Cashing In on Digital Services

MAVIS SCANLON

Faster rollouts by MSOs may change Wall Street's tune from `wait and see' to `count it now'

The new services offered by cable operators - digital TV, high-speed Internet access and cable telephony - may finally be catching on. Getting those services to register on MSOs' bottom lines, and in their stock prices, is the next hurdle.

In the third quarter, Charter Communications averaged 21,500 digital cable installations per week, an eye-popping 80% increase in the average weekly install rate over the second quarter.

"Demand has exceeded, and continues to exceed, expectations," says Kent Kalkwarf, CFO of Charter. "We think it will continue to drive growth in the future."

Despite Charter's 20% growth in operating cash flow during the quarter, the stock fell 68 cents on the news.

Although the other major MSOs could not boast similar weekly install gains, the rollout of new services is accelerating and is beginning to show signs of getting respect from analysts on Wall Street. Impressive rollout rates were repeatedly mentioned by stock watchers as the overriding trend that stood out during the quarter.

"We're seeing signs that these products and services are finally starting to make headway to becoming a more broad-based consumer phenomenon," says Russ Solomon, VP/senior media analyst at Moody's Investors Service. "We expect this trend will continue."

The hopes for revenue growth in the $28 billion cable industry are pinned on the rollout of the new services.

The relatively mature basic cable market is fighting increasing programming costs as well as competition from DBS on the video side and digital subscriber line (DSL) providers on the Internet side. Basic subscribers are growing at the lackluster rate of 1.5% to 2% annually, while rate increases for MSOs have been held in check at 4% to 6%. In addition, the lack of high-profile boxing matches has MSOs turning in weak year-over-year pay-per-view comparisons. It's no wonder revenue from new services will grow increasingly important in the next several years.

How much new revenue can actually be wrung out of these new services, and how soon? Even though unit growth in new services is becoming more visible, investors will want to see proof that revenue generating unit (RGU) growth is actually hitting the bottom line, says David Lee Smith, who follows the cable group at Dain Rauscher Wessels.

That means execution - from system upgrades to business plan implementation to stellar customer service - is of utmost importance. Investors have shown time and again they will not continue to pay lofty valuations if they see signs that promises made by cable operators are not being executed.

As a group, the stocks of cable MSOs are down 30% year-to-date. That's far less than the stocks of Internet advertisers or long-distance companies, which are down 80% and 54%, respectively, as of Oct. 10. The decline in cable MSO stocks far exceeds the decline in the Standard & Poor's 500-stock average, which is down 7% year-to-date.

"This is certainly very much of a `what have you done for me lately' market," Smith says. "That market wants to see a translation of the RGUs to actual revenue growth."

Adds Doug Shapiro at Banc of America Securities, "The reason why the very strong unit growth in the quarter didn't drive the stocks more is because you haven't seen enough of an impact" on the profit and loss statement.

That may change as early as next year. Both analysts agree that during the next few quarters, the year-over-year comparisons in revenue generated from new services will begin to make an impact, and that impact will accelerate towards the end of 2001.

By the end of next year, for example, the incremental revenue per subscriber generated by these new services is expected to contribute two-thirds of an MSO's total projected revenue increase, some analysts estimate.

Revenues charge ahead A closer look at a long-term revenue and operating cash flow model provides a better understanding of the market potential for new services.

Richard Bilotti, an analyst at Morgan Stanley Dean Witter, projects that pro forma revenue for AT&T Broadband's digital services could grow to $1.1 billion in 2005, up from a projected $322.4 million in 2000. He projects revenue from high-speed data and telephony could grow even faster, jumping to more than $1.6 billion in 2005 from $326.2 million this year.

At Charter, one of Bilotti's top picks, it's a similar story. He projects digital cable revenue to grow to $734.8 million, up from an estimated $66.4 million this year. High-speed data revenue, he estimates, should grow to $562.3 million, up from $63.4 million this year. Combined, revenue from digital cable and high-speed data should total $1.3 billion in 2005 for Charter, about 20% of his $6.2 billion revenue projection for that year.

Revenue increases from these new services should certainly offset any basic cable subscriber erosion to new pay TV services, says Solomon at Moody's.

Adding to the bullish case for cable operators is an indication of somewhat slowing growth at satellite companies.

Satellite providers grew revenue at a searing pace in 1999, outpacing MSOs by a wide margin. In 1999, combined revenue for satellite providers leapt 55.7% to $5.9 billion, according to Veronis Suhler Associates, an investment bank focused on the media and communications industries. That's an eight-fold increase since 1995.

That growth may be slowing. DirectTV, the satellite unit of Hughes Electronics, reported net subscriber growth of 450,000 in the third quarter. Although that growth was up 6% year-over-year, it was actually down slightly from the net subscriber growth of 452,000 the company posted in the second quarter.

Upgrading the network Satellite providers, with offerings that include greater channel selection and superior picture quality, have, to a large degree, provided the MSOs with the impetus to accelerate system upgrades.

The backbone of the new offerings, and the interactive services that are quickly expected to follow, is a fully upgraded network. The always capital-intensive cable industry has become more so in recent years as operators tapped the equity and debt market in a rush to ensure they would have the capital to complete the upgrades.

A few operators, including Charter, the fourth-largest MSO, and Insight Communications, the eighth-largest MSO, have accelerated the build-outs of their plants to the 750 MHz standard, but nearly all the MSOs expect to have between 68% and 90% of their plants upgraded to 750 MHz capability by year's end.

That will allow for more aggressive marketing of new services next year. In some cases, however, the intense focus on upgrades and implementation of new services means a less aggressive marketing stance for basic services. Insight, for example, saw basic customer subscriptions decline slightly, from 966,000 in the second quarter to 962,000 in the third quarter.

The decrease was not a surprise, as Michael Willner, Insight's president/CEO, pointed out in an e-mail interview.

This year is a transitional year for the company, he says, which was made clear when the company went public last year.

"We determined that because we are so near completion of our rebuild cycle (90% as of December), we should not be aggressive at marketing our standard cable fare," he wrote. "We are going to launch our fully interactive digital service throughout the entire company by the end of the first quarter 2001."

New growth Overall, operators saw impressive results in the third quarter. Consider some highlights:

- Cable operators added about 690,000 new high-speed modem customers during the quarter, bringing the number of U.S. cable modem customers close to 3 million, according to a survey released last week by the NCTA.

- The nation's digital video customer base grew to 7.8 million, with 700,000 new digital video customers added during the quarter.

- A record 139,000 residential cable telephony customers were added during the quarter, bringing the total cable telephony base to about 568,000.

As a result of better-than-expected growth during the quarter, several MSOs upped their year-end target numbers.

Philadelphia-based Comcast increased its year-end target for digital customers by 100,000 to 1.35 million. Comcast added 190,000 digital customers during the quarter, or about 14,600 per week. It also saw enough net additions in its high-speed data products to raise its year-end targets for data customers to 375,000 from 350,000.

Atlanta-based Cox Communications added 123,000 digital subscribers, or about 9,500 per week. Cox had 683,000 digital subscribers at the end of September.

The company was also adding 3,000 telephony customers a week by September. Nearly 10% of the homes in which digital telephony is available in Cox's footprint were taking the service.

Charter saw blistering growth in its digital offering. Granted, the "Summer Sizzle" promotion, a package of 200 channels priced at $49.95, helped boost sign-up, but Charter's high-speed modem install rate during the third quarter, at 2,700 a week, was about 200 more per week than the company projected. Charter ended the third quarter with 184,600 data customers, a 24% increase over the second quarter.

Service by service As operators roll out services more aggressively, what penetration levels can these new services achieve? The question is difficult to answer and should be looked at service by service.

Telephony "is going to be the slowest of the three services," says Thomas Eagan, first VP at UBS Warburg. "It's all a matter of where (the operators) focus their installers."

Several MSOs are hanging back to see results of IP, or packet switch, tests. IP is generally considered a more efficient and economic option, but to date is not as reliable as the current circuit switch standard.

Still, cable operators' ability to offer several services on one physical infrastructure gives them lower capital and operating costs and the ability to pass along savings to consumers. That's a benefit MSOs have over local carriers, says Shapiro at Banc of America. Moreover, pricing for local phone service is set statewide, and an incumbent carrier would have to undercut itself across a state to beat a price in one market, which they'd be reluctant to do.

Those benefits "suggest cable (telephony) can get to decent levels of penetration," says Shapiro.

When looking at the total market opportunity for high-speed modems, you have to look at how many homes are online.

At the end of 1999, more than 40 million households had access to the Internet, a 41.6% increase over 1998. Some estimates say the number of Internet homes may grow to more than 60 million, Shapiro says. Even with the use of DSL and a large base of narrow-band users, cable high-speed modems could likely capture about 50% of the market for a penetration rate of 30%.

"Our products follow beautifully those escalations" in PC ownership and Internet usage, says Maggie Bellville, EVP-operations at Cox Communications. "We are in the home, and that's key. We got in the home early when we could create that barrier to entry, and now we have the opportunity to layer on more products."

Meanwhile, some analysts are already revising their projections for cable modem users for this year. Bilotti at Morgan Stanley upped his 2000 year-end estimates for cable modem subscribers at the eight largest MSOs to 3.4 million, up from 3.2 million.

The NCTA expects an even higher number - 3.6 million - by year's end, which would be more than double the 1.6 million cable modem customers at the end of 1999.

Driving the acceleration "is the tremendous demand for broadband connectivity in the residential market," Bilotti wrote.

That's a good sign for cable operators. As more people come online and use the Internet for play as much as for work, the value of high-speed connections will grow accordingly.

Digital cable will be the key for MSOs who want to offer advanced interactive services. Again, estimates for penetration vary widely.

Right now about two-thirds of cable subscribers have set-top boxes in the home, most of which are analog. It's very likely the last analog set-top box has been installed, so those boxes will eventually be replaced with digital set-tops.

"Theoretically that alone could drive digital to 70% of subscriptions," says Shapiro at Banc of America.

The industry is keeping a close watch as Cablevision implements its digital strategy. Beginning next month, Cablevision will begin a 1,000-person test of Sony's souped-up digital set-top box. The initial test will ramp up to 5,000 by early next year, and Cablevision expects an aggressive rollout in the second quarter of 2001.

Given the extent of its investment, Cablevision is taking pains to get the technology right and listen to consumer demands. While the box will include a modem, access to video-on-demand, e-mail and interactive features, the company is waiting for customer feedback regarding design and layout.

Winning the race Who is winning what is arguably the most important race for MSOs in decades?

Companies with a comprehensive marketing plan, including retail distribution, will stay ahead of competition, say those following the industry. Overall, Cox and Comcast are winning kudos for their execution, but if Cablevision can live up to its promises on digital, it may have an edge.

Cablevision "will beat the pants off the industry in terms of getting the next generation of boxes out there," says Smith at Dain Rauscher. "They waited for real functionality."

Further, Cablevision has a natural distribution outlet in the consumer electronics chain it owns, The Wiz, and will also attempt to grow its online fulfillment operations.

On Comcast's earnings conference call, Steve Burke, president of Comcast's cable division, said retail distribution "is absolutely critical" to growing that business.

Comcast, which finished the third quarter with about 303,000 Comcast customers, expects its weekly install rate for modems to jump to 8,000 per week by December, up from 5,000 a week in the third quarter.

Analysts suggest the lack of consolidation prospects in an industry where the eight or nine largest players control about 85% of the market has played into the downturn of cable stocks. If the MSOs deliver on the promise and potential of their new services, they will create new and profitable revenue streams. That's the key to getting investors thrilled with the industry once more.