Shifting gears in the race

Among the 'Third Network' companies, those with investors from the power utility industries appear to have the most solid financial footing.

BY DON GALL AND MITCH SHAPIRO

By now, most everyone on the planet has probably heard of the words "broadband" and "convergence" and is at least vaguely aware of the intense race now underway among various sectors of the communications industry. The Holy Grail in this pursuit is the convergence of voice, data, audio, video, and more (e.g., security, energy management, in-home networks) into an offering that cost-effectively provides customers with greatly expanded value and generates correspondingly new revenue streams. The race started in the early 1990s and has had a long and torturous route. The versatility and huge bandwidth capacity of fiber optics has played a major role. In fact, fiber has been the key enabler.

In the late 1970s and early '80s, the cable industry exploded into the larger cities with a network architecture suited for small towns and no experience running large service organizations. The main problem with the network architecture was that it did not scale very well. Analog fiber optics came to the rescue, allowing the network to be broken into small enough segments to be practical. This concept, hybrid fiber/coax revolutionized the industry. However, it did not help with staffing, training, and customer service issues that remain a concern.

The telephone industry was receiving similar benefits from fiber optics, revolutionizing long-distance communications and allowing for a much more reliable network overall. It was not long before both industries looked over the fence and saw greener grass on the other side. When the Telecommunications Act of 1996 began to tear down that fence, both industries experimented with the other's core business. They found some success and many failures, and both learned important lessons along the way. At the same time, the Internet was expanding at breakneck speed, opening up new avenues of potential growth-and raising new challenges-for these historically video- and voice-centric industries.

As if there was not enough going on, federal and state governments also began deregulating the power industry, another long-standing monopoly. This development introduced the potential need for real-time monitoring of each customer's energy use and a telecommunications network to support it. Some power companies decided that if they had to build such a network, they might as well expand it to include carriage of telephone and cable television. Again, this situation led to some success, more failure, and valuable lessons learned.

The plot continued to thicken with AT&T's 1998 purchase of TCI and MediaOne, two of the nation's top-three cable operators at that time. AT&T paid a premium for these cable systems, with the intent of deploying telephone service in them as quickly as possible. In many cases, that was a very steep uphill battle. Not only were many of the systems in need of extensive work to accommodate a lifeline telephone service, the majority of the staff needed to be trained to operate in an entirely different mindset than they were accustomed. Last year, AT&T announced the split into four independent groups, distancing the broadband group from the other business groups, partly because of lowered expectations for the deployment of telephony services. This story is definitely not over yet.

Around the same time, Paul Allen, a co-founder of Microsoft, began his own cable spending spree, buying up mid-sized operators (also at premium prices) and bringing them together under the name Charter Communications, one of the first operators he acquired. Whereas AT&T had a primary focus on cable as a platform for delivering telephony, reflecting its core long-distance business, Allen seemed more interested in cable's potential to deliver new digital media and interactive services.

Reflecting this focus, Charter last year achieved one of the industry's most rapid ramp-ups of digital set-top deployments. With little more than 150,000 digital set-tops in place at the start of 2000, the company reached the one-million-unit mark by Christmas, a digital penetration of roughly 16%. Charter has also embarked on one of the industry's most aggressive network-upgrade programs, at a budgeted cost of $3.5 billion. Using an architecture that brings six fibers to nodes serving an average of 380 homes, Charter plans to serve 93% of its customers with 750-860-MHz plant by the end 2002. And if demand warrants, its plans call for DWDM coupled with node splitting down to 60 home service areas. Charter has also emerged as a leader in deploying new video-centric services, including a major rollout of video on demand (VoD) in Los Angeles.

Thanks in large part to the influence of these new buyers, acquisition prices skyrocketed from 1997 to 2000. According to our research, the average price nearly doubled during this period to more than $3,800 per subscriber for deals closing in 2000, while the highest price paid per year more than doubled to nearly $5,400.

One side effect of these dramatically higher acquisition prices was to raise cable valuations to the point where several venture-capital groups (including some that had recently cashed out their cable holdings) saw an opportunity to build entirely new networks over the top of the existing networks. They prepared business plans that bundled telephone, cable TV, and data communications using a combination of new network designs that were being considered by both the telephone and cable industries. A few of them, as discussed in previous "Broadband" columns, are even considering deploying fiber-to-the-home networks.

RCN, Western Integrated Network, Wide Open West, Digital Access, Everest, and Carolina Broadband, to name a few, were able to collectively raise well over $1 billion in startup capital with the promise of much more as they became successful. These and other companies have also applied for and received franchise rights to build new networks in many local markets.

Last year, thanks to a sharp contraction in the stock market and signs of economic downturn, the pool of capital on which these new "Third Network" companies depend began to tighten dramatically. That has caused many of these firms to reevaluate their deployment plans, with RCN, the most established of the group, announcing plans at the end of 2000 to focus on its existing markets and hold off on new market development until there is a reopening of the capital markets.

Third Network companies with investors from the power utility industries appear to have the most solid overall financial footing as well as strong strategic partners. This new branch of the converging industries includes several very innovative and resourceful individuals that should not be counted out of the fray. For now, we expect other Third Network companies to follow RCN's example of focusing on successful growth in a more select group of markets with the goal of convincing sources of capital-especially debt-that this new industry sector truly is a good investment. We believe further that the deployment of cost-effective fiber-rich networks designed specifically for the new age of digital convergence will enhance their chances of success.

After attending two major cable industry events, the Western Show held in late 2000 and January's Emerging Technology Conference sponsored by the Society of Telecommunications Engineers, we feel another change is in the wind.

Part of the problem with convergence is that there are almost too many choices, several of which represent revenue streams that have a lot of promise but little or no track record. There are also unique skill sets that apply in each core business that often do not transfer readily to another branch of the communications industry.

The cable industry, with few exceptions, appears to have at least temporarily backed off from aggressively deploying telephony services and is instead focusing more heavily on deployment of VoD services. VoD comes much closer to resembling the broadband Internet data services that have achieved success as an incremental line of business.

Another factor is that the cost of the computer servers necessary to deploy VoD has become reasonable enough to make it a viable business. Operators also see VoD as a natural next step that (1) leverages their successful rollout of digital set-tops, (2) allows them to deliver on-demand services that satellite operators cannot match, and (3) continues to build a platform to support future interactive TV services while technical and business elements of interactive TV evolve over the next few years.

You might ask why pontificate on these changes in direction and players in a magazine dedicated to fiber optics. Almost since its inception, fiber has been the instigator of all of these changes, and in turn the drive to convergence has vastly multiplied the demand for fiber-optic cable, electronics, connectors, and passive components. The new class of over-builders (assuming they will survive the current downturn) alone will build thousands of miles of new fiber-optic network. As for VoD, an example would be a town of 250,000 homes with 150,000 customers. If you designed the network for a peak demand of 25% of households watching a video, that comes to 37,500 simultaneous video streams. Using 3.2 Mbits/sec per stream, the network would need to have a throughput of 120 Gbits/sec during peak periods.

Mitch Shapiro has been tracking and analyzing the broadband industry for more than 12 years. He currently directs the strategic research program of Broadband Markets, which develops and markets proprietary databases, financial modeling tools, and strategic reports focused on the competitive broadband industry. He can be reached at [email protected].