What’s so bad about being a dumb pipe?

1Executive Summary

Earlier this month, Time Warner Cable CEO Glenn Britt said in an interview with the Wall Street Journal that his company could soon consider broadband its “anchor product.” That runs counter to most of the rest of the cable industry, which is still focused on providing pay-TV services. But with the number of TV subscribers declining and programmers seeking ever-higher per-subscriber fees to carry their shows, broadband could become a cash cow not only for Time Warner Cable but for other cable providers as well.

No one wants to be a dumb pipe

Internet access is seen as a commodity service with no real differentiation among providers, and offering up just broadband means passing on a lot of value-added services, where the bulk of cable revenues are made. Furthermore, there’s nothing flashy about broadband and no opportunity for leasing extra equipment like HD set-top boxes or DVRs. In metropolitan areas, an HD DVR can run up to $20 a month, and many households have more than one, so this can be a significant revenue source.

Indeed, much of the cable industry seems focused on trying to find new and interesting products that can be added on top of broadband services. Comcast, for instance, has recently added a home surveillance offering to its list of value-added products, and it has announced plans to sell Skype-powered video chat services, which include additional hardware.

Broadband is growing

But even though high-speed Internet services aren’t sexy, they’re growing dramatically. Also, they typically have higher margins than comparable video offerings.

While the number of pay-TV subscribers at cable systems in the U.S. has been gradually declining across the board, the number of broadband subscribers continues to grow. In Time Warner Cable’s case, video subscribers declined from 12.7 million to 12.1 million from the second quarter of 2010 to the second quarter of 2011. In the same period, the number of people paying for broadband increased from 9.3 million to 9.7 million subscribers.

And that growth in broadband subscribers is translating into real revenues. In the case of Time Warner Cable, broadband revenues grew 8.5 percent year over year in the second quarter. Meanwhile, despite increases in the price of cable packages and equipment like HD set-top boxes and DVRs, video revenues were largely flat.

Time Warner Cable isn’t alone in seeing broadband become a more important part of its revenue mix: According to Leichtman Research Group, which tracks the top 14 multichannel video providers, the industry lost about 325,000 million TV subscribers in the second quarter of 2011 but picked up 350,000 broadband subs in the same period. We expect that trend to continue as the price of cable services continues to rise and broadband becomes ever more important to U.S. residents.

Netflix and Hulu and YouTube, oh my!

More and more viewers are now turning to online services for video entertainment. Already we’ve seen huge growth from services like Netflix, which has more subscribers than Comcast these days. And according to comScore, Internet users watch an average of 5.9 hours of YouTube and 3.4 hours of Hulu per month. That’s a far cry from the amount of time those same viewers spend watching traditional TV services, but it’s a number that has been growing significantly.

One big reason ISPs don’t want to resort to selling broadband services is the effect that IP-based video services have on their top line. By focusing on broadband services, they are enabling cheaper video services like Netflix and Hulu Plus to flourish, which means potentially sacrificing revenues that come from traditional video services. Those streaming video services are also becoming big traffic hogs, particularly during peak hours.

According to Sandvine, Netflix now accounts for approximately 29.7 percent of all peak downstream traffic in North America, and it shows no sign of letting up. As services like Netflix become an ever-larger portion of Internet traffic, ISPs also worry that the explosive growth of video-related IP traffic will necessitate upgrades to their broadband networks.

In fact, the increase in data traffic from streaming video has many ISPs considering usage-based pricing for their broadband services, if they haven’t already rolled it out. While Britt recently said on an earnings call that he believes there should always be an option for unlimited data traffic, many other providers are looking to increase revenues by tying the volume of data transferred to how much their customers pay.

There’s no profit-sharing in broadband

All that said, there are good reasons for ISPs to embrace high-speed Internet services. Broadband is where all the growth has been for the major cable companies over the past several years, and it also has better margins than cable video products typically get. That’s due to a mix of factors, the most important of which is the ever-rising cost of content.

While cable providers and other ISPs don’t make any additional revenues off the content that flows over their broadband pipes, they also don’t have to pay for the programming that viewers watch over the Internet. As a result, the profits that they make over and above their investments in infrastructure are all theirs.

Take a look at this graph from Strategy Analytics to see how broadband margins have improved relative to overall cable TV margins:

strategy analytics

The equation looks even better for broadband when you consider margin compression that’s happening on the video side of the business. Cable networks have always operated as dual-revenue businesses, with part of that revenue coming from advertising and the rest coming from per-subscriber fees paid by distributors. Those fees typically increase with every new distribution agreement, as programmers add new channels while demanding more for existing networks.

But it’s not just the traditional cable networks that are looking to cash in on carriage fees for their programming. Broadcasters like ABC, CBS and Fox are also now seeking payment for their programming. As a result, they’ve been successfully negotiating retransmission fees for their broadcast channels. And all of this means that programming fees continue to increase.

A paradigm shift in the way content gets paid for

It doesn’t have to be this way. Rather than have their margins squeezed by content partners, ISPs can focus instead on the high-margin broadband business. Of course, doing so would have wide-ranging implications for the multichannel video industry as a whole, in particular how content is consumed and paid for. Right now digital licensing is a nice incremental addition to monies that content creators get through advertisers and carriage fees from distributors, but it’s in no position to replace the multichannel video market.

We expect that Time Warner Cable won’t be the only operator to move beyond pay-TV services and focus on broadband as its “anchor business.” The question then becomes how content creators adapt to the shifting market trends and changing market focus of their most important distribution partners.

Relevant analyst in broadband
You must be logged in to post a comment.
11 Comments Subscribers to comment
  1. I think cable’s big fear in OTT content (you know, besides the entire infrastructure they’ve built out for current delivery that is useless in this scenario) is the loss of control of the subscriber. They currently own the pipes, the players, everything that delivers content to their subscribers, so they know pretty much everything about them. In a world here they rely on CDNs to deliver content and third party metrics companies to feed data back, I feel like they think they are sharing too much of “their” customer with others – whether its a cost thing or an actually sharing of subscriber info.
    That said, I do like TWCs approach here – they seem to have a very strategic smart approach to data driven video delivery that they plan to roll out (I saw their CTO speak at Cablelabs in early august and this was focus of pretty much the whole show).

  2. They’d maintain more of that control if they would deploy equipment in their IP networks to participate in the intelligent, efficient delivery of OTT video. Transparent caches, for example.

  3. The dumb pipe is a very viable business model. The question is for how long. If Netflix is doing 30% traffic, and has a successful business model, which co-exists with Cable cos, who as the article suggests, make higher margins, then all is well.

    The only problem is then that someone will come along and try to get a share of this happy ecosystem, join hands (vertical or horizontal integration), and disrupt the dumb pipe and OTT apps independence.

    I am sure there are many Netflix competitors, and one willing to part with a share of thier piece of revenues with the cable cos for preferred traffic, no longer leaving the pipe dumb. The question is whether this will happen in 1-2 years or 5-10 years.

Explore Related Topics

Learn about our services or Contact us: Email / 800-906-8098