Cable in the Catbird Seat

"Red Barber announces the Dodger games over the radio and he uses those expressions – picked ‘em up down South... 'Tearing up the pea patch' meant going on a rampage; 'sitting in the catbird seat' means sitting pretty, like a batter with three balls and no strikes on him."
— James Thurber, The Catbird Seat

Although U.S. telcos act like they're tearing up the pea patch through their fiber rollouts, it is cable operators who are truly sitting in the catbird seat for the foreseeable future. That's the spot-on conclusion of analysts with Sanford C. Bernstein & Co. Inc.

While a "death by telco" scenario for cable makes a catchy headline, a coming ice age for Bell dinosaurs is far more likely when the economic, technological, operational, and regulatory dynamics are fully considered. Bernstein VP and senior analyst Craig Moffett, a Comcast Corp. (Nasdaq: CMCSA, CMCSK) bull on Wall Street, made a convincing case for cable's advantage in a recent investor conference call addressing the "Dumb Pipe Paradox."

Moffett's thesis? The two trends typically posited as harbingers of cable's demise – telco fiber deployments and service disintermediation (i.e., over-the-top voice and video applications) – are grossly over-exaggerated. Concurrently, the strategic value of owning the lowest-cost, farthest-reaching broadband distribution network is vastly underappreciated.

Taking on the disintermediation issue first, Moffett contends that there's "a huge disconnect between what the technologists would like to pretend can be done and the physical infrastructure on the ground and what it’s ready to provide." In other words, the notion of mainstream consumers getting their HDTV programming via YouTube Inc. downloads anytime soon is sheer fantasy.

"Downloading a full-screen, two-hour HD movie is the equivalent of downloading almost 2,300 songs from iTunes," Moffett said. "It’s a phenomenally bandwidth-intensive set of activities... Remember, the average American family is watching 57 hours a week of television. We are not close to ready to transitioning from video over linear distribution systems like cable."

However, even if such an "over-the-top" attack from Net video players were to succeed, cable would still come out ahead. Being a "dumb pipe" could actually be a great business for MSOs, Moffett argued.

"To understand the implications of the 'dumb-pipe' scenario for the cable companies, let’s postulate that there are two competitors for every home: a terrestrial telco network and a terrestrial cable network. Further, let’s assume that in a dumb-pipe scenario, customers who want to watch video buy directly from YouTube or Joost or Viacom Inc. (NYSE: VIA)'s Website. As a result, the cable companies and the telcos are no longer in the video delivery business. They are simply in the broadband business. In addition, let’s assume that all telephone service is provided by the likes of Skype Ltd. or Vonage Holdings Corp. (NYSE: VG)... Given both the telcos and the cable companies are offering only a dumb pipe, we posit that a 50/50 duopoly would emerge" for broadband access.

Now here's the punch line: "From a cost perspective, a telco would shed the variable cost associated with the line losses, and would reallocate its fixed costs across that smaller base. If the telcos delivered nothing more than a broadband signal," cable operators would benefit because they "have a much lower cost structure than the telcos. They could be profitable by simply matching their price to the telcos' cost."

Moffett's models estimate that in a dumb-pipe scenario, a cable operator's average revenue per user (APRU) would fall by about 45 percent. Operating expenses, however, would fall even more significantly, and the biggest cost center for MSOs – programming – would vanish.

The net effect? "Although revenues would fall by about 45 percent, EBITDA would fall substantially less: only by about 25 percent or so. As a result, operating cashflow margins would actually expand," Moffett said. Furthermore, "capital expenditures would fall even more sharply, because the MSOs would not be in the business of providing customers' set-top boxes anymore... That means free cashflow would actually rise." Hey, dumb can be fun!

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