February 22, 2014

An earlier blog post had focused on Charter’s attempt to purchase Time Warner Cable with a relatively underpowered bid and a reliance on value creation through both synergies as well as deploying a tax shield.

Time Warner Cable had been, to put it mildly, dismissive of this bid. Matters have now been resolved with industry leader Comcast intervening to pay roughly $67 billion in an agreed bid (8x 2014 EBITDA and probably more like 7x EBITDA assuming all synergies can be captured). The battle over Time Warner Cable was interesting from the point of view of M&A tactics. (Charter had met with most major Time Warner Cable shareholders and had nominated a slate of directors; it would therefore have been interesting to see how a low-premium deal would ultimately play out.)

More interesting is what this implies for the M&A strategy of cable companies in North America. Whilst Comcast is currently engaged in a charm offensive to secure approval of the deal (for example it plans to sell up to 3 million subscribers in areas with overlap, leaving it with a base of roughly 30 million households) the assumption is that the deal will most likely proceed. Securing this deal will allow Comcast to acquire greater scale and, in so doing, influence the competitive landscape around “cord cutting” and content costs.

What could be some of the underlying thinking at Comcast?

• Firstly, scale can allow for pricing of bundles to make it unattractive for “cord cutters” to actually snip the line (we discuss this in more detail below. Underpinning this is the ability to secure an advantage over rivals in terms operating expenses and pricing buffers (Comcast is targeting over $1.5 billion in OpEx cuts once the merger is fully complete) and capital expenditures (the target here is network equipment savings of $400 million).

• Secondly, Comcast seems to believe that larger service providers owning larger broadband networks can negotiate better pricing for programming. Some observers see a substantial portion of the $1.5 billion in operating synergies as coming from better pricing for popular content. This is interesting in the context of the recent, abortive conversations between the Discovery Channel and Scripps Interactive: Discovery had looked at buying Scripps but ultimately passed on the opportunity because it concluded that it already had the heft to negotiate content costs with cable providers. Dicsovery may have made that judgment over-hastily. We also discuss this below.

Cord Cutting: A Real Possibility?

The U.S. is, paradoxically, actually one of the world’s more expensive markets for cable and broadband. In Canada the average cable bill is somewhere above $70 (based on data from Centris and the CRTC) whilst in America the mean for cable bills is approximately $90 (according to NPD Group). Triple play pricing (television, landline telephony and broadband internet access) in the US seems to settle at about $110-120. These averages conceal the fact that a great deal of what is provided in the average cable television plan is viewed as rubbish by many consumers; commonly desired add-ons such as HBO or sports channels can add substantially to the bills. In the US, HBO alone is typically billed out at between $10-$20 per month.

This stands in sharp distinction to the $7.99, all-you-can-watch model of Netflix. This web-based service itself is beginning to establish a reputation for its own content: the American remake of “House of Cards” stands as an excellent, and seemingly wildly popular example. Netflix and iTunes have – when coupled with over-the-air local television and access to Hulu – encouraged 1% of American cable subscribers to end their cable television subscriptions in favour of an internet-access only model: this is termed “cutting the cord” by a number of its partisans. Other subscribers – operating under much the same principle – have significantly curtailed what they buy from their cable provider.

Comcast/Time Warner Cable can therefore be understood in the context of how a major cable provider can move – via M&A – to protect cash flows from the impact of the “cord cutters”. The rationale appears to be both leverage on the cost side (the aforementioned $1.5 billion of savings in operating expenses) as well as enhanced pricing power through control of the best and easiest broadband pipe into the home.

Implicit therefore in the Comcast/Time Warnber Cable deal is the assumption that, even if millions more Americans “cut the cord”, cable companies can compensate by charging more for internet access. More streaming video consumes more bandwidth; more bandwidth and more speed therefore represent revenue opportunities.

This equation was reinforced by recent Federal Communications rulings on open access/network neutrality. These rulings moved to interdict differential pricing for certain types of internet traffic– in effect stating that Netflix cannot be penalised on a cable network. Netflix is potentially cable’s Enemy Number One. As such, the F.C.C. actions leaves raising overall pricing as the default alternative. (That said, Netflix may well decide to strike preferential deals with cable operators – becoming, in effect, much like a television network paying for access.)

Pricing tactics are seemingly taking two forms. The first is rendering the marginal cost of cord cutting relatively unappealing. An example is to be found in Comcast’s current pricing, where the differential between high-speed internet access ($40 per month for up to 25 Mbps) and basic cable plus internet ($50 per month for a basic package of cable channels as well as HBO and HBO on mobile devices) is tight enough to make many consumers think twice about the joys of a life of Netflix and iTunes only.

The second has to do with price increases. Thinking in the cable industry appears that the window between now and 2018 may be the period of greatest vulnerability because the aforementioned network neutrality rules (imposed on Comcast when it bought NBC Universal) expire in that year. Excessive price increases in the interim may therefore be ill-advised, particularly given regulatory scrutiny and the fact that cable companies and telcos have already sought to monetise their broadband investments with some rather striking changes to consumer bills. A recent study of internet pricing by SNL Kagan, a research consultancy, found that in some urban markets both cable and telephone companies raised pricing for internet access 30%-50% over the last four years.

A more short-term fix could come in the form of using scale and market presence to drive through consumption caps (consume your allotted bandwidth, find you have sign up to a more expensive plan). Comcast has a 250 gigabyte monthly download limit for many of its internet plans whilst Time Warner, interestingly, largely offered uncapped plans. Though a consumer would have to be a prodigious watcher of Netflix to consume this amount, it would not be a complete surprise to see the cap imposed at Time Warner, and then see the limits on consumption evolve (downwards) in years to come.

The Impact Of Scale On Content Costs and Media Consolidation

Comcast’s wooing of the board of Time Warner Cable also casts the debate around content costs into sharper relief.

Time Warner Cable and CBS had a very public spat (written about in a past newsletter) about content pricing. CBS was in fact denied a broadcast signal at certain Time Warner Cable systems : this being a very public attempt to deploy customers as leverage in a negotiation over the CBS’ proposed rate increase. CBS won that round when customers demanded access to shows they expected to find in their basic cable service. (Denying Americans N.F.L. football and “60 Minutes” is evidently a dicey proposition.)

Comcast, by contrast, bought a major content provider (NBC Universal). This allows Comcast to both sit on the other side of the fence (hedging its bets) as well as gaining a clear insight into the thinking and economics of content providers.

Cheverny expects that Comcast/Time Warner Cable will spark a drive for scale amongst smaller cable operators eyeing the scale of Comcast (30 million subscribers) and influence the thinking even of giant telcos (such as Verizon, which has well over 5 million Fios television subscribers).

On the content provider side The Walt Disney Corporation, for example, could decide that it needs yet more heft. Perhaps Discovery may decide that it is a seller rather than a buyer. Similarly niche players such as AMC may find that the last season of “Mad Men” creates less negotiating leverage with cable systems, and that in turn sparks a desire to be part of a larger group able to go head to head with cable giants. A larger player such as Viacom (which owns everything from Paramount Studios to MTV) may reach similar conclusions.

Likewise smaller broadcasters such as local television stations – in effect firms that produce local content – may be the first impelled to move as they are in a vastly weaker position than, say, CBS. A list of companies in this camp would include Lin Media, Nexstar Broadcasting and Sinclair Broadcast.