Cox Cable Plays Defense and Offense

Satellite TV has been feasting on cable. Across the country, it has grabbed 25% of the multichannel-TV business. In some markets, notably Atlanta and Dallas, its share is climbing toward 50%.

But not in San Diego. Cox Communications' system there has long been one of the MSO's showcase operations, a property long emphasizing customer service, investing in its plant and aggressively adding new products. In San Diego, DirecTV and EchoStar count just 7% of the market.

"I take DirecTV and what they do very seriously," says Bill Geppert, general manager of Cox's San Diego system. "I don't like to lose one customer. I'm saddened to see the [DBS] penetrations at other systems."

Is San Diego a special case for Cox? Nope. DBS penetration in all of Cox's markets averages just 11%. Cox is proud of holding off DBS better than companies like Comcast and Charter do. And having done so, it is in solid financial shape. As other operators have been rocked by scandals and operating problems, Cox has led the industry with 14%-18% growth in operating cash flow.

What's more, while other major MSOs are only now getting serious about the telephone business, Cox has offered it for more than four years, in large part because it upgraded its systems earlier. That allows Cox to bundle cheap telephone service with video and high-speed data on a single platform. Something DBS and telco rivals are trying to emulate.

Differentiating Cox from DBS and telephone companies is important to Cox. "We see real affection for customer service as a long-term competitive weapon," says Cox Communications President James Robbins. "Everybody is imitating the bundle. I think video is a critical component of that. That's why you see the phone companies scrambling to do a bundle with video in it."

Interestingly, that doesn't necessarily include video-on-demand. While operators like Time Warner Cable are aggressively rolling out VOD, Cox has moved slowly, looking for a more solid business plan.

Like other cable operators, Cox faces plenty of threats. News Corp. Chairman Rupert Murdoch is expected to inject a lot of marketing muscle into the already strong DirecTV. And telcos are fighting back. Already, SBC Corp. is starting to resell DBS service for EchoStar, bundling it with phone services. Other telcos are slashing prices for DSL service to undercut Cox's other source of growth, high-speed data service.

"I think Rupert will make life very interesting," says Robbins. "I worry a lot about DBS, but I like our position."

With 6.2 million subscribers, Cox is the fourth-largest cable operator. It's major systems serve Phoenix, San Diego, Las Vegas, Hampton Roads, Va., and New Orleans.

It outpaces most major MSOs tracked by Bank of America analyst Doug Shapiro in key measures like basic-cable penetration and revenue per subscriber (a huge $76 per month). Only Cablevision Systems posts similar numbers, but it has been in and out of financial and operating trouble in the past two years.

Like other operators, Cox has done well selling high-speed Internet service, securing 2 million subscribers.

But its big advantage is telephone. Cox launched residential phone services on systems serving about 4.7 million of its subscribers and so far has signed up 1 million customers. Even with prices 20%-30% less than local phone companies charge, Cox is collecting almost $50 per subscriber monthly. That's in addition to the $50 in video revenue those customers already pay.

By next year, predicts Morgan Stanley media analyst Richard Bilotti, telephone will account for around 14% of Cox's profits but, more important, 27% of its profit growth.

Cox's phone doesn't represent a big technology breakthrough, since it doesn't really run over the coax cable used for video. Cox's "circuit-switched" service runs on thin wires encased with the coax. The breakthrough technology emerging now is voice over IP (VoIP). Calls are translated into Internet protocols and actually run over the same coax cable carrying video and high-speed Internet service.

The beauty of VoIP is that capital costs are lower, perhaps much lower. The years-long promise of VoIP is the reason MSOs like Comcast and Time Warner have delayed entering the phone business. "Business is all about return on capital," says a senior executive of one cable operator. "We saw much cheaper technology down the road. If the capital costs are a lot lower, waiting even three or four years will be worth it in the long run."

Cox has invested $700-$900 in capital for each new phone customer over the past few years, including a special network-interface unit in each home. That cost is dropping. With VoIP, cable operators might be spending just $300.

So, did Cox move too soon on telephony? "You've got to be careful when you talk about cheap," Robbins says. He says the low-end cost estimates for VoIP don't include things like battery power for the home for "full-replacement" service, reliable enough to completely replace the local phone company, which works in blackouts.

Where Cox falls short is profit margin. Staffing up on customer-service reps and investing in training has long depressed Cox's operating cash-flow margins, which dropped to as low as 32% two years ago before climbing back up to 36% last year. Other MSOs run in the 40%-43% range.

Raising margin is a big goal at Cox, but Sanford Bernstein & Co. cable analyst Craig Moffett questions whether the company can do it. "The real reason for their margin, I think, is that they've got a higher mix of phone revenues, and that comes at a lower margin."

Cox's clusters, he adds, average 220,000 per market area, half the size of Time Warner's clusters and a third that of Comcast's. "Relatively small clusters are less efficient to operate," Moffett says.

Cox Communications COO Pat Esser says that such concern is overblown and that Cox's emphasis on customer service depresses operating margins by just two percentage points.

"We're very fortunate," says Esser, with a nod toward Cox Enterprises Inc. and its CEO, Jim Kennedy. "Our largest shareholder has always taken a long-term view of the businesses they own. They have principles they want things run under, quality standards they want met." CEI owns 65% of Cox's stock.

But Esser acknowledges that increasing the margin has become one of his primary missions. And it's going to come from much more than the company's war with ESPN over programming costs, He's trying to squeeze costs out of the operation, largely by controlling Cox's need for installation and service calls. He's heartened by progress in the Omaha system, which has the longest history of introducing new products. Eighty percent of new installations of cable modems and digital television are handled by the customers themselves, though often with some skilled coaching over the telephone.

"Two years ago, basically all high-speed Internet connections were done by us, rolling a truck," Esser points out. In September, 40% of data customers installed it themselves. "We're taking that to 50%."

One big question is Cox's changing appetite for major acquisitions. In the past, Robbins and his executives had something of an inferiority complex about size, believing that size brings not just economies of scale—cheaper programming and equipment costs—but also a bigger voice when it comes to things like technology standards and lobbying. Cox may be the fourth-ranked cable operator, but count in DirecTV and EchoStar, and Cox is just the sixth-largest "cable" network distributor.

Cox was a major bidder in the heat of the cable deal market and, just two years ago, dueled Comcast for AT&T Broadband, which sold for $47 billion and made Comcast an industry giant with 22 million subscribers.

But Robbins says his need for greater scale has abated: "Philosophically, is scale everything? I don't think it's everything."

He now says Cox doesn't pay that much more to networks like MTV and Food Network or gear vendors like Motorola and Scientific-Atlanta than Comcast and Time Warner Cable.

He isn't closing the door on acquisitions. Adelphia, Cablevision or parts of Charter Communications may come on the market in the next year or two. Says Robbins: "We're looking."