The telcos are coming! The telcos are coming!
First heard a decade ago, that cry has become almost deafening in recent months as the three giant telephone companies tout plans to spend tens of billions of dollars upgrading their plant, aiming squarely at cable systems.
Prodded by cable's assault on their own core residential-telephone business, giants Verizon and SBC are counterattacking with video services and promises to dramatically improve their high-speed Internet products.
SBC, for example plans to replace much of its low-capacity copper plant with optical fiber, taking it to neighborhood “nodes” serving 300-400 homes. “We're pretty confident that it will be a better product than what's out there,” says Jeff Webber, VP of product and strategy for SBC's Project Lightspeed. “We're going to cover a lot of homes relatively quickly, 18 million in three years. It's a very aggressive build.”
We've heard this before: tough talk aimed at wowing regulators and legislators while terrifying cable operators' investors and lenders. After spending hundreds of millions of dollars on various video systems—remember Tele-TV and Americast?—the phone companies pulled the plug, saying video turned out to be more difficult and expensive than anticipated.
Skeptics on Wall Street
So you have to ask the question: Are the telcos for real this time? Will these three telephone giants really spend the roughly $25 billion they're budgeting over the next several years to rebuild their networks and launch video?
All these proclamations would be easier to believe if Wall Street weren't so skeptical. Many analysts generally can't see how the Baby Bells generate a reasonable return on their gigantic investments. Deutsche Bank's Viktor Shvets says telcos' capital spending is akin to “Armageddon.”
Sanford Bernstein's Craig Moffett—a former management consultant to telephone companies—concurs. He believes that, by 2010, telephone companies could be selling video service to 15% of the homes that the new systems pass. While that crimps cash flow for cable and DBS companies, it's not likely to be enough to justify the huge expense involved. “The economics don't make any sense,” Moffett says.
But the telcos may charge ahead anyway. By the end of next year, about 75% of U.S. cable systems will be selling telephone service, mostly high-quality VoIP (voice over Internet Protocol) service. Aggressive operators like Cox and Cablevision are signing up around 20% of their video customers to telephone, taking many of them right out of the hides of Verizon and SBC.
By offering the same—and perhaps an even better—bundle of telecom and video services as cable, perhaps telcos can keep more of their customers. It's the Karl Rove approach to corporate war: Don't attack your enemy's weaknesses, attack its strengths. In this case, that's video.
Otherwise, telephone companies risk losing customers even faster than the current 4% annual rate, as customers drop phone lines in favor of cable phones or simply cellphones. They don't want to emulate AT&T, which has suffered a humiliating downward spiral over the past two years.
“A lot of this is defensive.” says Timm Bechter, telecom-equipment analyst for Legg Mason. “How do you assess return on investment in spending on the army?”
Cable operators don't want to let down their guard. “We will fight like this is the last fight of our lives,” says David Pugliese, Cox Communications VP of product marketing. “We will preserve the customer relationships that we have worked so hard at creating.”
Though upstarts in the video business, the telephone companies still have tremendous financial power. The smallest of the three major Baby Bells—BellSouth—generates as much revenue, around $20 billion, as the very largest cable operator, Comcast. Verizon is triple Comcast's size.
The telcos are planning an upgrade every bit as substantial as the cable industry's 10-year, $95 billion rebuild that has allowed operators high-speed Internet and telephone services.
Initially, the telcos are using their upgraded plant to improve high-speed data service. (Their current DSL services generally run at much lower speeds than cable operators offer.) But they expect to be offering video services within months. SBC is hatching an ambitious scheme to send video via Internet Protocol, the so-called IPTV. That kind of “switched” video takes up much less capacity than current cable signals do, giving SBC much more flexibility.
Sanford Bernstein's Moffett—who has studied the telco's video plans—expects SBC to upgrade about half its homes, spending $4 billion-$6 billion by 2007. BellSouth has been hesitant to finalize its plans, but Moffett expects the company to take the same path.
Verizon also has an ambitious plan to pull high-capacity fiber all the way to people's homes. Verizon calls it FTTP, or fiber-to-the-premises. (Cable operators deride it as “fiber-to-the-press release.”) That would offer tremendous capacity, far more than that last stretch of copper could. But that plan is dramatically more expensive, because that “last mile” of any telephone or cable system is the most expensive and labor-intensive to replace.
Even though Verizon service has about the same number of homes as SBC and plans to upgrade only about a third of its plant, spending for its more ambitious plan could reach $20 billion over the next six years. SBC executives estimate that taking fiber all the way to the home would cost them five times as much and take three times as long to upgrade.
Lucrative Markets Only
But Verizon executives contend that such an extensive upgrade is essential. “This investment is fueled by the belief that a copper-based technology is not in the long-term operating best interest of the business,” Verizon CFO Doreen Toben recently told an investor conference.
The company has already brought fiber into neighborhoods serving 1 million homes and expects to add neighborhoods with another million homes by year-end. Fiber will be brought only to homes actually ordering advance services. A pilot system in Keller, Texas, has gotten Verizon's new high-speed Internet service into 20% of the town's homes, but the video service has yet to be launched.
Many cable systems won't even face telco-video competition because phone companies are not building in every market—just the most lucrative ones. SBC's immediate plan calls for upgrading plant serving around half of its 31 million homes. Their goal: to reach the best potential customers, the 25% of homes spending $160-$200 monthly on cable, Internet and telephone services.
But kids, we've seen this movie before. Ivan Seidenberg, then CEO of Nynex and now CEO of Verizon declared in 1994, “We will offer consumers the next generation of on-demand programming and interactive services, including shopping, games, sports, information and education.”
Bell Atlantic Chairman Ray Smith famously attempted to buy Tele-Communications Inc., then launched the Stargazer video-on-demand system in Alexandria, Va. SBC built a system in a Dallas suburb, US West in Omaha and Phoenix, Ameritech in Ohio and Michigan, PacTel in San Jose.
All that started collapsing in 1997. Many of the wireless companies went bankrupt, the programming ventures all collapsed, and the wired systems were shelved or sold.
The most cynical cable and Wall Street executives believe that the noise about video is aimed primarily at Washington, intended at projecting a progressive image that will create new competition. Indeed, after telcos won the right to enter the long-distance market with the 1996 Telecommunication Act, many of their video efforts lost steam.
“There's lots of regulatory noise about the desire of the Bells to completely rewrite the telecom law, and so there's a bit of questioning as to how sustainable this is,” Comcast Corp. Chairman/CEO Brian Roberts recently told investors. “But in those markets where it happens, it's a meaningful competitor.”
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