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The Costs of War

The best place to get a snapshot of the costs of the cable-TV/telco war is New York. To launch video and fast Internet services on suburban Long Island, Verizon spent heavily on an extensive overhaul of its telephone plant. Some estimates put the cost at up to $1,100 in capital for each home “passed” in its new FiOS TV optical-fiber systems, and it will take an average of an additional $700 or so to actually connect a new subscriber.

Preparing to defend itself, local cable operator Cablevision Systems tweaked its own plant. It boosted its Internet service to even higher speeds than Verizon's and stepped up its sales of cable telephone service, to steal Verizon's residential customers before the telco's system was ready.

Cablevision's capital expenditure was lower. The Internet boost cost it just $15 per home passed; each new phone customer cost around $200.

The yawning capital-spending gap shows how much of a disadvantage telephone companies are at as they push into the video business. Cable operators have largely been finished with their gigantic rebuild for several years and have a big video and Internet customer base already giving them a return on that investment.

Verizon is expected to spend $20 billion. Compatriot AT&T—deploying a much cheaper technology—is spending $5 billion. Because they'll be splitting the video market with entrenched cable and DBS companies, both companies face difficulties generating strong returns from the heavy investment.

Despite skepticism on Wall Street and from cable operators because of earlier half-hearted attempts, the telcos show no signs of hesitating. “We are only limited on this in terms of how quickly we can deploy the fiber,” Verizon CEO Ivan Seidenberg declared at a recent investor conference held by Sanford C. Bernstein & Co. “And just for what it's worth, we are deploying it as quickly as we know how and as fast as we know how in every place we can.”

Why such optimism? Verizon and AT&T aren't just calculating the revenues from new businesses; they're also taking into account the value of protecting existing ones, according to UBS media analyst Aryeh Bourkoff and telecom specialist John Hodulik. The two analysts have made telco video a special franchise and write about it extensively. “The whole strategy is a defensive strategy,” Bourkoff says. “They're going to continue to build. They don't really need it financially.”

Telcos have an enormous—$20 billion or so a year—cash cow in consumer telephone service; their relatively slow DSL service has also captured half the Web market. Pushing into video could trip up cable operators and slow the pace at which they're stealing telco residential customers.

Further, telcos see that cable's next obvious move is targeting services to small and medium-size businesses.

Seidenberg considers cable executives' recent talk about business services a sign of their anxiety: “We have picked up our momentum on broadband; we have slowed down the cable juggernaut a little bit. And that is part of the reason they are now looking at some collateral moves into small and medium business.”

Both telcos' plans are ambitious. Verizon is dramatically upgrading its network in parts of its service area, primarily suburban towns. Like cable operators, the company is stretching fiber deep into neighborhoods. But the telcos are going a step further, pulling fiber all the way to customers' homes.

That offers enormous capacity for video and data, but “fiber to the home” (FTTH) is also enormously expensive. One major cost: labor. With strong unions and a history of bureaucratic bloat, Hodulik estimates that the labor cost alone to lay that “last mile” of fiber underground to subscribers' homes is $700. (Stringing it on poles is about half that.)

AT&T is avoiding that cost with a cheaper but more limited architecture. The telco is laying fiber to neighborhood “nodes” but relying on plain-old twisted-pair copper to bridge the last few thousand feet to customers' homes. To get quality video through those wires, AT&T is relying on IPTV (Internet Protocol television) technology.

“I can tell you that cable is impressed so far because I know of one case where they offered a San Antonio customer a 33% discount off his cable bill if he would not switch to our IPTV service,” said AT&T CEO Ed Whitacre at the Sanford Bernstein conference. “So I know it's working.”

How badly might cable be hurt? Not a lot—at first. UBS analysts believe it will take the telcos a while to get going, predicting they'll secure fewer than 3 million subscribers each by the end of 2010.

And cable may not be the most vulnerable here. In Verizon's initial video launches, Hodulik sees a different victim: “They're taking a disproportionate share from satellite TV.” Whereas DirecTV and EchoStar combined have 27% of the video market, around half of Verizon's video customers are coming from DBS.

Why? “Most of these customers already have DSL,” he says. “They're already Verizon customers.”

Senior executives don't appear panicked yet about the telcos' entry into the video market. Comcast CEO Brian Roberts notes that cable already faces huge competition. Newspapers are filled with ads for a free satellite dish or a $12.95 monthly broadband connection. And yet, he says, “we're going to have maybe the fastest growth rate of the company at any time in the last four or five years.”

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