Multichannel TV: What, Me Worry?
Paul Sagawa / Artur Pylak
203.901.1633 / 203.901.1634
sagawa@ / firstname.lastname@example.org
January 30, 2012
Multichannel TV: What, Me Worry?
- Most multichannel TV forecasts assume a stable industry model facing incremental changes that will play out over many years. We believe that assumptions for robust ARPU gains, higher ad sales, and a stable subscriber base are unrealistic, given high current prices, pressures on consumer budgets, and increasingly strong competition. A accelerating cycle of a growing on-line audience, increasing internet ad spend, and improving streaming content, fueled by advancing technology is a serious threat to the status quo inherent in these forecasts. While recent cord cutting has been modest, as the on-line cycle approaches a tipping point where the audience reaches critical mass, we expect the phenomenon will strongly accelerate. As a result, we remain skeptical of the long term health of multichannel TV and favor companies levered against the eventual move to an on-line distribution model.
- Most cable industry forecasts project growing revenues for channelized video from growing ARPU, rising ad dollars, and stable subscribership. SNL Kagan’s ten year forecast for the cable system operators projects a revenue CAGR of 2.5%. A big piece of this derives from assuming a 3.7% annual rise in ARPU for operators and 8.2%/yr growth in cable advertising. Against this, Kagan projects total multichannel TV subscriptions to grow almost 1% a year. Analyst estimates for public operators suggest that Kagan’s views roughly mirror consensus.
- Projections for 40% 10yr rise in video ARPU are aggressive – prices already high, squeeze on HH budgets, on-line alternatives, etc.. Most of the increase in projected ARPU is simply increasing prices, with the monthly cost of basic service rising from just over $50 in 2012 to more than $70 in 2021, with the incremental fee for premium tiers and HDTV assumed as steady. This assumes that a trajectory that saw multichannel video go from 0.9% of household expenditures to 1.9% over the past decade can continue on to more than 2.5% in the next 10 years. With rising household costs for health care, education, food and taxes, this seems unrealistic, even without the threat of on-line video.
- Non-video ARPU will be sharply pressured by wireless telephony substitution and the poorly appreciated potential of wireless broadband. Kagan projects cable telephony subscribers to hold steady at ~25M households through 2021 despite rampant wireless substitution – 50%+ of adults under 30 are wireless only (25% of all households) vs. 0% in 2000. Cable modem subs are expected to grow at a 2% CAGR at flat rates, assuming little to no competition, although next-gen 4G wireless will be able to deliver residential broadband with cost and performance advantages vs. current cable technology.
- Trend line forecasting for cable ad revenues greatly understates threat of on-line competition, although 2012 should be strong on campaign spending. Kagan projects top MSOs to increase ad revenues per sub per month from about $4.75 to $8.50 over 10 years. Including DBS, telco, regional sports nets and video-on-demand, total industry ad sales is expected to grow at 8.2%/yr. On-line video advertising, with its precise targeting, is particularly threatening to this aggressive forecast. While advertising is only ~4% of revenues today, it accounts for 100bp of the forecast growth through 2021.
- Multichannel service subscriptions are projected to grow 1%/yr, despite sharply increasing prices and rapidly emerging competitive alternatives. Cable subscriptions are projected to decline slightly, while DBS and telco TV gain. This seems inconsistent with rising ARPU, given rising household costs for health care, education and food, and improving on-line alternatives. Moreover, the explosion of tablets and connected TVs over the past year are likely to disrupt the historical viewing trends behind the projections. We also believe that the most valuable content will NOT remain exclusive to multichannel distributers – an assertion that we will address in detail in subsequent research. “TV Everywhere” offerings may sap some early demand for on-line only services, but do not address the increasingly high cost of cable service for consumers or recognize the interest of content owners in nurturing their own on-line offerings.
- Shifts in viewership and advertising, and an increasing choice and quality of on-line video offerings will predate cord-cutting, which will accelerate in the back half of the decade. Cord cutting is a modest trend today, but is likely to grow surprisingly robust with time. A self-reinforcing cycle has begun by which the growing audience for on-line video is attracting advertisers willing to pay a premium for more certain and targeted impressions. In turn, programming networks are getting more serious about their on-line offerings, as creative talent negotiates with on-line aggregators and explores developing content specifically for on-line audiences. This cycle is already accelerating, and, we believe, will spur increasingly serious cord-cutting as multichannel service prices rise and the alternative gets increasingly attractive and easy to access.
- On–line aggregators, aggressive network brands, Internet savvy advertising, and talent will win. The shifting audience and advertising market represents significant opportunity for on-line video streaming aggregators, such as Amazon, Google, and possibly, NetFlix, and for companies positioned to lever existing businesses into on-line video, like Apple, Facebook and Microsoft. Networks that are aggressive in establishing their channel brands on-line, such as CBS and NewsCorp could also prosper, along with advertising firms that fully embrace the change. Finally, producers/owners of compelling content will gain greater control over their offerings and thus, capture more of the value.
- Multichannel system operators, resistant network brands, and traditional advertising will lose. The rise of on-line video is unequivocally bad for multichannel system operators, who will also face growing competition in their internet and telephony franchises. Networks that are slow to establish their brands on-line will also suffer, as will advertising businesses that don’t develop internet expertise.
Dancing with Bulls
The bull case for multichannel video – i.e. cable MSOs, satellite TV and telephone company provided TV – speaks to the power of status quo. The 30 year trend line is unequivocal. Thirty years of subscriber gains, as the nation was methodically wired up for cable. Thirty years of ARPU (average revenue per user) growth, as channel selection broadened, premium channels were launched, and new services – e.g. cable telephony, high speed data, video on demand – were added. Thirty years of advertising growth. Thirty years of increasing numbers of TVs per household and thirty years of rising viewership. All with only occasional slips coincident with economic recessions. From 2000 to 2010, US household spending on multichannel video offerings grew by 145% to make up nearly 2% of spending for the average American household. On an annualized basis, this amounts to 9.3% growth, a rate faster than the expansion of either health care or higher education expenses for the average family. This is also faster than the 7.9% CAGR in overall consumer spending on entertainment, with the growth in multichannel TV accounting for 62% of the growth in overall entertainment spending. With that backdrop, industry analyst SNL Kagan’s forecasts for 4.4% growth in multichannel TV revenues across cable, satellite and telco providers through 2021, might seem reasonable.
A complete bull case would then describe a minimal competitive threat to the status quo. Yes, consumers have begun to watch video on-line, BUT the quality of the video is not nearly as good as that delivered by cable and the growth in viewership does not seem to have resulted in any reduction in the audience for multichannel TV. Even more importantly, the most popular video programs are controlled by a small community of media companies with strong ties to the multichannel TV model. With the large majority of their sales and profits tied to the fees paid by multichannel operators, there is no immediate incentive for these companies to do more than dabble in the on-line market, right?
It helps that for 70% of US households, the ONLY choice for broadband internet access fast enough to support decent video streaming is a cable modem. Cable executives openly discuss how any loss of video subscribers could be more than balanced by increasing the price of high speed data services. Already, MSOs have begun to implement price premiums for high usage subscribers and the shared nature of cable modem architecture naturally throttles back system performance for everyone during times of high usage. Most cable modem subscriber can testify to frustration on Friday nights, when downstream rates slow to a crawl as neighbors fire up their Netflix. Given the circumstances, cable operators have little incentive to push capex into the network to expand capacity, a capstone to the bull case, as light capex implies heavy cash flows in an infrastructure intensive business.
Yadda, Yadda, Yadda
An interesting corollary to the current circumstances is evident during the early years of cable, only 30 years ago. In 1980, the four main broadcast networks, ABC, CBS, NBC and PBS controlled 98% of the television audience. Fast forward to today, and the broadcast networks, which now includes FOX and the WB, control just 25% of the television audience, with 75% of viewers at any given time watching the hundreds of other networks available on the typical multichannel system. This has had a profound impact on the profitability of the traditional broadcast networks, as the rise of hundreds of competitive channels has changed the balance of power in negotiations with the creators and owners of programming. Negotiations with the NFL are a case in point: Pre-1980, CBS had the NFC, NBC had the AFC and ABC had Monday Night Football. With the advent of cable, additional channels got into the mix. In this new context, rights fees for the NFL have skyrocketed to where CBS’s new contract, at $1B/year equates to nearly 25% of its annual advertising revenue. In all, annual NFL rights fees have risen by a factor of 11x during the cable era, a 9.5% CAGR. As a result, Kagan projects only CBS as consistently profitable over the next five years, with cable networks continuing to siphon advertising revenue along the way.
The problem with trend-based analysis is that trends end. Arguably, on-line video is in a similar position to the cable networks 30 years ago, when the idea that a cable-only network would wrest Monday Night Football away from ABC would have been dismissed out of hand. Yet, by 1987, ESPN had convinced the NFL to give them a try for a Sunday night game. By 2006, the unthinkable happened, not just with ESPN taking Monday Night Football, but with the NFL creating its own channel, the NFL Network for Thursday night games. It would seem folly to assume that the NFL would not consider its own on-line presence, bypassing the traditional networks, at the end of its current deal in 2021.
You Want How Much?
The average cable household pays roughly $128 every month for a mix of services anchored by multichannel video and sometimes including high speed internet access and/or telephone service. SNL Kagan’s ten-year forecast for the industry assumes that this ARPU can grow 3.1%/yr through 2021 to nearly $175 per month. At a median household income of $49,995 in 2010, this now accounts for 3% of the typical cable household pre-tax budget today, rising to roughly 4% in ten years, depending on assumptions for growth in disposable income. At the same time, health care related expenses are now roughly 16% of household spending, and growing at a 9% annual pace. With other categories in the household budget, notably education and food, also growing, the math may not accommodate an additional percentage point for cable.
Within the cable bundle, multichannel video holds its own, at 61% of the monthly tab and expected to grow 3.3% per year. The mechanics of rate hikes in multichannel video starts far up stream, where the true owners of content – creative talent, sports leagues, independent producers, etc. – have used the leverage of cable channel expansion to demand ever higher compensation. In turn, the networks have turned to push their own cost escalation down onto multichannel distributors. Over the past decade, standoffs between network owners and the distributors have grown more common, but still universally end with agreement for higher fees. These fees are then jammed down on subscribers, most of it coming in the base level fee for service. In this, the 3.3% ARPU growth forecast assumes very little elasticity of demand for consumers – households are pure price takers, begrudgingly swallowing each rate hike without repercussions for the value chain.
Much of this is coming at the hands of sports programming, which is presumed to have the stickiest of viewer loyalty and is used by networks and operators as a loss leader of sorts, a vehicle to promote other programming to a relatively certain audience base. However, this has the secondary effect of an implicit cross subsidy from those indifferent to sports who, nonetheless, have to pay the freight for programming viewed by others. ESPN is the most expensive channel on the cable roster, accounting for 9.4% of the basic cable rate and projected to rise at an 8.2% CAGR to 11.2% by 2015. Of course, in a universe of hundreds of channels, ESPN does not account for nearly 9% of viewership on average or even during its most popular programming, much less 11.2%.
With the growth of non-sports entertainment options on-line, the implicit subsidy of sports fans creates an umbrella for competitors to exploit. In response to this, Cox recently announced that it would launch a $35/month bargain service that did not include ESPN in its channel bundle, flying in the face of traditional industry solidarity against unbundling and putting at risk the assumption of ever rising video ARPU.
Unfortunately, another factor is piracy. During the recent conflict between Time Warner Cable and the Madison Square Garden Network, New York Knicks games were pulled from the Manhattan cable system. During one blacked out game, Fred Wilson, a partner in the New York based Union Square Ventures, tweeted a picture of the game on his TV via a pirate aggregator, along with the hashtag #screwcable. The fact is that it is easy to find live TV pirated on the net, a phenomenon that is likely to become more common, particularly if rates continue to rise and channels remain bundled.
Telephone Cordcutting, Redux
From the launch of cable telephone service in 1998, cable operators have gone on to capture 25 million residential telephone customers, with an ARPU of $33/month. Kagan projects cable telephone subscribership to hold fairly steady going forward, with a slight deterioration in monthly billing. While this forecast holds to historical trend, it ignores two fundamental changes to the market. First, wireless substitution has become real. Nearly 50% of all adults below the age of 30 do not have a wired home telephone, relying entirely on their mobile device. However, this is not isolated to the young, nearly 30% of all US households now rely entirely on wireless telephony. We believe that this phenomenon accounts for an abrupt slow down in the adoption of cable telephony over the past three years and threatens to begin to erode the existing subscriber base as well. Moreover, internet-based telephony is becoming a more viable alternative as well. Microsoft’s recent purchase of Skype and Google’s launch of its Voice service and the integration of conference calling to its Google Plus social network are indicative of the resources lining up to attack the traditional telephone market.
Even though telephony only accounts for 10% of cable industry revenue, it carries high margins as further leverage against the network investment to deliver video. The added sales from telephony likely account for 20-25% of many cable operators profit. We see this business as highly vulnerable to industry change. Any telephone company executive can tell you how the story plays out.
There is Another
The ace in the hole for cable operators is their near monopoly for residential broadband internet service. According to the FCC’s national broadband plan, 70% of American’s have no other choice than their cable operator for internet connections fast enough to handle video. A common bullish cable refrain suggests that deterioration in the multichannel TV business is OK, since the margins are razor thin in video and operators can simply hike rates in the high margin high speed data business to make up the lost revenue. This presumes two things. First, that there will be no credible competition on the scene to keep cable MSOs honest; and second, that the government would let them jack up prices on broadband despite already ample margins.
Cable executives have been confident about their competitive free hand, since both Verizon and AT&T announced an end to their rollouts of fiber-based broadband service. Verizon had been the most dangerous rival, as its “fiber to the home” service offered speeds and channel capacities far ahead of cable’s coaxial based offerings. However, the costs of pulling new optical fiber street by street and house by house are prohibitive in most geographies, and Verizon has signaled plans to end its FiOS investment by 2014. AT&T expects to have its U-verse service, based on a cheaper but less capable technology than Verizon, available to roughly 30M US homes, but intends to end its roll out at year end.
However, there is a hidden menace for cable broadband. In its current incarnation, 4G wireless offers lightning fast 10Mbps downloads, but has an aggregate capacity per cell site of roughly 100Mbps. While this is fairly comparable to the 152Mbps that most cable providers offer for each 500 household node to share via DOCSIS3 modems, it is tight enough that Verizon and AT&T are careful to control their subscribers usage with caps. The initial focus for both wireless giants is coverage, to reach more users and to give their users trouble free roaming around the country. Coverage is expensive, given 50,000 or more cell sites needed for adequate nationwide reach, so ample reason to keep rates as high as possible, on tacit agreement between the two overwhelming market leaders.
Time may change things. First, the specifications for the next iteration on 4G technology have been ratified, offering as much as a 20 fold increase in the practical capacity of a cell site, depending on how much spectrum can be put to use. This technology should be commercially available by 2013. Second, new spectrum to fuel the new technology may be auctioned. The FCC has asked congress for approval for incentive auctions of television broadcast spectrum in the same rough frequency band that it licensed to operators in 2008. We believe that this approval is very likely to be approved in 2012, allowing auctions to proceed in 2013 of as much as 120MHz of spectrum in the 700MHz band. This spectrum could enable new competition and ease the costs of transition to LTE for existing carriers. Third, LTE Advanced, with maximum mobile speeds of 100Mbps, need not be deployed as comprehensively as basic LTE. Cherry picking residential markets would allow wireless operators to attack residential broadband at very low cost. Rather than pulling fiber down streets on spec, a single $50K LTE advanced base station could deliver more than 1Gbps of aggregate capacity, available to be shared by any user within the 3-6 mile service radius of the cell.
The wireless alternative would be all the more attractive should cable operators follow through with their plans to stifle capital investment and raise rates. Even if 4G operators were in on the game and held back their attack, the rising rates would stink of anticompetitive behavior. Cable operators were able to stave off common-carrier status and rate regulation in the last round of FCC and Congressional inquiry into “net neutrality”, but jamming captive consumers with sky high rates and throttled service would almost certainly bring the issue back to the front burner. Given that cable operators are already almost universally reviled in customer satisfaction polls, it would seem unlikely that they could count on the same legislative support the next time around after a run of purposeful customer abuse.
The Advertising Racket
Local advertising provides $4.73/sub/month in revenue to cable operators, or roughly 3.7% of total residential revenues. This is projected by Kagan to grow at a 6% CAGR to $8.50/sub/month, or roughly 4.8% of total residential revenues, accounting for a full 100bp of projected revenue growth for the cable industry. Adding in advertising revenues for satellite operators, telco TV, video-on-demand, and regional sports networks suggests even faster growth at a CAGR of 8.2%. The rationale for this is superior targeting at the local level and a general faith in the long term strength of broadcast video advertising in general.
While cable MSO advertising may well be more effective for targeting than national broadcast advertising, it is clearly inferior to on-line video advertising, where targeting can be honed to the specific viewer, where impressions can be confirmed, and the advertiser can interact directly with the viewer. CPMs for on-line video sell for a 20% premium vs. broadcast TV and the total on-line video advertising market has been growing at a 52.1% pace despite the economic malaise. With on-line viewership doubling year over year, the emergence of ever more attractive content available and a clear enthusiasm on the part of advertisers and their agencies for the on-line forum, it seems quite optimistic to project 8%+ annual growth in local advertising for the multichannel operators.
If You Gouge Them, They Will Leave
Amazingly, in a scenario where cable operators take their average monthly residential bill from $128 to $173 in a decade, total multichannel TV subscriptions are projected to grow by 1% a year through the end of the decade. Slight subscriber losses by cable are expected to be more than offset by DBS and telco TV operators, who are also expect to see strong growth in ARPU. Having already addressed the obvious pressures on the average household budget to foot this ever growing line item, we turn to the alternative.
Cord cutting has been modest, even in the teeth of the recession, although most investors likely know at least one family that lives happily cable free. However, we note that two years ago, the iPad had not yet been introduced, while total world-wide tablet shipments hit almost 27 million in 4Q11. 29% of TVs sold in the US in 2011 offered integrated internet connectivity vs. essentially 0% just three years ago. Xbox gaming consoles offering internet access are in 66 million homes world-wide, up more than 20% YoY, with 60% subscribing to the Xbox Live internet service with links to top on-line video providers. Trends that were established prior to this revolution in access to the Internet via the living room TV must be considered suspect indicators of coming years.
TV Everywhere, which allows cable subscribers to access programming over the internet as long as they continue to pay the hefty monthly bill, may temporarily thwart some on-line video services, but would not seem a long-term deterrent to cord-cutting as long as the intention remains to raise rates. Moreover, exclusivity over on-line distribution would only drive content costs even higher as content owners get more confident in their own opportunities on-line.
We recognize that a big piece of the bullish argument for cable hinges on an assertion that the chain that links talent and content creators to broadcast/cable networks and then to multichannel distribution is solid, with little reason for participants at any level to break ranks and endanger the health of a system that continues to deliver the vast majority of their sales. We plan to explore this issue in considerable detail in subsequent pieces, but offer a brief assessment here.
While multichannel distribution is easily the largest part of a network’s revenues via advertising and fees, on-line is not insubstantial. Kagan reports CBS’s on-line related revenues at $220 M for 2Q11, roughly 6% of total revenues for the company and up 43% YoY. Even with inevitable deceleration, it would seem likely that on-line will top 10% of company revenues before long while generating the majority of the growth. Nurturing a business like that should be important to any company. Moreover, it is important to note that networks do not actually create most of the programming that they broadcast. They buy it, and each year, the networks must assess the health of their programming and replace shows that are no longer delivering the expected audiences. Over time, the cost of replacing that content has risen, as the talent and producers that create content have used the proliferation of channels to raise their bargaining power. On-line represents yet another bargaining chip in these ongoing negotiations, one that has the added advantage of cutting out a range of intermediaries between the content creators and his/her audience. Many content creators have already begun to apply themselves to the on-line channel, with the champions of on-line video – such as Google’s YouTube, Netflix and Amazon – stepping in with funding to kickstart the process.
Ultimately, we believe that a virtuous self-reinforcing cycle has already begun. On-line programming is attracting audiences – YouTube alone had 160 million unique US viewers in October, serving more than 20 billion videos, averaging more than 7 hours per viewer, with total viewing up more than 100% YoY. The audiences are attracting advertising. The advertising attracts more content, which fuels the growth of the audience. The numbers are still quite small relative to American consumption of traditional TV, but the growth is the killer along with the demographics. The youngest viewers watch the most video on-line, and as they age, these habits will follow them and grow. Content owners will ignore this at their own peril.
Timing is Everything
Much of the bleak outlook that we have presented will really hit in the back half of the decade. On-line video is still a bit too small to really hurt near term multichannel TV performance. Network owners and content providers have not yet strayed too far from the cable mothership. Wireless networks still lack the capacity and are too expensive to be a realistic alternative for residential broadband. The local advertising market shift to on-line is not yet apparent.
But the signs are there. Cable telephony penetration has abruptly slowed and could begin to decline in short order. The audience for on-line video continues its explosive growth. The premium for on-line advertising CPMs vs. broadcasts persists. Penetration of tablets and connected TVs continues apace. When cord-cutting picks up three or four years from now, it will be too late to do anything about it.
Winners and Losers
The winners will be the champions of the on-line video model. Chief amongst these are the platform owners positioned to deliver integrated multi-device, multi-application experiences to their users, including the aggregation of on-line video – i.e. Apple, Google, Amazon, Facebook and Microsoft. Within the traditional multichannel TV chain, network owners that act decisively to establish their content brands in an on-line context may very well win the day. Right now, CBS and Fox appear to be making the most aggressive moves to establish their branded presence. Advertising agencies will either embrace on-line and learn how to exploit its unique attributes or be subsumed by those that do. Talent and producers will see benefit from an expansion in their potential audience.
The losers will be the multichannel operators, who ultimately, will be unable to hold together an unstable industry value chain, with the cable industry likely to feel the pain before satellite operators or telcos. Networks and advertising businesses that fail to adapt to the new medium will likely fail.