CABLE SYSTEM ECONOMICS

For all the talk about the cable industry and conglomeration, cable remains an essentially local operation. From a local market structure perspective, cable television can be conceptualized as a system of local cable operators, each providing their subscribers access to a mix of video programming provided by a variety of local (public access channels, local governments, local cable advertising, local broadcast television stations), regional (regional cable networks), national (national cable networks), and international (international cable networks) programmers. There are almost 10,000 local cable systems in the United States, serving roughly 69 million cable subscribers (National Cable Television Association, 2002b). As an industry, cable offers some distinctive economic structures and insights.

Market Structure

Most markets fostered a natural monopoly for local cable operators through lengthy exclusive franchise agreements. Although the 1996 Telecommunica- tions Act prevented these local franchises from being exclusive (i.e., giving cable a legal monopoly), the significant costs of overbuilding the network has limited the amount of direct competitors. Thus, there are only a few areas with directly competing cable systems. However, as noted earlier, a variety of other multichannel video programming services have entered the market, bringing an increasing degree of competition into the TV marketplace. Fur- ther, as cable used fiber to become more interactive, telephone and data networks are using fiber to become broadband providers, hoping to enter the market with their own mix of telephone, data, and multichannel video services. As cable penetration is near maximum and as market boundaries continue to break down, local cable markets are likely to become increasingly competitive. This suggests that cable systems will need to develop new businesses and revenue streams and are likely to continue to seek economies through increased conglomeration and concentration.

Revenues

The business model of cable television revolves around the subscriber. Ca- ble systems package sets of channels in a variety of subscription tiers, from basic cable and premium cable channels to pay-per-view channels. Cable

8. THE ECONOMICS OF THE CABLE INDUSTRY

operators generate 80% of income through subscriptions to these various tiers of services (Federal Communications Commission, 2002a), with the oldest and largest source of revenue coming from basic subscription fees. After basic, the next tier of service is expanded basic, which includes all networks not included in the basic service and not included in the per-channel service (Parsons & Frieden, 1998). That’s followed by the premium cable network services, which are dominated by movie channels such as HBO, Showtime and Starz!. Subscribers pay an additional monthly fee to gain access to these networks. The final type of service is the per-channel or pay- per-view service. Access to these services is based on a viewing session by viewing session basis. Sporting events, movies, and other types of events are provided for a one-time, flat-fee basis.

Pay-TV channels are charged separately, with the network normally splitting the basic monthly charge with the local cable system. Other emerging cable networks pay local cable systems to carry their channels. These payments run from a few cents per subscriber per month to as high as

a few dollars, providing additional revenue to the local cable operator. With shopping channels, cable systems receive a percentage of the sales coming from people in their service areas. Regulations mandating leased channel access also have provided a new, if not widely used, revenue source.

Other revenue (see Table 8.2) comes from equipment rental, installation charges, and, increasingly, new services based on emerging technologies (Federal Communications Commission, 2002a). Local advertising sales also have become an important source of revenue for cable systems. At first, growth in local advertising was slow; systems had to acquire the equipment and staff to sell and insert the local ads, and cable network ratings were low. However, as cable network viewership increased, so did demand for local advertising spots. Over time, commercial insert equipment also became cheaper and more reliable. Local advertising is now a significant and growing part of most cable systems’ revenue streams.

Expenses

The cost of doing business in the cable industry revolves around expenses related to acquiring, distributing, and marketing programming and services. In local markets, the cable system operates with the same types of expenses as other media outlets with one major exception, the costs associated with the network distribution system. Although the normal operating expenses mirror those of other media, cable tends to have signifi- cantly higher infrastructure investment in order to provide their product to consumers. Cable systems also face local franchise fees (typically 3% of gross subscriber revenues) and a variety of other state and federally mandated fees (typically 2% of gross).

BATES AND CHAMBERS

TABLE 8.2

Cable Revenue Sources ($ in millions)

Type of Service

2000 (est.) Basic Tiers

$21,830 $24,445 Pay Tiers

$5,084 $5,177 Local Advertising

$627 $1,522 Home Shopping

$187 $202 Advanced Services

$452 $4,238 (inc. cable modem)

Total Revenue

$32,661 $41,741 Operating Cash Flow

$14,602 $17,160 Average Basic

65.4 million HH 67.7 million HH Subscriptions

62.8 million HH

Revenue per sub

499 617 Note. From National Cable Television Association, Federal Communications

Commission.

Cable requires a significant investment in infrastructure before it can offer its service to consumers. At the basic level, a local cable system faces the capital costs of antennas for both satellite and broadcast reception, the headend (signal processing center), and the components (cable and fiber, signal processors and amplifiers) of the distribution network. In addition, cable systems must pay a pole attachment fee to telephone and utility companies. Cable systems also have to invest in customer premises equipment (the familiar cable boxes). For cable systems offering a wider variety of services such as high-speed Internet access, telephony, and data services, there is a need to purchase and maintain telephone switchers and other types of equipment such as servers.

Since the passage of the Telecommunications Act of 1996, the cable industry has spent billions upgrading cable plants, systems, and infrastructure to handle the demand for broadband applications such as digital television, high-speed Internet access, and cable telephony. Cable industry investment has averaged around $15 billion a year over the past 4 years (National Cable Television Association, 2002b). This investment must be paid for and, hopefully, recouped over a period of years. From a normal operating budget perspective, these capital expenditures have a current ex-

8. THE ECONOMICS OF THE CABLE INDUSTRY

pense component: the associated need to install, maintain, and repair the wires and equipment. One of the largest segments (30%) of the local cable system’s operating budget is the payroll for cable installers and repair per- sonnel (U.S. Department of Labor, 2001). As more cable systems roll out new services, the number of fixed and operating expenses related to the technical acquisition and distribution of cable programming will continue to increase.

Another large expense category for a cable system is the cost of program acquisition. Per subscriber, program expenses including licensing fees, copyright fees and network services are on the increase. New networks usually pay around $7 to $10 per subscriber to get carriage on cable systems (Grillo, 2001). The average monthly subscriber fee for basic channels ranges from 50¢ to $1. Some sports networks are demanding monthly subscriber fees of up to $2 per subscriber (Berkowitz, 2002). Program costs range from about $100,000 per hour for an independently produced show to $250,000 per hour for a special event (Petrozello, 1998). These variable programming and production costs currently account for almost 36% of cable’s operating expenses (U.S. Census Bureau, 1999). Cable operators spent almost $9 billion for programming in 2000 (Federal Communica- tions Commission, 2002b).

Outside of program acquisition and distribution expenses, the largest operating expense for local cable systems involves administration and marketing. Because cable television uses a subscription model, customer service and billing departments account for almost 35% of the payroll budget (U.S. Department of Labor, 2001). The consolidation of the cable industry is creating opportunities for companies like Cox Communications to create regional cable service providers by purchasing smaller systems. At the regional level, the cable provider can consolidate customer service and telemarketing centers to create efficiencies across several markets. The next largest payroll category for the local cable system is in the area of marketing the cable system and its core video products and other services to advertis- ers, subscribers, and businesses.

As an advertising medium, cable television continues to increase its local, regional, and national advertising revenues. The increase in the number of viewers to cable television programming has been associated with an increased demand for advertiser access to the audience. While providing additional revenues, it also increases the size and cost of the sales and marketing departments. The cost of soliciting new clients and maintaining old clients involves competitive salary and benefits packages as well as invest- ments in employee training programs. The growth in the number of pay- television choices, high-speed Internet access, and digital cable television has created marketing needs, along with associated costs, for cable systems as they add new services and “bundles” of programming.

BATES AND CHAMBERS

There has always been a fairly high degree of turnover, or churn, in cable, particularly in the higher service tiers. In the marketing battle with DBS providers and other competing uses, local cable systems must continually invest in advertising and marketing campaigns to prevent subscriber turnover (churn). In addition, the deployment of the fiber optic distribution network for cable systems has provided opportunities to market high-speed data services to local and regional businesses, as well as the more tradi- tional residential customer. All this has added to marketing and promo- tions costs.

Many cable systems face another quite significant expense, one that has recently eroded most of the profit margins in the large MSOs. Many cable firms carry a substantial debt load, partly as a result of the need to invest in system upgrades. For many MSOs, though, the largest portion of the debt load is a result of mergers and acquisition activities over the past 20 years. System purchases and the costs of infrastructure upgrades have piled up huge debts, which cable is finding harder to pay off in today’s more competitive environment. For many MSOs, debt service is currently wiping out most or all of the systems average 40% operating profit margin (Federal Communications Commission, 2001).

Industry Structure

As noted earlier, cable emerged and developed locally. In the early days, what few economies of scale and scope that existed were contained in cable’s status as a natural, local, monopoly. Local licensing also meant local regulation, which tended to offer little in benefits for greater system aggregation.

The growing emphasis on imported and additional programming redefined cable’s product into something economically viable in larger markets, where the economies of scale and scope really began to kick in. These economies combined with the growing demand for cable’s redefined product, leading to higher profits and a greater interest in acquisitions and the rise to prominence of MSOs. The MSOs’ growing coverage and scope gave them negotiating power with cable networks, and many even helped to finance new networks in order to generate additional programming resources. Fur- ther, many smaller systems, faced with the prospects of having to invest in significant system upgrades to reach the higher channel capacities the new product demanded, took advantage of the high demand and prices for systems by selling out. The 1980s and 1990s were marked by significant merger and acquisition activity, and the rise in conglomeration and concentration by MSOs.

Ownership of these systems is dominated by Multiple System Operators or MSOs. According to the FCC, the top 10 MSOs serve 87% of all cable subscribers (Federal Communications Commission, 2001). At the national

8. THE ECONOMICS OF THE CABLE INDUSTRY

level, a few large companies such as AT&T Broadband, AOL Time Warner, Cox Communications, and Comcast control the majority of cable subscribers. Based on information from the National Cable Television Association (NCTA), the top 25 MSOs serve 63,855,900 subscribers. Prior to the merger of Comcast and AT&T’s cable unit, the top five MSOs accounted for almost

50 million of the nation’s 69 million cable subscribers (see Table 8.3). Although MSOs have dominated the cable industry for years, it is important to review the economic importance of this structure. MSOs exercise market power through relationships with subscribers and program distrib- utors. A recent study of cable prices by the FCC found that MSOs have monthly subscriber rates that are 23% higher than non-MSOs (Federal Communications Commission, 2002a). In 2000, cable operators spent almost $9 billion producing and acquiring programming (Federal Communi- cations Commission, 2002b). Of this $9 billion, 71% went to license fees, 24% went to license fees for premium programming, and the remaining went to copyright fees and production of original programming.

Since 1996, there have been two massive mergers in cable television that changed the industry. First, in February 1999, the Federal Communications Commission approved the merger of AT&T and TCI, at the time the nation’s largest cable television operator (Federal Communications Commis- sion, 1999). The FCC justified its decision based on the idea that the merged company would provide certain procompetitive benefits to consumers such as local telephone service alternatives (Federal Communications Commission, 1999). This merger catapulted the nation’s leading long-dis- tance telephone provider into the leading role as a cable television operator. Later, however, AT&T spun off its cable and Internet operations before merging the cable portion with Comcast.

Less than a year after the AT&T/TCI announcement, the Internet Service Provider (ISP) America Online announced its $350 billion stock merger

TABLE 8.3

Largest MSOs by Number of Subscribers (Sept. 2002)

21,625,800 2 Time Warner Cable

1 Comcast Corp.

10,862,000 3 Charter Communications

6,697,900 4 Cox Communications

5,775,000 Source. National Cable Television Association (2002b).

5 Adelphia

Note. The AT&T Broadband and Comcast merger has been approved by the FCC.

BATES AND CHAMBERS

with Time Warner. The merger of the largest ISP with the second largest cable television MSO created AOL Time Warner, a multiplatform media company with 26 million AOL subscribers, 12.6 million Time Warner cable subscribers, residential high-speed Internet lines, video programming networks such as CNN and HBO (among others), a movie studio, magazines, music labels, a broadcast television network, and other interests including sports franchises (Federal Communications Commission, 2001). The FCC approved the AOL-Time Warner merger because of the potential economic benefits to consumers in terms of deployment of broadband technologies and the development of advanced services for those technologies (Federal Communications Commission, 2001). The AOL-Time Warner merger high- lighted the evolutionary shift from cable television as a local provider of video content to a local access point to a variety of broadband telecommunications services.

In order to understand this shift from basic cable television provider to a so- phisticated provider of bundled telecommunications services, it is important to examine the basic premise of cable—paying for access to content via a cable. Cable television is not broadcast television. Although cable operators use satellite distribution as a form of signal capture, cable television, by definition, requires an actual wire or cable to deliver its programming. That system, in a digital age, can also be used to deliver a range of communication services and products. In an increasingly competitive environment, future growth and profitability is likely to depend on the ability to identify and deliver the services consumers want and are willing to pay for. Thus, many of the larger MSOs sought partners who they thought could provide those services.

MSOs have had a long affiliation with cable programming networks (see Table 8.4). MSOs sought out and sponsored networks as a means of providing additional programming for their systems, and networks sought affiliation with MSOs as a means of gaining access to their systems. Of the 20 most widely distributed cable networks, only C-SPAN has no MSO or broadcast network ownership (and 95% of its funding comes from cable systems). As of December 31, 2001, there were 287 national cable television networks (National Cable Television Association, 2002b). On a system-by-system basis, there was an average of 59 channels available on analog cable systems in the United States (Federal Communications Commission, 2002a). About 80% of systems offer digital services, with hundreds of channels available. Digital video had approximately 15 million subscribers in 2001, with pre- dicted growth reaching 48 million homes in 2005 (National Cable Televi- sion Association, 2002b).

Rate Regulation

Throughout its history, the FCC has been charged with both regulating and deregulating the demand side of the industry—basic cable television rates.

8. THE ECONOMICS OF THE CABLE INDUSTRY

TABLE 8.4

MSOs and Number of Cable TV Networks

MSO Number of Networks Prominent Franchise(s) AT&T

Encore, Starz!, SciFi, Telemundo, TLC, USA

AOL Time Warner

CNN, HBO, Cartoon Network, TBS, TNT

Bravo, AMC Comcast

Viewers Choice, Discovery Channel

Source. Federal Communications Commission, 8th Annual Video Competition Report (2002).

Starting with the Cable Communications Policy Act of 1984, basic cable rates were deregulated. After years of consumer complaints and Congres- sional hearings, basic cable rates were reregulated with the passage of the Cable Television Consumer Protection and Competition Act of 1992. In a recent study measuring the impact of the 1992 Cable Act on household demand for welfare, Crawford (2000) concluded that the there were no welfare benefits to households as a result of rate regulation. In other words, despite the Congressionally mandated rate regulation, cable subscribers did not realize the benefit.

By the time the 1996 Telecommunications Act passed, Congress had linked rate deregulation in 1999 with the desire to open advanced telecommunications and information technology service markets to competition (Federal Communications Commission, 2000). In addition, the 1996 Act granted small cable operators—those serving less than 1% of the United States and without connection to companies with less than $250 million in revenue—an exemption from rate regulation.

Since 1999, certain groups of consumers have complained about the increases in basic cable rates (McConnell, 2001). In its 8th Annual Video Compe- tition Report, the FCC (2002b) reported that cable rates increased at a rate higher than inflation. The FCC noted that the average basic cable rate was $33.75 per month—a 7% increase from the previous year (Federal Commu- nications Commission, 2002a). Cable companies have argued that the rate increases also are due to technology upgrades and new cable services such as digital cable, high-speed Internet access, and local telephone service. They argue that there was not much of an increase based on a per-channel basis. In other words, consumers are “getting more for their money.”

BATES AND CHAMBERS

CABLE SYSTEM ECONOMICS