April 20, 2010 A Thousand Paper Cuts: The Future of Cable TV
Cable operators face a panoply of threats that, taken individually, may seem distant and minor, but considered collectively, could reverse industry growth and seriously strain profitability. First, we believe that share gains in highly profitable residential telephony will reverse, as the trend toward mobile-only households accelerates. Second, we expect that multiple 4G wireless roll-outs will bring further competition for residential broadband, both pressuring prices and taking market share. Third, web-based video technology is improving rapidly just as the tools to access it via the television are becoming more widespread. We believe on-line television will soon begin to siphon viewership from traditional cable and shift the balance of power in negotiations for content away from multi-channel video operators, bringing significant pain even if the sea-change of internet related subscriber churn is a decade or more away. As such, we anticipate that the returns for cable and satellite TV providers will be amongst the worst in the TMT universe over the next few years.
The heavily fixed-cost nature of cable economics makes the industry particularly vulnerable to revenue disappointments. Gross margins in telephone and internet service are better than 75%, compared to less than 50% for television. With non-video sources generating more than 40% of industry revenues, and thus, the large majority of the contribution against fixed expenses, pressure on the price and market share of cable operators in those businesses is dangerous.
Since 2006, the percentage of US households relying only on wireless for telephone service has increased from 10.5% to nearly 23%. The demographic of this phenomenon skews very young, suggesting that we could see this trend continue long into the future. Moreover, the emergence of low cost fempto-cells that extend wireless coverage into homes by connecting into broadband connections could accelerate this process, putting a serious damper on cable’s share.
The recently released FCC National Broadband Plan (see our piece from April 6 “The National Broadband Plan: Windfall for Wireless, but Catastrophe for Carriers) is explicit in its intent to open 300-500MHz of new radio spectrum for wireless broadband, more than twice the bandwidth currently licensed by mobile carriers. The amount of spectrum to be made available and the proposed process by which it is to be assigned make it likely that the cozy Verizon and AT&T dominated club of American wireless could expand to 5-7 national 4G networks, each able to deliver better than 5 Mbps service to households. We believe that this would pressure broadband pricing, materially affect the penetration of cable broadband and spur additional capex for cable operators.
To date, internet television has been limited by technical shortcomings and lack of access to the living room TV. Higher speed networks, better compression, and faster servers are yielding dramatic improvements to video streaming and download performance, that we expect to spur significant increases in viewership. Deals with video console makers have opened a door to the television set for pioneers like Netflix that should be pushed open wider with the FCC recommended mandate for ending cable MSO domination of set-top-boxes. Shifting viewing patterns will make on-line platforms more attractive for content providers and advertisers. At the same time, a smaller audience would have the opposite effect on cable operators, who would find content owners driving harder bargains and advertisers losing interest.
As internet TV becomes a more viable alternative to cable, a key issue will be the decisions of the owners of the most desirable content to either embrace or stiff-arm internet distribution. For films, the process has begun with Netflix, Redbox and AppleTV. Most sports organizations have also begun to make their content available on web, although the next round of fee negotiations with broadcasters will undoubtedly bring this issue to the front burner. We believe the inherent benefits of internet TV – audience targeting, flexible terms for monetization (pay-per-view, subscription, ad-driven, commerce driven, etc.), location independence, flexible scheduling, etc. – will draw most, if not all, important content to the medium.
We believe that we will begin to see a meaningful exodus of households from multi-channel TV to internet-only viewing by the end of the decade. As this eventuality becomes more apparent over time, we believe investors will seriously question the long-term value of cable and satellite TV franchise assets, and that the stocks will suffer accordingly. The primary beneficiaries of these changes will be those technology companies that facilitate network competition – Cisco, Juniper, Google, Ericsson, etc. – and companies that are able to build successful internet-based video franchsies – Netflix, Apple, Google, etc. Companies that own or control compelling content – Disney, Viacom, Newscorp, etc. – face a mix of challenges and opportunities that will separate those companies with strong visions from the others.