Price Pressure Could Reduce ISPs to Tiers

For cable TV operators, offering Internet connections has been a gold mine this year. But in 2003, they might have to settle for silver.

If cable companies want to continue the impressive growth of their high-speed data service, they soon will have to start offering their customers lower-priced packages, or tiers, say some analysts. That possibility, currently obscured by cable executives' insistence they'll be raising prices for Internet service, could translate into slower returns on the industry's billion-dollar technology upgrades -- and lower stock prices, as well.

"There will definitely have to be tiered pricing very soon -- easily within the next year," says Bruce Leichtman, president of the Leichtman Research Group broadband consulting firm. That means, according to Leichtman and others, that cable operators will have to supplement their $45-a-month list-price service offer cut-rate broadband service with, say, a $30-per-month alternative by the end of 2003.

That's great news for thrifty consumers, but bad news for cable TV shareholders. Amid slowing growth of digital video service and competition from satellite, high-speed Internet service, or broadband, has been a particularly strong performer for cable TV operators this year.

But the prospect of lower broadband subscriber growth and declining revenue per user recently led one cable analyst to cut his industrywide financial forecasts for broadband. The lower growth rate could "meaningfully" cut equity values of major cable operators, says the analyst, by as much as 14%.

Broad and Pattison

Narrowing Broadband Demand Old and new forecasts for cable industry net broadband additions (in millions)*

* Totals Include Major Cable Operators Cablevision, Charter, Comcast, Cox, Insight, Mediacom; exclude AOL Time Warner and Adelphia. Source: J.P. Morgan

Certainly, as the cable industry continues on its perennial quest to achieve free cash flow from operations -- that is, cash flow from operations once interest expense and capital expenditures have been subtracted out -- broadband revenue is a top-billed vehicle for the journey.

Although Charter Communications CHTR has introduced low-tier plans, such a pricing strategy isn't on the agenda of most large cable operators, judging from comments executives made during third-quarter conference calls. Indicating confidence in their pricing power, for example, both Cox Communications COX and Cablevision Systems CVC announced plans for broad-based broadband price increases. Comcast CMCSA executives speculated advanced services they could offer in more expensive broadband packages. Furthermore, Cablevision and Mediacom Communications MCCC turned away analysts' questions about plans for low-priced tiers with similar responses that, if anything, they were considering offering higher-priced tiers featuring higher data speeds.

Taking a Licking

The Need for Speed Percentage of AOL subscribers who'll pay for broadband at proposed prices

Source: J.P. Morgan

But a demand for high-priced service doesn't eliminate the need for a lower-priced one, just the way that increased sales of Patek Philippe watches won't put Timex out of business. And some recent consumer research indicates that cable investors will have to pay more attention to the low end than cable operators might want to admit.

Based on his survey this fall of consumers in areas served by cable TV systems, Leichtman says that operators are running out of people willing to pay $45 a month for a broadband connection. For example, he says, the percentage of dial-up Internet subscribers who say they are interested in broadband is lower than it was a year ago -- about 30%, down from 40%. That, says Leichtman, indicates that many people who might be interested in broadband already have it.

Of those people who are interested in broadband but haven't yet subscribed, about one-quarter would pay $45 a month for the service, while another quarter would jump in at $30. In other words, dropping the price from $45 to $30 a month would double the number of buyers.

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J.P. Morgan comes to a similar conclusion about the need for low-priced tiers, based on separate research the company conducted in November among households subscribing to AOL Time Warner's AOL America Online service -- a population that accounts for roughly half of online users in the U.S.

Although consumers appear more willing to pay for broadband than when J.P. Morgan did a similar study in 2001, a large segment of the population still refuses to subscribe at current prices. Some 22% say they won't pay up until pricing falls below $40 per month; 45% are waiting for the price to fall below $30. "Broadband pricing (excluding promotions) must decline to $30 by fourth quarter 2003 or the industry will face significantly slowing net adds shortly thereafter," reads the J.P. Morgan report.

To Charter's credit, J.P. Morgan says the company's current tiers of $50, $40 and $30 per month, at different connection speeds, is "probably optimal" for capturing as many subscribers as possible, while minimizing the risk that lower-priced tiers eat into demand for higher-priced options. But in a related note, J.P. Morgan cable analyst Jason Bazinet says that because of the lower outlook for broadband revenue growth, the highly leveraged Charter could suffer a 14% loss in equity value, more than any other cable operator.