The Price for Time Warner Cable Could be Over the Top

In September, Sony Corp. (SNE) and Viacom Inc. (VIA) formally announced a long-expected programming agreement to carry live and on-demand programming for at least 22 cable networks, including Nickelodeon, MTV and Comedy Central, on Sony's over-the-top TV service in the U.S. The deal puts some meat on Viacom's purported plan to begin testing a pay-television service delivered via PlayStation consoles, Bravia smart TVs and other Sony devices by the end of the year.

Viacom's plans would be a dramatic expansion of so-called over-the-top television, the new pay-TV services that are threatening the business model of the dominant incumbent cable operators like Comcast Corp. (CMCSA) , which deliver television programming and Internet services over their broadband fiber network, and of the satellite TV providers Dish Network Corp. (DISH) and DirecTV Group Inc. (DTV) . Unlike the traditional TV services and video services offered by major telephone companies, Verizon Communications Inc. (VZ) and AT&T Inc. (T) , the OTT providers would not own their own telecom networks but would deliver programming over the very Internet lines controlled by Comcast and the other incumbent providers. The most popular OTT at the moment, is, of course, Netflix Inc. (NFLX) , which TV viewers subscribe to as either an add-on to their traditional pay-TV service or as a stripped-down programming service delivering video-on-demand and original programming to the budget-minded.

Sony's plan is more ambitious than the Netflix model. Sony ultimately plans to become a full-blown competitor to cable and satellite TV, all delivered over the pipes of the incumbent cable operators and telcos. Sony isn't the only player seeking to get in the OTT game in a big way. Others include British Sky Broadcasting plc, Inc. (AMZN) , Apple Inc. (AAPL) , Microsoft Corp. (MSFT) and Google Inc. (GOOG) . Time Warner Inc. (TWX) joined the list Oct. 15 when it announced plans to launch an online version of its HBO network. Even Dish is planning to provide an OTT service and has announced a programming deal with Walt Disney Co. (DIS) .

Providing a physical conduit for these new competitors may be the pound of flesh Comcast would have to sacrifice to win Washington's approval for the company's proposed $45 billion acquisition of fellow cable TV and broadband provider Time Warner Cable Inc. (TWC) . The merger of the country's two largest cable operators was announced in February and is being reviewed by the Department of Justice and the Federal Communications Commission.

Washington regulators, the FCC in particular, want to "protect anything that puts pressure on cable TV," said Paul Gallant, a telecom and media analyst with Guggenheim Securities LLC. "They want to ensure that there is fast, standalone broadband to enable over-the-top services."

The federal government's review of the Time Warner deal is shaping up to be one of the most contentious merger reviews before regulators today. Consumer and public advocacy groups are calling on the FCC and the DOJ to block the acquisition of TWC because it would marry Comcast, the country's largest cable TV and broadband provider with the second-largest player, handing the merged company tremendous horizontal and vertical market power.

Netflix and Dish have opposed the deal and some cable networks, including Discovery Communications Inc. (DISCA) , have expressed deep reservations.

The intensity of the lobbying war between Comcast and the deal's critics was on display at the end of September when Comcast fired back at statements the opponents made about the deal in the petitions demanding that the FCC deny the merger.

The opponents' attacks on the deal provoked Comcast executive vice president David Cohen to argue on a conference call with reporters that they and others were attempting "extortion" by demanding network carriage and other concessions in exchange for supporting the deal. Cohen called Discovery "a poster child" for inappropriate complaints by programmers against the deal.

Similarly, he complained that Netflix was attempting to shift backbone costs from its customers to all cable broadband customers when it attacked the peering payment contract it previously entered to improve the speed of its video transmissions over Comcast's network.

In a filing to the FCC, Comcast also charged its opponents with demanding "favors" such as free backbone interconnection, participation in advertising interconnects, advanced advertising technology that Comcast develops and wholesale service arrangements.

Whether the FCC is inclined to impose the conditions on OTT service will likely depend on how it views the opposing sides' views on whether there is a national market for broadband service and, if so, whether the merger will lead to unacceptable concentration in that market.

Public Knowledge and the Open Technology Institute, two advocacy groups for consumers' digital rights, have argued that the merger would give Comcast a 50% share in the market for high-speed residential broadband distribution and would provide Comcast with gatekeeper power that would allow it to raise costs for online programming, interfere with the open Internet and control the market for streaming video devices. Comcast has repeatedly countered that the deal poses no competitive harms because the companies do not compete in any local or regional cable programming markets and that neither the FCC nor the DOJ have every found there to be a national market for broadband service.

What's more, Comcast said its post-transaction share of wired broadband connections nationwide will be 35.5% — not the 50% its critics state. Ongoing developments will cause even the 35% number to erode to around 15%, Comcast said, as Verizon and phone providers roll out mobile broadband 4G/LTE connections.

The deal's critics, Comcast insisted, are misstating the effects of the merger to push policy agendas that don't have anything to do with the merger.

But Guggenheim analyst Gallant said the regulators may at long last be ready to view cable mergers through a new lens, in large part because of regulators' desire to promote OTT as an alternative to cable TV service. To reliably receive TV programming via the Internet, transmission speeds need to be much higher than the bare minimum of what the FCC considers to be broadband service — 4 Mbps. That's about all telephone-delivered DSL is capable of offering. Cable platforms, however, offer as much as 50 Mbps, a far superior rate for OTT. As a result the FCC may be inclined to accept the argument of Comcast's critics, who say that DSL should no longer be considered a viable competitor to cable broadband. If the FCC goes that route, it will dramatically increase how it views Comcast's share of the broadband market and possibly create a roadblock for approval of the TWC acquisition.

"There is skepticism about the deal getting done," Gallant said. "I do think there is a nontrivial level of risk." Nevertheless, he leans strongly toward predicting the deal will ultimately be approved with a strong set of OTT and Internet network neutrality provisions.

"In the end I think there is a win-win for the FCC and Comcast involving fairly serious conditions around net neutrality and Internet-based TV," he said.

When the transaction was announced Comcast offered to apply network neutrality provisions it agreed to when it won approval to buy NBC Universal in 2010. Those provisions bar Comcast from giving preferential treatment in-house content versus unaffiliated programmers.

Gallant said he could see regulators agreeing to the deal in return for three major conditions. First, they would want to ensure that customers can buy fast, standalone broadband.. Gallant suggested that $40 a month for 25 Mbps might be the level of service Comcast would need to offer. "Otherwise, cable companies could jack up the price of standalone broadband so it would be too expensive for customers to go the OTT route.

Gallant noted that FCC Chairman Tom Wheeler has given a handful of speeches in which he indicated that the traditional definition of broadband may be inadequate and should be redefined as what's necessary to duplicate cable television quality over the Internet. "That's a strong indication of where his policy leanings might be on market definition," Gallant said.

He also predicted there could be two other important conditions: broadband traffic management rules aimed at protecting OTT providers from unreasonable discrimination and a requirement that Comcast sell NBCU programming to OTT providers.

Indeed, the FCC has indicated that it is considering issues that go beyond a traditional merger of cable operators.

In August, the FCC sent Comcast a list of questions about its video and broadband operations, including asking how it uses data caps and other tools for web traffic management, documents pertaining to company decision to block or interfere with online video distributors' transmissions or to prioritize Comcast content over being transmitted over Comcast's broadband network.

John Bergmayer, senior staff attorney at Public Knowledge, said the FCC questions are encouraging. "The probing nature of questions is an indication that the FCC is looking at many aspects of this deal and not just rubber stamping it."

Bergmayer, however, doesn't want to see the merger approved with the kinds of conditions Gallant predicted. He criticized the FCC's enforcement of the conditions imposed on Comcast's acquisition of NBC Universal in 2010, the core of which required Comcast to adhere to net neutrality provisions. Comcast has offered to extend those net neutrality obligations to operations acquired with Time Warner.

Public Knowledge has complained that Comcast has failed to live up to its obligations. "Lots of conditions in the NBC order were violated, which brings into question how effective conditions are at achieving policy goals."

Critics have charged that Comcast has violated the conditions by exempting its own Xfinity on Demand Xbox service from broadband data caps; not making content available to all third parties at the same price as it does for those — such as Netflix — that have signed peering agreements, and failing to honor requirements that similar channels be grouped into "neighborhoods" adjacent to each other on the program guide.

Aside from a minor neighborhooding violation, however, the FCC has not found Comcast out of compliance with any other NBCU conditions.

Comcast spokeswoman Sena Fitzmaurice brushed off the complaints as being in the same vein as the public harms Public Knowledge and other groups opposing media consolidation have been predicting would result from traditional cable mergers for years. "They've been making these same claims for 20 years, yet it's clear the Internet has grown to levels that nobody could have imagined. There's more programming available than ever."

As for whether the critics' claim are getting traction with the regulators, she said it's too early in the process for the commissioners to have developed opinions on where they want to go, much less for anyone to draw conclusions about where they stand. "The record isn't close to complete and the commissioners aren't even near beginning consideration. There are a lot of things they haven't had a chance to look at."

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