The Anglo File: Microsoft Deal Could Darken Murdoch's BSkyB

Sky's Rupert Murdoch is known for crushing anything in his way, but he may find he's met his match in Microsoft and AT&T.
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Microsoft's

(MSFT) - Get Report

announcement last Thursday that it will buy almost 30% of U.K. cable provider

Telewest

(TWSTY)

makes

British Sky Broadcasting's

bold

decision the previous day to give away free digital set-top boxes look distinctly like desperation.

The market applauded the attempt by

Rupert Murdoch's

Sky to increase the number of subscribers to its digital TV service when it was announced on Wednesday. Sky shares rose 11.7% in London after the deal was announced, while Telewest fell 5.7%. Shares of other cable and digital providers suffered a similar fate.

Yet the market did a flip-flop on Thursday. Telewest surged 12.4%, while Sky fell 3.7%. On Friday, Telewest rose 1.2% to 290 pence, and Sky ended up 1.5% at 588 pence.

The stake in Telewest that Microsoft has agreed to buy is currently owned by

MediaOne

(UMG)

, which

AT&T

(T) - Get Report

recently acquired. Although the terms of the deal weren't disclosed, it involves a stock swap. Based on current market prices, this would equal around 34 million shares of Microsoft stock, although it's highly likely that Microsoft paid a premium over the current market price of MediaOne.

Microsoft's acquisition of the 29.9% stake in the U.K.'s second-largest cable provider is part of a much larger alliance with AT&T. Microsoft will invest $5 billion in AT&T in return for AT&T agreeing to increase the use of

Windows CE

and other Microsoft Internet software in digital set-top boxes.

Amid predictions of the demise of the PC and the dawning of digital TV, Microsoft is pushing hard to become the primary software infrastructure provider for these boxes.

As such, Microsoft is not attempting to become a pay-TV provider that would compete directly with Sky. Yet Murdoch and his team should at the very least be apprehensive about

Bill Gates'

latest investment in the U.K.'s cable industry.

Microsoft arrives on these shores with very deep products and ready to invest in an industry that has long been mismanaged, underfunded, burdened with debt and overly cautious about its business strategy.

"The cable industry until now has being willing to suffer an abrasion in its subscriber base to Sky. It's cheaper than trying to retain every one of its customers with expensive packages," says Steven Adshead, an industry analyst at

Datamonitor

, a management consultancy.

The cable industry in the U.K. has been consolidating gradually for some years, although this process still has some way to go. Microsoft is now in a position to help complete the process.

Microsoft already has cable investments in the U.K. In January, it took a 5% stake in

NTL

(NTLI)

, the U.K.'s third-biggest cable operator. And with Telewest already in discussions about a possible merger with the second-largest cable provider,

Cable & Wireless Communications

(CWZ)

, Microsoft is well placed to play the role of matchmaker.

A cable industry with all the benefits of economies of scale that a major round of consolidation would bring presents a much greater challenge to Sky's dream of becoming the dominant provider of digital TV in the country.

On a more fundamental level, cable is a platform much better suited to the digital age than satellite.

As part of its new package, Sky will not only give away set-top boxes, but will also include free Internet access and a 40% discount on standard telephone calls. Yet Sky is cobbling together its satellite TV system with a phone service from

British Telecommunications

(BTY)

-- using the Internet will require customers to have a personal computer.

Cable, on the other hand, offers a broadband two-way pipe, which is capable of offering high-speed Internet access, superior interactive services and video on demand.

Bold move or not, Sky's new package to lure digital customers is surely the first shot fired in a battle set to rage for some time. Murdoch is known for crushing anything in his way, but he may find he's met his match in Microsoft and AT&T.