Classic Communications filed for bankruptcy last week, a rare event in the cable industry and one that underscores the unique difficulties small and rural operators have in trying to modernize their sytems while fending off fierce competition from satellite TV.

In the industry's half-century history, cable operators have seldom been forced into bankruptcy. But the prospect is becoming more prevalent for smaller, independent operators, especially those that go head-to-head with direct broadcast satellite (DBS) in rural areas. Indeed, Classic ? the nation's 12th-largest MSO, with 386,000 basic subscribers ? isn't the only operator in financial disarray these days. Galaxy Telecom, filed for bankruptcy protection in September, with a $120-million debt load.

Many operators ? both urban and rural ? have increased their debt leverage to expand their reach and upgrade their systems to add digital and other advanced services. Competition from DBS firms has made that business strategy even more important. But rural operators face a few different challenges from their urban brethren. For one thing, it's more expensive to upgrade rural markets and it takes longer to make that money back. For another, competition from DBS has generally been fiercer in rural areas than it has been in urban markets, which keeps operators from raising rates to earn back their outlays.

?Classic's problems are a classic example of the problems all small operators around the country face today,? says Yankee Group analyst Michael Goodman. ?There are a lot of places where it just doesn't make economic sense to upgrade. But if you don't upgrade, you face the prospect of losing customers to DBS.?

Many upgrade expenses are the same for both large and small systems. It costs the same to upgrade a 1,000-subscriber headend as it does a 10,000- or 100,000-subscriber system. But the returns aren't as good, nor do they arrive as quickly, in small rural operations. The fewer the customers, the less the revenue generated by the system and the longer it takes to make a return on that investment.

Yet the argument to upgrade is even more important for operators in rural areas where DBS firms have already signed up millions of customers. Classic lost 23,000 subscribers in the 12 months ending Sept. 30, 2001. That left a total 352,600 subscribers in nonmetropolitan markets in Texas, Arkansas, Louisiana, Kansas, Oklahoma, Nebraska, Missouri, Colorado, New Mexico and Ohio. Although company executives can't say exactly how many customers exchanged their cable boxes for satellite dishes, CEO Dale Bennett believes most defected ? as opposed to turning off their TVs altogether.

?These people didn't just stop watching TV,? adds Jimmy Schaeffler, CEO of consulting firm the Carmel Group. ?Common sense would suggest those lost cable customers are moving to DBS. Many of Classic's systems are in the Southeast, and DBS firms have been particularly aggressive in obtaining customers in that part of the country. The first dish was sold in 1994 in Mississippi. The DBS firms have always heavily marketed their products there.?

Classic was formed in 1992 by financier Merritt Belisle (who served as the company's CEO until last summer, when the board ousted him in favor of Bennett, a former AT&T Broadband executive). Belisle envisioned acquiring systems until the company reached 1 million customers. But even after 20 acquisitions in eight years, the company still found itself serving only about 400,000 subscribers. Yet the debt had skyrocketed. Not only did it cost a lot to buy the properties, it cost even more to upgrade them. The company's debt load grew from $192 million in 1997 to $559 million by 2000. Cash flow for 2000 totaled $73.4 million, putting the company's debt-to-cash-flow ratio at a whopping 7.6 times. That compares unfavorably with a debt-to-cash flow ratio of less than 4 times at Comcast, considered one of the industry's better-managed MSOs.

By 1999, Classic had enough customers to go public. The company figured it could use equity rather than debt to continue its expansion plans. Classic went public in December 1999, riding a euphoric financial environment that lured several MSOs to the equity markets in 1998 and 1999. The company's stock initially sold for $30 a share and quickly reached a high of $39. But the market soon tumbled, and Classic's stock fell with it.

With its debt on the rise and its stock tanking, Classic couldn't afford to buy more systems. Nor could it afford to upgrade the systems it had acquired.

The company began missing interest payments on its huge debt load earlier this year. By the time the company finally marched into the U.S. Bankruptcy Court for the District of Delaware in Wilmington, Del., last week, few industry observers were surprised.

Still, the choice was unusual in an industry where few operators have been faced with such a prospect. With their assured cash flow and relative freedom from regulation, cable companies have rarely needed to file for bankruptcy protection. Aside from Galaxy's Chapter 11 plans, which call for the company to pay all unsecured debt holders, the last operator to file for bankruptcy protection was James Cable Partners eight years ago.

Both Galaxy and Classic share many of the same problems. Both companies serve rural communities, faced exorbitant upgrade costs and experienced intense competition from DBS.

Bennett says Classic got caught between a rock and hard place. Its plans to upgrade its acquired properties were proving too costly compared to the returns it was getting from those operations.

At the end of the third quarter, Classic counted 352,600 customers spread across 576 head-ends, for an average 612 customers per head-end. Many of the company's systems are simply too small to justify the upgrade expense, despite the fact that by not upgrading, the company stands to lose even more customers to DBS, Bennett says.

The company spent $13.8 million in 1998; $32.9 million in 1999; and $80 million in 2000 on systems upgrades so it could deliver digital services. At the end of 2000, 11% of the company's customers subscribed to digital service, according to the company's securities filings. Another $197 million had been allocated to continue the upgrades over the next four years. The company had tapped $56 million of the total to be spent this year. It's unclear whether Classic will follow through with those plans in the wake of its Chapter 11 status.

Without question, most of Classic's cable properties are in dire need of being rebuilt and upgraded. In a world where most urban cable systems have been rebuilt to at least 750 MHz, most of Classic's systems remain at 330 MHz.

?When we bought those properties, everyone thought that you could squeeze $70 a month out of every customer no matter how small the systems are,? Bennett says. ?Well, the industry has found that theory not to be true, and you can't pull that much out of many small rural systems.?

While interest payments and operating costs have been piling up, quarterly revenues have continued to slip. Revenues for the second quarter were $46.1 million vs. $47.1 million for the year-earlier period. The company told analysts on Oct. 3 that third-quarter revenues would dip even further to $44 million. Cash flow ? the barometer for financial health given to cable companies by financial institutions and investors ? has also been in a free fall. Cash flow skidded almost 12% in the second quarter, and the company warned investors that a continued drop was expected in the third quarter.

It's too soon to determine what Classic will do going forward. To raise some much-needed operating cash, the MSO agreed to sell three of its Colorado systems to AT&T Broadband earlier this month. It's also been trying to sell 670 transmission towers it owns around the country. Some analysts expect the sale of the towers will net Classic up to $70 million, but so far the company has been unable to unload them.

Bennett says Classic will continue to upgrade some of its larger systems so the company can offer customers digital services as an alternative to DBS. It's also possible the company could partner with other companies to provide digital video and high-speed-data services to customers.

?It's hard to predict how small we'll go with upgrades at this point,? he says. ?There have been a lot of technological advancements that have allowed smaller operators to upgrade some smaller markets. And costs for upgrades are coming down. You don't need 860-MHz in 1,000-customer systems. We're still trying to create solutions for our markets. Some could be upgraded with wire, some with other technologies.?

Bennett declined to say which companies Classic is talking to but says the MSO could team up with a satellite or wireless provider to offer digital services in areas that are too small to upgrade.

Although some industry experts peg Classic's problems as unique, Yankee Group's Goodman and Carmel Group's Schaeffler believe other small, rural cable operators could be facing similar trials in the coming months.

?It is so expensive to upgrade, especially in rural markets,? Schaeffler says. ?Many started so late that DBS already had a strong foothold in their territories. I imagine that what is happening to Classic could easily happen to other rural operators as well.?

But Matt Polka, president of the American Cable Association, a lobbying group that represents some 1,000 small to midsize cable operators around the country, calls Classic's situation ?an isolated incident.?

?Small operators face challenges every day,? Polka says. ?Competition from DBS, rising operational costs ? these are not new issues for our members. But I don't think Classic's troubles are a harbinger of things of come. I don't think you'll see a run on bankruptcy filings by small operators.?

Ironically, Classic's financial woes might actually help other operators, both Goodman and Schaeffler say. The MSO's situation may help Polka and other lobbyists better illustrate the problems and issues small operators face. It could also hurt EchoStar Communications' efforts to buy DirecTV, he notes.

There are already nine million unwired households in the U.S. today, Goodman says. If companies like Classic walk away from their systems or can't compete, all of a sudden the unwired market, which already belongs to the DBS providers, becomes much larger. It may become difficult for EchoStar to convince regulators that a combined DISH/DTV entity isn't a monopoly worth worrying about, he says.

?Small operators are in a lot of trouble today,? Goodman says. ?The investment community already knows that, but regulators don't readily recognize it yet. This could be a wake-up call to them that says the cable isn't one big entity. The whole is a sum of a bunch of parts, some healthier than others and some with better circumstances than others. The bigger EchoStar's monopoly becomes, the harder it's going to be to justify its purchase of DirecTV. At least two DBS providers keeps everyone honest even if there isn't a cable operator to round things out.?

In the meantime, Bennett remains bullish, if somewhat vague, on Classic's future. ?We think we can emerge from this a stronger, better company,? he says.

Back to this issue