loose ends

SBC’s Scott Helbing

SBC COMMUNICATIONS INC.’S VIDEO service strategy may be far less certain than official pronouncements suggest judging from the magnitude of unresolved challenges it faces on the business front.

SBC, with Microsoft Corp. and Alcatel as the respective suppliers of the video and network infrastructures, says its goal is to achieve 20 percent market penetration of 18 million households by the end of 2007, which officials assert would make the carrier the second largest purveyor of video services within the targeted footprint. About 17 million of those homes are to be served via highspeed DSL lines connected to fiber nodes terminating much closer to households than is generally the case today, and another 1 million or so are to be served by all-fiber networks.

A key question underlying the entire rollout strategy is whether SBC’s IPTV service falls outside the local franchising requirements the Telecom Act of ’96 imposes on cable service. SBC officials assert that the FCC’s decision to exempt IP-based voice from much of the traditional telephony regulatory regime logically implies that IP-based video should be exempted from traditional cable franchise rules.

SBC CEO Edward Whitacre Jr., speaking in January at the Consumer Electronics Show, explained his thinking this way: “Cable’s putting telephony [on their network] and they’re not paying, so why should we?” In an interview, Scott Helbing, senior vice president of marketing at SBC, is blunter still: “As far as we know, we don’t need a cable franchise.”

While avoiding the franchise obligation would save time and money, there’s something even more vital to SBC’s business plan when it comes to the regulatory assumptions executives are making. As Banc of America Securities LLC senior research analyst Douglas Shapiro notes in a recent report, “[SBC] has indicated that its 18 million-home deployment will reach 90 percent of its ‘high-value’ subs. With roughly 30 million residential passings (overall), that means that 40 percent of all its residential customers will be left out. Since these high-value subs aren’t all necessarily living contiguously, it suggests that SBC will be faced with the challenge of marketing a service that won’t be available uniformly across large service areas.”

This is why avoiding franchise requirements is so important to SBC, says senior analyst Gregg Moffett of Sanford C. Bernstein & Co. LLC. “Franchises might limit their ability to pick and choose which areas they want to serve, which would impact their revenue assumptions,” he says. High-end customers are important, he adds, because they are viewed as more likely to be swayed by SBC’s marketing message that it offers a more compelling service than cable with à la carte options that would drive revenue well beyond the basic service fee.

Former FCC Chairman Michael Powell lent some credibility to SBC’s stance on the franchise issue when, in an appearance with Whitacre at CES, he said, “Are you a cable company or an Internet company? I don’t know.”

But Kagan Research LLC analyst John Mansell says the question of whether or not IPTV should be subject to franchise fees is not the FCC’s to decide. “It would take a change in the law,” he says, noting this point was confirmed in a conversation with a senior official at the commission. “He pointed out that under the Telecom Act (of 1996) any retransmission of a broadcast station’s programming is defined as a cable service, which means you need a franchise.”

Equally challenging to the notion of IPTV being something apart from regular cable TV is the fact that, unlike VoIP, which uses the basic transport protocols of the IP regime, the video content to be carried over the Microsoft platform will be encapsulated in the same 188-byte MPEG transport frames in which cable TV is transported. MPEG is a framing format for the emerging compression VC-1 standard, which is based on Microsoft’s Windows Media 9, just as it is for the MPEG-4 standard.

“There’s been a lot of confusion about IPTV,” says Phil Corman, director for partner business development at Microsoft’s MSTV unit. “This isn’t video streamed from the Internet; it’s digital television. The IP component is the management layer that allows us to use our software to create a compelling service by adding digital rights management, interactive features and much else to that video stream.”

Over a year ago, SBC asked the FCC to declare that IPTV would not be subject to the traditional rules governing cable and broadcast programming based on the notion that “the technology underlying IP-based networks and the ability of such networks to converge services defy such segregation.” But, just as SBC employs Ethernet at the networking layer to route and switch all traffic to be delivered over its new fiber-rich networks, cable employs the combination of DOCSIS (data over cable service interface specification), an Ethernet-like means of managing data traffic, in conjunction with MPEG and other types of data signaling for managing video to create a unified stream of video, data and voice over the same network.

For the commission and Congress to achieve a new regime would seem to involve a sweeping approach that addresses cable integration as well as integration of services over telco networks, Mansell notes.

Working through such issues obviously will take a long time, especially in light of the fact that no move to revisit the Telecom Act of ’96 appears imminent in Congress. Meanwhile, SBC faces other challenges to its business plan, starting with efforts to put together content at costs that will justify its business assumptions.

A recent report from Forrester Research Inc. asserts that while the recently announced platform integration partnership between Alcatel and Microsoft likely will accelerate the pace of IPTV network rollouts, “IPTV has bigger problems than this integration. ... With few customers, the IPTV deployments’ per-customer costs will remain very high.” Even where telcos are willing to bite the capex cost factor, they still have to negotiate with program suppliers on the basis of having limited costs of scale, says Forrester analyst Lars Godell. “It’s a real chicken-and-egg issue,” he comments.

Indeed, content suppliers show little sympathy for telco efforts to cut deals based on future volume subscription expectations. “We’ve been approached by telephone companies who want us to help them grow their business,” says Larry Shapiro, executive vice president of business development and operations for Walt Disney Co.’s Internet Group. “But, for us, this isn’t a variable-cost business.”

SBC’s first line of attack has been to achieve volume price discounts through its relationship with EchoStar Communications Corp., with which it is partnered in the marketing of DBS service as part of triple-play offerings throughout its territories.

But it isn’t clear whether EchoStar’s contracts with its content suppliers give it the option to count content for a terrestrial supplier like SBC as part of its discount pool. “Can they go to Viacom [International Inc.] and say, ‘I’m going to increase my distribution of your content from 6 million to 10 million through delivery over SBC’s lines?’” Helbing asks. “That’s the type of question they’re asking right now.”

If the EchoStar ploy doesn’t work out, SBC has other ideas as to how it might achieve discount content pricing, Helbing notes. “We’re prepared to be aggregators ourselves,” he says. “The issue will be how aggregation works in the context of our company’s market position.”

For example, he notes, SBC can offer its mobile market base through Cingular Wireless as a point of distribution for video content suppliers. Moreover, he adds, “we spend $1.6 billion (annually) on advertising SBC’s and Cingular’s services with Viacom, NBC, etc., and that should give us some leverage in our discussions on cost of content.”

Bernstein senior analyst Jeffrey Halpern explains how important content costs are to making SBC’s business plan fly. If the carrier has to pay a 15 percent premium on content compared to cable, which Halpern’s research indicates is a reasonable assumption, and it discounts its video service prices against cable by 15 percent to win subscribers, its cash flow margin on the service would be 29 percent compared to 45 percent in cable, Halpern says.

If one assumes these discount pricing and content cost parameters, along with a 2.5 percent rate of churn, and counts in the benefits of voice subscriber retention and high-speed-data gains through service bundling on the fiber network, Halpern says SBC would have to achieve 100 percent video penetration in its targeted market to reach a 10 percent internal rate of return. “Even without a price discount they would need to capture one-third of the market for multichannel video to achieve that rate of return,” he says.