Economics and Technology, Inc. -- Views and News, November 2010

November 2010

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De-linking video content from video delivery: Are longstanding business models now at risk?

From their birth as "community antenna television" (CATV) systems that were created to capture the weak over-the-air broadcast TV signals in fringe areas and distribute them to subscribers via coaxial cable, to modern broadband digital hybrid fiber/coax systems owned by national multisystem operators (MSOs) such as Comcast, Cox, TimeWarner and Cablevision, all have one thing in common: The cable operator is in total control of the video content that is delivered over its facilities. The early CATV systems had a passive relationship with the content they carried – they picked up the broadcast TV signals using large antenna arrays, amplified those signals and re-transmitted them over their cable networks. The earliest systems had extremely limited capacity – sometimes as few as 12 video channels – and produced little or no content of their own. But even though current state-of-the-art digital systems have the capacity to support hundreds of individual channels, the cable operator maintains absolute control over their assignment to specific content providers – broadcast TV stations, "free" and "premium" cable channels, and on-demand and pay-per-view content.

Those early CATV systems were typically locally owned and not affiliated with any regional or national parent company. But by the mid-1990s, large-scale consolidations had become the norm, and when the dust had finally settled some 83.9% of all US video subscribers were being served by one of ten large MSOs. Significantly, that massive restructuring of the US cable TV industry fundamentally changed the relationship between those that produced video content and those that distributed it.

The post-consolidation MSOs had each achieved a scale of operations sufficient to exert market power vis-a-vis nonaffiliated content providers – something that no small, independent cable system could have ever hoped to do – and could, among other things, refuse to carry any content whose providers failed to agree to the MSO’s terms. Vertical integration of content and distribution got underway, culminating in Comcast’s planned acquisition of NBCU, now awaiting government approval. Of course, some content providers themselves possess considerable market power and are often in a position to dictate terms to the cable distributor. This sometimes leads to big-time confrontations, as in the recent Mexican standoff between the Fox TV network and several MSOs regarding the payment of fees being demanded by Fox for the MSOs’ right to carry Fox network programming. The standoff arises because each party actually realizes significant economic benefits from any agreement – the content provider expands the size of its audience, enabling it to command higher advertising fees from commercial sponsors, and the cable operator is able to offer the additional content to its own subscribers, making its service that much more attractive to existing and potential customers, perhaps even to the point where it is able to increase subscription fees. Both parties enter the negotiation with considerable strengths, resulting in what amounts to a game of “chicken” that will not produce a deal until one of the parties gives in.

The cable operators’ business model is, of course, heavily dependent upon revenues generated by subscriptions to “premium” channels and pay-per-view offerings. And for most of the history of cable, subscribers had limited alternative source of such content – particularly where it was occurring in real time, as with sports, news events, or other shared cultural experiences. Pay-per-view movies compete with DVD purchases and rentals, and premium channels compete with “free” services and, of course, with over-the-air broadcast TV. But if a subscriber wanted the convenience of having the desired content piped into her livingroom, the selected cable service provider was often the only source. The entry of local telephone companies into the video distribution business did little to change that dynamic. Once having chosen between, for example, Comcast or Verizon FiOS, the selected service took on the role of being the only broadband connection to the home, because content and distribution seemed to be inexorably linked.

Enter the Internet

Unlike cable- or ILEC-provided video services, and even though these same companies furnish broadband Internet access over the same physical facility (coax or fiber), they do not control Internet content, effectively de-linking content from delivery. That is nothing new – users have been free to access any website, any content, from anywhere on the Internet and, in fact, current FCC “net neutrality” principles are intended to assure that consumers are entitled to “access the lawful Internet content of their choice[;] ... run applications and use services of their choice, subject to the needs of law enforcement[;] ...[and] connect their choice of legal devices that do not harm the network.” Yet while Internet users have been downloading videos from YouTube and other sources for some time, the nature of content available over the Internet did not place it in head-to-head competition with cable or telco video services. Moreover, for many Internet users, their home computer was typically located in a den or bedroom, not in the livingroom where the TV set lived. So even where entire motion pictures could be streamed or downloaded for viewing on the PC or Mac, for most households this point of delivery was less than ideal. But all of this may change – and possibly quite quickly.

Several new consumer devices have recently come on the market that bring Internet-based video content directly into the livingroom, right onto the high-definition TV screen, without the use of the home computer. AppleTV sells for $99. It receives video streams over the Internet via ethernet or WiFi, and converts them to standard 1080p HDTV signals. The unit is connected to any HDMI-equipped HDTV receiver via an industry standard HDMI cable. Roku offers several versions of its streaming video player, ranging in price from $59.95 to $99.95. The Roku products support composite video and audio (for use with conventional TV receivers) as well as HDMI-based HDTVs. Both are menu-driven, permitting the user to choose from a selection of movies, TV shows and other video content offered by the device. Neither enables the customer to surf the web for any content; both limit the customer to selected video content providers with whom Apple or Roku, as the case may be, has contracted. Both, however, offer Netflix subscribers the ability to stream any films in the Netflix library that are available for streaming. Netflix subscribers pay as little as $7.99 per month for this capability.

Netflix began offering streaming video of certain movies back in 2007, but these generally had to be viewed on the subscriber’s PC monitor. In 2008, Netflix began offering streaming video service over non-PC devices such as video game consoles and set-top boxes. Netflix recently announced that Internet streaming now accounts for more movie viewings than via DVD mailings. The company has adopted a video distribution network architecture that is the electronic analog of its DVD distribution strategy. For DVDs, Netflix maintains multiple local distribution facilities across the country. By bringing the point of mailing and returning close to its customers, postal service delays are minimized, and most often DVDs are received (either by the customer or by Netflix when returned) the day after they are mailed. Similarly, Netflix maintains (caches) online copies of streamable content at thousands of individual servers operated by Akamai or other providers that are located in close geographic proximity to the end user. The initial distribution of the material to be stored at these sites is accomplished over the Internet, but once done, delivery to end users involves little more transport than the “last mile” link from the subscriber’s ISP to his home. Netflix currently has more than 16-million subscribers, and anticipates that growing to 19-million by the end of this year.

Charging customers for their use of alternative video services

While the cable or telco Internet access provider cannot (currently) limit a customer’s ability to obtain video content from these alternative sources, other proactive responses are certainly possible. The broadband access provider, for example, certainly has the ability to revise its pricing model from “unlimited” to one based upon a customer’s use of the Internet access service. Indeed, this may occur sooner rather than later. Instead of offering “all you can eat” flat-rate pricing, ISPs are beginning to impose limits on the aggregate bandwidth that a customer may use in a monthly billing cycle, with additional or “overage” charges applying for usage in excess of that cap. Several US cable MSOs have begun trials of usage-based pricing, and the practice has been adopted by all US wireless carriers with respect to their data services. In Canada this model is already in widespread use for landline broadband services.

Rogers Communications, Canada’s second biggest Internet provider, recently lowered the usage limits it had previously set on some of its plans. Perhaps not coincidentally, this announcement came just days after Netflix announced it was expanding its video streaming service into Canada; Rogers’ preemptive response may have been well-founded. In the first week following the September 22 launch of Netflix’s Canadian service, some 10% of all Canadian broadband customers had visited its site. Typical movie downloads range between 2 Gb and 5 Gb, depending upon length, standard or high definition, and type of coding being used. Rogers’ current pricing structure offers a range of bandwidth (and speed) choices:

Service	Download speed	Usage cap	Monthly rate	Overage charge
Ultra-Lite	500 kbps	2 Gb	C$ 27.99	C$5.00/Gb
Lite	3 mbps	15 Gb	C$ 35.99	C$4.00/Gb
Express	10 mbps	60 Gb	C$ 46.99	C$2.00/Gb
Extreme	15 mbps	80 Gb	C$ 59.99	C$1.50/Gb
Extreme Plus	25 mbps	125 Gb	C$ 69.99	C$1.25/Gb
Ultimate	50 mbps	175 Gb	C$ 99.99	C$0.50/Gb

Netflix’s impact on the Internet

A recently-issued report by Sandvine Incorporated of Waterloo, Ontario estimates that real-time entertainment services now account for some 42.7% (up from 29.5% in 2009) of peak-hour Internet traffic in North America (US and Canada), nearly half of which (20.6%) is associated with Netflix downloads.

While this surge in real-time entertainment traffic may affect the capacity requirements and costs attendant to the provision of broadband Internet access, a potentially much greater concern, from the standpoint of the broadband providers, is the potential loss of premium video content revenue to downstream content resellers like Netflix and Hulu as well as to content owners themselves, such as film studios and sports leagues. For example, Comcast’s entry rate for “basic cable” in the Boston area is $14.20 per month, for a channel lineup consisting mainly of local broadcast TV stations. At the high end is Comcast’s Digital Premier package priced at $119.30, providing “200+ digital cable channels. over 17,000 movies and shows – most free, On Demand, and 45 commercial-free music channels, from Top 40 to classical to hip-hop,” all in addition to the same local news, sports, kids’ programs and weather that are available with the $14.30 package. Put differently, $105 out of the total $119.30 Digital Premium revenues are, potentially, at risk to Comcast, as more, and perhaps ultimately all, of this premium content becomes available online.

Verizon’s FiOS business model could well be at even greater risk from Internet-borne content. The company, which earlier this year advised its shareholders of its intent to discontinue further deployment of FiOS after 2010, will have by then invested some $23-billion and will pass 18-million homes. However, Verizon’s “take rate” is running at around 3.5-million – less than 20% of homes passed – suggesting a capital investment per connected FiOS customer of more than $7,000. And that capex estimate likely does not include costs of customer acquisition, operating expenses, or costs involved in the procurement of content. This would suggest a bare minimum break-even revenue “nut” of close to $200 per subscriber per month – a level that would be problematic even without Internet-based content competition, and that seems quite unrealistic given the growing content choices and sources.

These financial realities facing cable and telco broadband providers go a long way toward explaining the intensity of their resistance to any meaningful net neutrality regulations whose effect would be to undermine their ability to exploit their captive relationship with video and Internet access subscribers so as to force them to purchase content through only those channels allowed by the broadband provider. But in addition to explaining the facilities-based broadband ISPs’ conduct, this reality also confirms that what the ILECs and cablecos are seeking from the federal government is protection from competition, a result that is only possible if the government is prepared to shut down much of the competitive Internet content market. Despite the political clout of the telcos and cablecos, one would hope that something like this is highly unlikely.

If you would like more information on this subject, please contact Dr. Lee L. Selwyn.

Read the rest of Views and News, November 2010.

About ETI. Founded in 1972, Economics and Technology, Inc. is a leading research and consulting firm specializing in telecommunications regulation and policy, litigation support, taxation, service procurement, and negotiation. ETI serves a wide range of telecom industry stakeholders in the US and abroad, including telecommunications carriers, attorneys and their clients, consumer advocates, state and local governments, regulatory agencies, and large corporate, institutional and government purchasers of telecom services.