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Allen's MSO Takes Digital Lead

Over the past year, Charter Communications Inc. has come to embody the "wired world" strategy of its visionary owner, Paul Allen.

After purchasing a traditional, mainline cable MSO, the Microsoft Corp. co-founder issued a directive to Charter's executives: Go forth and buy.

With that charge, CEO Jerry Kent and company have completed 12 acquisitions that added 3.8 million subscribers, launched an impressive $3.5 billion rebuild plan that will upgrade 70 percent of the subscriber base by year's end, and vigorously rolled out digital set-tops and cable modems.

The company has also been aggressive in working with WorldGate Communications Inc. and Diva Systems Corp. to deliver Internet-over-TV and video-on-demand applications. And two weeks ago, Charter teamed with Motorola Broadband Communications Sector and ReplayTV Inc. to bring hard-drive storage capabilities to Motorola's "DCT-5000" set-top.

Charter has emerged as one of cable's leaders in the development and deployment of new services. In fact, if the operator reaches its 1 million digital set-top goal, it's possible it will have a greater percentage of digital set-tops in the field than any of its counterparts, save for AT & T Broadband.

That's a truly remarkable accomplishment, considering the MSO started 2000 with 155,000 set-tops deployed.

Though Charter hasn't fared any better in the stock market than its fellow MSOs, Wall Street is noticing the company's execution.

"The perception of the company is changing from one of a relatively less well-clustered and less well-upgraded company to one of an industry leader in terms of vision, performance and plant status," Goldman, Sachs & Co. analyst Barry Kaplan said in a recent research note.

But despite Allen's far-reaching ambitions-including signing on Vulcan Ventures'Digeo Broadband Inc. unit to work on an Internet portal for Charter-most of what the operator has accomplished in the interactive and broadband arena has been accomplished with traditional suppliers.

WorldGate Communications Corp. launched its interactive-TV service on Charter's St. Louis system in 1998 and now counts 7,200 subscribers across 429,000 WorldGate-enabled homes. This summer, Charter joined Comcast Corp., Cox Communications Inc. and Adelphia Communications Corp. in taking a financial stake in WorldGate as the company develops a competitor to Gemstar-TV Guide International Inc.'s market-leading electronic programming guide.

Last month, Charter invested $5 million in VOD provider Diva Systems Corp. It has deployed Diva's VOD system to 9,000 homes in Atlanta and will soon add its 1.2 million-subscriber Los Angeles system to Diva's list.

And Charter is rolling out interactive advertising through Wink Communications Corp. in St. Louis; Maryville, Ill.; Kingsport, Tenn.; and Fort Worth, Texas. The service is available to 200,000 subscribers.

All those interactive moves are predicated on Charter's ability to get boxes into the field. And that's dependent on the confluence of a number of strategies-clustering, rebuilds and aggressive marketing-which, in turn, are fueling the operator's digital growth.


Some 45 percent of Charter's subscribers are in 14 clusters that average 200,000 subscribers apiece.

"This clustering is allowing us to reduce the number of headends from nearly 1,300 to just less than 500," Charter chief executive officer Jerald Kent told analysts at a Merrill Lynch conference several weeks ago. "This also means that about 90 percent of our customers will be served by just 100 headends."

The clustering makes an aggressive rebuild schedule more economical. New chief operating officer Dave Barford said the company has spent a lot of time on integration rebuilds over the past 18 months.

"We've got the ability to go to 870-megahertz [capacity] with two-way plant, averaging about 380 homes per node," he said at a recent Paul Kagan Associates conference.

Charter is deploying six fibers to each node: two for current use and four for future use. The company plans to complete 70 percent of its rebuild by year's end and 90 percent by year-end 2001.

The MSO claims it can split nodes down to 60 homes, using dense wave-division multiplexing, if the consumer demand for bandwidth is sufficient.

Some 135,000 miles of the MSO's 180,000-mile plant are being upgraded. Charter is building 200 master headends that will range from 2,400 to 5,800 square feet in size. Another 325 new secondary-hub structures are also under construction.

Harmonic Inc. has received 65 percent of that order, and Scientific-Atlanta Inc. the other 35 percent.

Those rebuilds are a springboard for digital set-tops and advanced services. From a near-standing start in January, Charter sailed past the 500,000 digital set-top mark in August. It has deployed more than 100,000 boxes a month, putting it on track to push the 1 million mark by year-end.

That's one reason why Charter ordered 1.3 million S-A 3000 set-tops earlier this year.

With 6.3 million basic subscribers, Charter's digital growth would put it on course to reach a 20 percent digital-penetration level by early next year.

"Digital has been a great business for us," said Barford, who noted that the MSO adds 20,000 set-tops a week. That's helped drive average per-month revenue per subscriber from $37.50 to $42.63, year over year.


The digital-penetration increase was also fueled by a strong marketing assault against the direct-broadcast satellite providers. Charter offered new and nondigital subscribers a $49.95 package this summer, guaranteeing that price under a one-year contract.

Even in areas where Charter doesn't yet offer digital, the MSO made a similar offer for $39.95. (Since then, most divisions have shifted to a simplified $59.95 price structure, which restores some of the digital profit margin but keeps Charter competitive to DBS, the MSO said.)

In July and August, Charter signed 217,000 digital subscribers, Kent said. Another 30,000 new analog subscribers were signed up and some 90,000 customers upgraded their service, he said. Through the fall, individual Charter divisions will decide whether to continue the pricing promotion.

Hand in hand with the one-year pricing guarantee is Charter's buyback strategy. DBS subscribers are offered between $150 and $200 for their dish if they switch to Charter, Kent said. The MSO then gives the subscriber a free month of digital cable and free installation. It has bought back 2,400 DBS dishes.

Charter is now pushing towards 200,000 data subscribers, having logged 149,300 subscribers across 5.2 million data homes passed as of June 30.

"We're now gaining about 2,900 new customers each week," Kent told Merrill Lynch analysts.

Charter has purchased 300,000 additional modems from Motorola and 200,000 from S-A this year. "We're in a market-share race with DSL," Barford said.

The MSO also cut its monthly modem rates to $24.95 in a few markets.

"We've seen connect rates at two to three times the normal rate," Barford said. "The ability to get market share is very important."

Next year, Charter plans to launch a 256-kilobit service at that $24.95 price point.

Charter has laid off deployment of circuit-switched telephony, preferring to wait for progress on the Internet-protocol front.

"We're big believers in IP technology," Barford said.

The company is testing IP-based phone service in Wisconsin with Cisco Systems Inc. and Telcordia Technologies Inc., and will add a Nortel Networks trial in St. Louis later this year. But Barford doesn't expect commercial rollout for another year.

Charter has also increased its commitment to customer service. The company will build 12 to 14 new customer contact centers over the next three years, at a cost of $9.5 million apiece.

The rebuild and advanced set-tops provide the platform for part of Paul Allen's "wired world" agenda.

"The other exciting thing is, it's the platform for the future," said Barford. "VOD, Internet over TV-there's a lot of applications that will come from that set-top box."


Still, Charter's efforts have done little to move Wall Street. The company went public in November 1999, and sold stock for $19 a share in an initial public offering that raised $3.7 billion.

Like most cable stocks, Charter has been hit over the past year. Trading between a high of $27 and a low of $10, the company has drifted in the $15 range for the past few months.

Late last month, Merrill Lynch & Co. analyst Jessica Reif Cohen upgraded the company from "accumulate" to "buy," with a target price of $25 to $27. And PaineWebber Inc. analyst Tom Eagan recently wrote: "We have initiated coverage with an attractive rating," expecting share prices to rise to $18 to $19, "which reflects 12.9 times forward 12 months core cable cash flow."

But Charter's debt-to-cash-flow ratio of 7.05, which Eagan said is the sector's second-highest, weighs on the stock. In that same note, Eagan said he didn't expect to see free cash flow-cash left over after debt service, capital expenditures and other payouts-until 2003.

Eagan also raised concerns about Charter's vulnerability to DBS, since "same-store growth" fell from 3.1 percent in 1999 to 2.4 percent in first-quarter 2000 and 2.3 percent in the second quarter.

But Kaplan is less concerned about the debt.

"The company's subscriber and EBITDA growth will lead the industry in the third quarter, and probably beyond that," he said.

Charter's Clusters