The new economics of overbuilds
By Mitch Shapiro and Don Gall
As described in last month's Lightwave Special Report (see "Fiber-deep broadband 'overbuilders' challenge incumbents," June 2000, page 53), the term "overbuilder" has long been used to describe a company that builds a second network to compete with an incumbent cable operator. Historically, these overbuilds have been fairly rare and even more rarely successful. Today, however, a new generation of "broadband" overbuilders is emerging to challenge this longstanding pattern, a development with major implications for incumbent network operators, vendors, content and service providers, and customers. A key question in evaluating the competitive threat posed by these new players is how the latent capacity of their advanced networks will be used to provide a compelling reason for high-revenue customers to switch from incumbent service providers to these new kids on the block. As we shall see, the economics of today's broadband marketplace may help these upstarts win market share.
In the past, companies trying to compete with an incumbent cable-TV operator faced a simple but harsh economic reality: A community in which 50-70% of residents purchased multichannel video service for $30-$35 per month could simply not support two competing facilities-based operators on a long-term basis. To make matters worse, these newcomers, who in most cases could not offer customers anything truly unique, often focused on price competition, thus adding to the financial strains on both competitors. Aside from municipal overbuilds, which often enjoyed some level of subsidy from a local government or municipal utility, very few overbuilds have survived as financially viable long-term players.
Even deep-pocketed local-exchange carriers (LECs) have gradually backed away from a once-extensive overbuild agenda. SBC Communications has been a key player in this pullback, deciding to shut down or sell the overbuild operations of all three major LECs it has acquired. It first pulled the plug on the hybrid fiber/coax (HFC) networks being built by PacBell and SNET, both of which were intended to deliver a mix of voice, video, and data and become the next-generation network platform for these two LECs. More recently, SBC began seeking buyers for Ameritech's extensive HFC networks, which were more traditional overbuilds in that they were not designed to carry the LEC's voice service.
Given this history, one might assume that building a competitive broadband network today is still a very questionable investment. But such thinking ignores the changing reality of today's markets and technologies.
For one thing, the revenue potential is far more promising for today's competitive network operators. In contrast to the $30-$40-per-subscriber monthly revenue typical of traditional video-only overbuilders, these new players are offering service bundles that promise to generate $100+ monthly revenue streams per customer.
The experience of RCN, a pioneer in delivering bundled services over a competitive broadband network provides an early indication of this revenue potential. Since RCN began rolling out flat-rate "ResiLink" bundled service packages in 1999, it has experienced significant boosts in service penetration and per-customer revenue. For example, six months after ResiLink was introduced in its first test market-Waltham, MA-penetration rates had reached 35% for local voice, 28% for cable TV, and 11.5% for Internet service. After expanding the service to 90,000 homes during first quarter 2000, the average ResiLink customer was subscribing to more than three of RCN's services (video, Internet access, and local and long-distance telephony), and generating average monthly revenues of $125-$130 compared to $80 per month when offered on an a-la-carte basis.
Another factor in the competitive broadband economic equation is the increased financial vulnerability of cable operators, many of which have paid as much as $4,000-$5,000 per subscriber for recent large acquisitions. Only a few years ago, similar systems might have sold for little more than half of today's price.
If we assume an average penetration of 65%, these per-subscriber acquisition prices translate into costs of $2,600-$3,250 per home passed. Depending on the status of the acquired network and its service offerings, the new owner might also incur costs of several hundred dollars more per home for an HFC upgrade, plus service-specific costs to deploy digital video, high-speed data, and voice services. These costs compare with the roughly $500-$600 per home targeted by today's overbuilders for construction of state-of-the-art broadband networks (not including customer-premises equipment such as digital set-tops and cable modems).
This simple math suggests that, in some cases, a new network operator will invest only 15%-25% of what the incumbent competitor has spent to acquire and upgrade its own network. And while the incumbent enters the competitive fray with video subscribers in hand and, in many cases, a first-mover advantage in the high-speed data market, that is no guarantee of long-term dominance in the rapidly evolving broadband marketplace.
The history of Western Integrated Networks (WIN), an overbuilder targeting cities such as Sacramento and San Diego, CA, and Austin, San Antonio, Dallas, and Houston, TX, suggests that at least one cable veteran prefers the new overbuild economics to a growth path involving acquisitions of existing cable systems. WIN was founded in the fall of 1999 by Jim Vaughn, who last fall sold his former cable company, Frontier-
Vision, to Adelphia Communications for roughly $2.1 billion. This selling price equates to nearly $3,000 for each of the company's roughly 700,000 subscribers, $2,085 for each of the million homes its networks passed and roughly 14 times Frontiervision's 1998 cash flow.
At the end of 1998, a few months before the sale to Adelphia was announced, Frontiervision systems averaged 70% penetration, with an average capacity of 59 channels, average premium penetration of 41%, and average monthly revenue per subscriber of $33.84. At that time, a third of Frontiervision subscribers were in systems with less than 54 channels of capacity, the average number of subscribers served per headend was approximately 2,720, and the company had just over 5,000 digital subscribers (less than 1% of total subs) and only 139 high-speed data customers.
In short, Frontiervision's systems consisted largely of "classic" cable systems-small in size with relatively high basic-service penetration but low premium penetration, limited channel capacity, and modest per-subscriber revenues-that had barely begun positioning themselves to offer a full bundle of two-way broadband services.
If we include the expected cost to upgrade the Frontiervision systems, Adelphia will probably have paid $2,220-$2,300 or more per home and will likely need at least 2-3 years to complete this upgrade. The question then centers on how vulnerable these systems would be to a state-of-the-art overbuild that cost $500-$600 per home and targeted Frontiervision's (now Adelphia's) high-revenue subscribers with an attractively priced bundle of voice, video, data, and new digital services. Or put another way, if these systems did face such an overbuild, how many bundled-service customers would each operator claim five to 10 years down the road, how much would each of these customers be paying for these services, and what kind of return would each operator be getting on its investment?
Though cable is arguably still the leader in bringing broadband to the masses, the recent rash of high-priced acquisitions appears to be premised on business models that don't account for the presence of strong "third-network" competitors on top of the competition already present from DSL, satellite, and in some cases, wireless broadband.
The danger to cable-and to local-exchange carriers-is that today's broadband overbuilders will deploy state-of-the-art networks that can deliver far greater capacity, functionality, reliability, and value than incumbent's legacy-laden networks and business models can support.
Our discussions with third-network operators suggest that this "digital-leapfrog" strategy is a major driver of their business models. To the extent it is successful, we could see these new broadband operators capture a disproportionately large share of new market growth and, over time, also capture increasing shares of incumbents' core business. Incumbent cable operators most vulnerable to competitive harm from these new networks would be those that paid inflated acquisition prices, have poor technical, marketing, and customer-service track records, and have a difficult time integrating new acquisitions and managing network upgrades and new service launches.
Today, the service mix offered by RCN and other third-network operators consists of analog and digital video, high-speed data, and local and long-distance voice. Over time, these new operators (like incumbents) hope to augment this base with revenue from new digital services like video on demand, e-commerce, full-screen interactive, and targeted advertising, energy management, security, videoconferencing, distance-learning, and telemedicine. In addition, today's third-network operators are aiming for a strong market share in the small-to-medium-sized business market, which today is not especially well served by either cable operators or LECs.
In such a future, incumbents burdened with legacy networks and services may find it increasingly hard to compete with newcomers whose networks and business models are designed from the ground up to provide the most value at the least cost in an increasingly bandwidth-hungry, on-demand, digital marketplace.
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 firstname.lastname@example.org.
Don Gall has been involved with the cable-TV industry for the last 28 years. He was an integral part of the team at Time Warner that developed the first practical applications of analog fiber and hfc networks. He is currently a consultant with Pangrac & Associates (Port Aransas, TX) and can be reached at email@example.com.