Though cable television operators are struggling to improve the economics of digital video, cheaper cable boxes will turn the battle into a cakewalk.

That's the conclusion of one sell-side analyst, who earlier this week attempted to quantify the benefits of a new generation of cable boxes from cable industry suppliers

Scientific-Atlanta

(SFA)

and

Motorola

(MOT)

.

As reported by

TheStreet.com

earlier this month, cable operators will soon take delivery of new set-top boxes from Motorola and Scientific-Atlanta that are roughly $100 cheaper than high-end boxes they now use.

Though they won't have the clock displays or numerous inputs and outputs featured on current boxes, the less expensive ones will still be able to deliver many of the same advanced digital services, such as expanded channel lineups and video on demand, which lets viewers pick programming from an onscreen menu, then watch, pause or rewind the show or movie as if it were playing from a VCR in their living room. That's important because operators are banking on growth in these lucrative high-end services to offset a slowdown on the basic cable side. That slowdown has been among a number of factors driving cable stocks to steep declines through most of 2002.

Multiplier Effects

Alan Bezoza, an analyst at CIBC World Markets, has published a report calculating some of the benefits that cheaper digital boxes will bring to the cable industry. A cheaper box, he estimates, will shorten by seven to 10 months the amount of time it takes an operator to earn back its investment. As a rule of thumb, says Bezoza, cable operators expect to wait four years for a payback on their equipment investment.

The return on invested capital for lower-priced set-top boxes would double or triple from current levels using current boxes, using some standard assumptions about the endurance and spending of digital video customers.

Though one could argue with some of the assumptions, the report is good news for cable operators seeking to defend themselves from investors who have grown weary of the industry's heavy capital expenditures and minuscule (or worse) profit margins. While high-speed Internet connections have been a big hit for operators this year, digital video's expanded channel capacity and VOD have proven to be less than stellar, given the cost of setting consumers up with the service and the higher rate at which digital video subscribers drop the service.

In fact, two cable operators --

Cox Communications

(COX)

and

Charter Communications

(CHTR) - Get Report

-- have said in recent weeks that they are cutting back on the marketing of digital video because of less-than-stellar returns. Since Cox is one of the more successful cable operators these days, while Charter stands on shakier financial footing, the commonality of its problem suggests that a cheaper box could be of value throughout the cable industry.

In addition, since the simplified boxes are expected to widely roll out in the first half of 2003, and because they adhere to the same standards as boxes already in the field, their benefit to operators is quicker and more assured than other possible solutions, such as a new cable box initiative reportedly led by

Sony

(SNE) - Get Report

, about which another analyst wrote this week.

Payback

So, according to Bezoza, what does the cheap-box scenario look like? Let's start with the current setup, one in which a cable box costs operators about $250 apiece, and customers sign up for an average of 1.4 digital boxes per household. Add in the $80 cost of labor for installation, and the customer acquisition cost amounts to $430.

Plug in a few more rule-of-thumb numbers, including a $15 monthly digital cable revenue and a churn rate (the percentage of subscribers who drop their service) of 5% a month for digital television, and you've got net income of $36, or 8.3% of the original $430, over the average 20-month lifetime of a digital customer.

While about 40% of the churning digital customers drop their service because they move, and a smaller number are dropped for nonpayment, about 38% simply cut their service back from digital to basic analog service. In these cases, not only do cable operators lose digital revenue, but they also have to spend another $80 for a technician to swap out digital boxes and replace them with analog set-top boxes.

But using $150 digital boxes for these customers, says Bezoza, changes the economics. Not only does the customer acquisition cost drop from $430 to $290, but operators won't feel compelled to pull the boxes out and redeploy them in other digital households. That, he says, not only saves them the $80 labor cost of pulling the box, but also holds open the possibility that the basic customer will still be able to take VOD service if he's tempted. Even without the possible benefit of VOD, the ROI jumps to 35.2% for that digital customer. If operators manage to cut churn, the ROI improvement becomes even more striking. And even if operators decide to pull out the cheaper boxes, he says, the ROI is still 17.5%.

Back and Forth

As with all economic models plotted out on a spreadsheet, several of Bezoza's assumptions are debatable. He appears to have underestimated monthly depreciation costs, and he may have overestimated tax expense. One significant operational question affecting Bezoza's illustration is whether operators will deploy the stripped-down boxes throughout the houses of digital customers or limit the new boxes to additional connections in households that sign up for multiple digital set-tops. Relevantly, a Cox executive said recently the company envisioned using the cheaper boxes only for secondary TV sets in a household. In such a case, using Bezoza's numbers, the customer acquisition cost would fall from $430 to $390, not $290. Assuming the operator would come and remove the boxes, the ROI would fall somewhere between 8.3% and 17.5%.

Even so, the potential benefits to cable operators appear to be more promising than those from a reported effort spearheaded by

Sony

(SNE) - Get Report

to develop a new cable TV system architecture that would be cheaper and more efficient than the current technology dominated by Scientific-Atlanta and Motorola.

In a note published Monday, Needham & Co. analyst Anton Wahlman wrote that he believed Sony was leading a consortium of technology companies to develop a new, standardized architecture for cable system hardware and software.

Sony cable equipment spokespeople weren't immediately reachable for comment.

In his report, Wahlman acknowledges that Sony faces a number of challenges, not least of which is that Sony's recent episode as a set-top box provider to

Cablevision Systems

(CVC)

has been a "fiasco."

Other cable industry observers were even more skeptical. Deutsche Bank analyst Peter Ausnit characterized any such effort as years late, given the unlikelihood that operators would rip out their current equipment. Expected price declines of boxes used in current systems, he said, would likely erase any set-top savings of a new architecture.