their MSO valuations because they believed that telco TV would quickly grab market share. “The fear in the market in terms of valuation of cable operators was: ‘Here’s another significant competitor. It’s not only short-term, but long-term bad news,'” says Mike Paxton, In-Stat’s principal analyst for digital entertainment. “So their share prices were pushed down and have stayed down. Cox is very happy that they went private a few years ago because they felt like they were getting the shaft. They didn’t feel that the market was valuing them viably.”
Telco TV’s impact hasn’t been that apocalyptic: In 2009, telco TV’s customer base grew 65 percent, to 5.1 million, according to SNL Kagan. But cable lost only about 500,000, ending the year at 62.1 million. Now, some telcos are slowing their TV buildouts.
“That’s given some people optimism about cable’s ability to staunch the losses,” says Ian Olgeirson, SNL Kagan’s lead cable analyst. “We’ve got [telcos] adding in the neighborhood of 10 million subs over the 10-year outlook and taking their penetration of homes passed to 22 or so percent. There’s still a lot of headroom for them.”
Cable’s bigger, long-standing worry is DBS, which, at the end of 2009, had 32.7 million subscribers, marking the first time the satellite sector’s base was over half that of cable. But, with cable moving into mobile and leveraging its existing triple-play appeal, the competitive inroads on the video side are more than mitigated by gains elsewhere.
Many analysts point to cable’s average revenue per user (ARPU) as an indication not only of MSOs’ ability to compete, but also the health of their revenue streams. “Yeah, they’ve been losing some, but their ARPU keeps going up,” Paxton says. “Their net income is pretty solid.”
“Once you have a cable customer, it’s very easy technologically and from a sales standpoint to add a telephone or high-speed-data subscription,” says Rick Franklin, an Edward Jones telecom analyst. “We’ve seen Comcast expand their [per-customer] spending from $60 three years ago to over $70 today.”
Ads Point to a Turnaround
Even so, some customers have been cutting back since the recession began. If the economy continues to flounder, that could start to crimp ARPU and income.
“Some of the companies we follow – Comcast and Time Warner Cable – have seen decreased use of pay per view (PPV),” says Stifel, Nicolaus’ James. “People are buying fewer movies and subscribing less to premium channels: HBO, Showtime, things like that. A couple quarters ago, people were downgrading some of their video services to less expensive packages.”
Part of that also could be due to Hulu, Netflix and other over-the-top video services, which are in the right place at the right time to capitalize on consumers’ quest for cheap
or free fare. MSOs and telco TV providers also are being squeezed by Redbox, whose $1 rentals are significantly cheaper than PPV.
If downgraded video packages and less PPV usage were early signs of the recession, then advertising could indicate that the economy is starting to rebound. MSOs often say that advertising is a leading indicator for the rest of their business.
“Cable advertising for Comcast has been down as much as 23 percent in first quarter 2009, and it’s gradually come back,” James says. “In their most recent earnings report, cable advertising revenues were up 23 percent. It’s about the same growth rates as in first quarter, so you’re starting to see a turn in advertising, which is a very high margin business for these guys.”
The Double-Edged Enterprise
Although some MSOs – such as Cablevision, through its Optimum Lightpath unit, and Cox – have been targeting the enterprise market for years, it’s still largely the domain of telcos.
“Only two percent of Comcast’s revenues come from business customers,” says Edward Jones’ Franklin. “Cox is kind of a pioneer in cable at going after this space. They’re at 10 percent already. But the telecoms, half their wireline revenue is from business.”
In good times, cable’s limited enterprise focus might have been a drawback. In bad times, it isn’t.
“The telcos – Verizon and AT%26T in particular – have been slightly more affected overall than the cable operators because they’re more exposed to enterprises,” James says. “High unemployment really weighs on that part of the business.”
Spending on business communications tends to increase when an economy is well on its way out of a downturn – something that even the most optimistic pundits don’t believe has happened.
“We’re starting to see a little stabilization and a little growth in that area, but our view is that you’re not likely to see significant earnings growth and rebound in some of their key metrics until unemployment comes down a bit,” James says.
For MSOs that were deep in the enterprise market when the recession hit, business wasn’t all bad. In Q2, for example, Comcast Business Services said revenue grew 54 percent compared to one year earlier.
More CLEC Acquisitions Ahead?
One question is whether MSOs will aggressively pursue the enterprise market when the rebound comes. The answer depends partly on how far operators are willing to go beyond the reach of existing access lines to target medium and large enterprises. Often it just requires some short extensions of fiber from existing nodes where wavelengths available over hub-to-node distribution plant can be used to transport business services
“For most MSOs, there are a significant amount of businesses that are within reach of their plant,” says SNL Kagan’s Olgeirson.
But there are opportunities that merit more aggressive spending on network resources, not necessarily confined to the larger MSOs. Mediacom’s Enterprise Solutions division is a case in point. The unit has built a separate network based on business customers’ needs and locations, which positions it better to connect into the booming cell site backhaul market.
“Backhaul is a huge business,” says Edward Jones’ Franklin. “That’s all incremental for cable companies. I think that could be a very interesting growth opportunity.”
Some wireless carriers historically have preferred to use cable for backhaul partly because doing so meant they weren’t paying a telco competitor. But that option is dwindling as the number of MSOs with wireless units grows.
Over the past few years, some MSOs have bolstered their position in the enterprise market by acquiring CLECs. Considering how much free cash flow some MSOs have, more CLEC acquisitions could be in the works.
“Financial capacity is not the issue,” says Christopher Marangi, associate portfolio manager of the Gabelli Value Fund. “Cablevision and Comcast have bought small CLECs in the past 18 months.”
Some analysts think that footprint mismatch is a bigger issue: Because MSOs tend to be concentrated in parts of a state, those analysts wonder what they’d do with the CLEC’s presence outside of those areas.
“The big four [MSOs] are so scattered, would that even make sense?” says In-Stat’s Paxton.
But for some MSOs, the additional territory might be a way to compete across an entire state. For example, one hypothetical is Mediacom acquiring Socket in order to better compete with AT%26T across Missouri. An alternative: Simply lease fiber to increase the addressable market.
MSOs, which have been building regional backbones and, in some cases, national backbones are also working through their standards bodies to create a better environment for interconnectivity of their networks so they can all share these resources to reach branches of enterprise customers headquartered in their territories. This on-net strategy is a focus of Comcast’s efforts to get the industry to make better use of its far-flung national fiber infrastructure.
The Wideband Strategy
Many operators have begun to spend aggressively on DOCSIS 3.0 not only to trump bandwidth-limited telcos or to match fiber-to-the-premises competition but also to prepare for new IPTV services which they believe will give them a more flexible, faster-to-market response to competition from over-the-top and satellite providers. “When it comes to the speed race, the cable operators are winning hands down,” says In-Stat’s Paxton.
Consumers’ belt tightening hasn’t helped the market for DOCSIS 3.0-enabled 50 megabit-per-second and 100 mbps services, which at this point are priced at hefty premiums over standard broadband. The take rates for 50 Mbps and 100 Mbps services are infinitesimal, particularly on the consumer side.
“It certainly has something to do with the economy, but I think that primarily most people fail to see the benefits they would get with a 50 mbps connection versus 10 mbps or 12 mbps,” says SNL Kagan’s Olgeirson.
But operators’ immediate goals are less about driving consumer ARPU and more about having the bragging rights to highest speed as well as in laying the foundation for meeting future needs for high levels of IP transport capacity. Plus DOCSIS 3.0 helps operators in the commercial service market by giving them a tool for meeting escalating bandwidth requirements among SOHOs and medium-sized business covered by their residential plant.
The investment is worth it because DOCSIS 3.0 also benefits the cost structure on lower-speed tiers. “The impact of deploying DOCSIS 3.0 stretches beyond these ultra-premium tiers,” Olgeirson says. “The real benefit is the ability to boost capacity on a standard tier without spending a huge amount of money.”
That helps MSOs compete against both DSL and deep-fiber offerings.
“Second quarter is playing out as a great example of how that investment for the cable operators is benefitting the industry,” Olgeirson says. “Just look at what the DSL base of subscribers for AT%26T versus what Comcast did in Q2.” As reported in the June issue (p. 34), Comcast’s broadband subscriber count was up 2.5 percent over the previous quarter compared to a 1.34 percent gain for AT%26T. The cable group as a whole was up 2.38 percent compared to 0.66 percent for the telcos.
DOCSIS 3.0’s cost structure also plays particularly well during a recession because MSOs can continue to offer “free” speed upgrades to retain customers without profit margins taking a big hit.
“Their bread and butter is data,” Paxton says. “When we look at their margins for data service, it costs them $18-$20/month to supply them with cable modem service, and they’re charging them $40-$45. In many cases, I’ve heard they break even or are slightly profitable on video, but they’re making a bundle on voice and data.”
There are similar questions on the telco side: whether FTTH is overkill in light of limited adoption of super-fast tiers, questions about telco TV’s profitability and the possibility that the regulatory environment will change.
“Even if people question the long-term profitability and value of the FiOS project, I would argue that as a defensive move, it was absolutely right move,” says Sergey Dluzhevskiy, vice president at GAMCO Investors. “They had to do it.”
Dluzhevskiy says some might view AT%26T’s fiber-to-the-node strategy as safer but that that’s TBD.
“The jury is still out,” Dluzhevskiy says. “It’s not clear whether AT%26T can live as FTTN or whether they will have to expand to FTTH.”
Like DOCSIS 3.0, some analysts view telco TV as an expensive yet smart move defensively and offensively.
“Telco TV services in this country have been successful,” says In-Stat’s Paxton. “Are they a huge revenue center or a huge profit center? No, but as a defensive move, they’ve been pretty successful.”
Assuming the worst of the economic meltdown is history, the trend lines of the recent past suggest that, on balance, prospects are good for both the telco and cable sectors in the year ahead. Long term, no matter how the economy behaves, prospects for each sector will have more to do with whether the relative competitive balance holds up or whether one side or the other gains advantage through smart capital spending and service innovation.