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Cable Will Eat the Phone Company's Lunch...

5/02/2004 08:00:00 PM Eastern

When Time Warner Cable launched a phone service in Portland, Maine, last May, the company guessed that only a few thousand customers would shell out $49.95 for unlimited local and long-distance service.

Turns out, President Keith Berkley's predictions were wrong—way wrong. "We upped our goal, then doubled it," he says. "That sat on the table. Then we surpassed it." A year later, the Portland system has signed up roughly 140,000 customers—nearly 10% of its base-cable subscribers—to its phone service.

Portland is among the first cities where cable operators plan to devastate telephone companies with VoIP, or "voice over Internet Protocol," which allows phone calls to be transmitted in the same way e-mails are sent. Beyond TV and high-speed Internet, the new Internet phone service is the latest product—if not the hottest—that cable operators can now sell over the same wire.

As Cable Phone Subs Zoom…And Operators Steal More Than 10% of Telcos' Customers
Cable telephone and VoIP penetration
2003 2004E 2005E 2006E 2007E 2008E
E = Estimated *Market share of all U.S. residential phone lines Source: Merrill Lynch
Cable share* 1.9% 2.8% 5.3% 8.1% 10.6% 12.6%
Indie VoIP share* 0.1% 0.3% 0.7% 1.2% 1.6% 1.9%
Combined share 2.0% 3.1% 5.9% 9.4% 12.2% 14.5%
…Prices Will Fall
Cable telephone monthly revenue per subscriber
2001 2002 2003 2004E 2005E 2006E 2007E 2008E Chg.
E = Estimated
*'03-'08 annualized change
NA = Not applicable
Source: Sanford Bernstein's Craig Moffett
Comcast $50.80 $54.33 $48.90 $44.89 $41.65 $38.85 $36.14 $33.57 -7.2%
Cox $51.08 $49.62 $46.40 $43.37 $40.77 $38.32 $36.02 $33.86 -6.1%
Cablevision NA NA NA $34.69 $34.34 $34.00 $33.66 $33.32 -1.0%

Cable operators need a new hit product. Basic-subscriber growth has flattened. Congressional ire has chilled rate hikes. And DBS competitors are stealing customers. Perhaps most disappointing of all, cable's "next big thing"—video-on-demand—is not the moneymaker the industry hoped it would. Instead, the VOD service, like digital video recorders and HDTV services, is more valuable as a "glue" to keep subscribers away from DirecTV and EchoStar.

The new Internet phone service—sure to dominate discussion at the NCTA show in New Orleans this week—is scheduled to rolled out to 100% of Time Warner's 10 million customers by next year. If the company can replicate the Portland experience nationally, Time Warner would set a record; it took high-speed Internet service five years to hit similar penetration levels at most cable systems. Cablevision Systems, which launched its VoIP phone service last fall, has reached 50,000 of its 2.9 million customers. Comcast, Charter, and other operators have also launched market trials this year.

An estimated 16 million subscribers will buy cable telephone services within five years, generating up to $5 billion annually, say analysts. "By the middle of 2006, I think most homes passed will have an alternate cable VoIP choice," says Ralph Hodge, a senior vice president at long-distance giant Sprint, which is helping cable operators switch Internet phone calls from cable systems to the conventional phone network.

Competition promises to be fierce. Already 20-plus companies, including startup Vonage, are launching their own Internet phone services that ride cable's lines without paying a toll. And telcos aren't taking the hit sitting down. They've already lost 20 million access lines, mostly from business customers, to competing conventional wireline competitors, down from 90 million lines in 2000, according to Credit Suisse First Boston.

Their strategy now is to team up with DBS providers to include video in their own bundle of services. Verizon, Qwest, and Bell South are partnered with DirecTV in marketing partnerships, but such co-promotions have fizzled for telcos in the past. Telephone bills, for example, now come stuffed with DirecTV promos for discounts.

SBC's partnership with EchoStar is more involved, and entails bundling the Dish Network with telephone and DSL across SBC's 13-state service area. SBC is more of a franchisee, buying EchoStar's programming but handling installation, customer service, and the all-important billing on its own.

Because the first to offer the service has an advantage, Time Warner Cable wants to move aggressively. Says President John Billock, "We know that speed to market is an all important issue. Telcos aren't going to stand still."

Already, customers see some of the same startup snags as any other new product. Some complain that they sometimes have trouble reaching 800 numbers. They have problems getting fax machines to work. Dialing too fast can get you a fast-busy signal.

"It was really advertised pretty heavily like a real phone service," says Robert Testa, who used Cablevision's Optimum Voice service for three month before switching to AT&T's Internet phone service. "When you get down to the nitty gritty, it's really good only as a secondary line."

Don't tell that to the Santarpia family in the Bronx. They love the Cablevision service. "AT&T was charging us $50 a month, and we never used the phone," says Jerry Santarpia, the subscriber's son. "I said, 'Screw it. Get it for $35 a month.' You can't beat it." And most other subscribers contacted feel the same way. "Works perfectly for me," says one New Jersey subscriber.

In marketing the service to customers, cable operators are steering clear of technical jargon. Time Warner Cable steadfastly avoids using "Internet Protocol" and "VoIP" in communications with customers. "We just call it 'digital phone,'" says Billock.

The service works seamlessly on a home's existing phones and jacks. Calls are broken up into digital packets and sent in the same way as a subscriber's Web surfing, sometimes for several miles, sometimes for hundreds. (Calls from Maine get routed through Syracuse, N.Y. ) When the call hits a cable operator's switch, it gets treated more like a conventional phone call and is sent over separate networks.

While riding on cable operators' networks, voice packets get tagged "urgent" and shove aside packets containing Internet searches or pirated Britney Spears tracks. Cable operators see this firm control over their network as a major advantage over other VoIP providers like Vonage.

Today, cable's biggest growth engine is high-speed Internet service. Cable operators dominate 60% of the market, and high-speed data revenue accounts for about 44% of operators' overall revenue growth, says Morgan Stanley media analyst Richard Bilotti. That growth rate will surely drop as competition from telcos' DSL service intensifies and the product matures. As that happens, says Comcast President Steve Burke, "voice over Internet Protocol will be the next big thing for Comcast."

Cable telephone service itself isn't new. Cox Communications, Insight Communications, and systems now owned by Comcast started rolling out more-conventional circuit-switched telephone service six years ago and have 3 million customers. But Internet Protocol service is far more lucrative. It costs operators as much as 75% less to hook up a new Internet phone customer than a new circuit-switched caller. And cable systems can offer Internet phone service on pretty much any cable system.

Telephone companies are in a similar competitive position as cable when rival satellite companies launched in 1993. Cable was a wired, monopolistic incumbent lacking flexibility and capital to respond to aggressive satellite companies, which have now stolen more than 20% of the video market.

Like cable in the 1990s, telcos can't use their most effective weapon against cable—price-cutting—without slicing deeply into their existing $130 billion revenue base. "Everyone assumes the telcos are going to be voracious competitors protecting their turf," says Sanford Bernstein cable analyst Craig Moffett.

For now, cable companies are offering markedly different levels of service. In its trials, Cox gives customers battery backup so that the phone will work in a power outage—just like service from Verizon or BellSouth—and customers get to keep their old phone number.

"The consumer isn't looking for a different way to make phone calls. They're looking for convenience and value," says David Pugliese, Cox vice president of telephone marketing and management.

Conversely, Cablevision's units have no backup power (something the company sees as a small issue since cell phones are so common) and no voice mail or 411 service in the New York area. Customers need a new phone number, and they can't call overseas. Cablevision says those features are being added gradually as they're perfected. (Time Warner Portland was initially launched without voice mail.)

Time Warner's Portland division chief Berkley has revised his projections to match the company's ambition. "We're not limited by the number of homes that have a PC," he says. "Everybody's got a telephone."


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