Digital cable: Ready to hatch

MSOs are finally making room for long incubating networks

No cable network can do much with 10 million subscribers. But what can it do with 40 million? That's the key question facing the wave of digital cable networks that have started up over the past few years. For four years, they've limped along on programming leftovers from their libraries, financially hamstrung by digital cable's limited penetration. But operators had a tough time selling digital cable packages with programming recycled from MTV and, for a while, Fox Family Channel.

But after years of slow starts, cable operators are doing their part, turning in startlingly strong growth in digital cable. MSOs that had been holding back from investing the capital for pricey $350 to $400 digital set-tops are now upgrading thousands of subscribers a month. Morgan Stanley media analyst Richard Bilotti counts 8 million digital cable subscribers among the eight MSOs he follows, for penetration of about 15% of their basic homes.

A few years ago, many MSO executives predicted that they'd be lucky if digital cable penetration hit 20% to 25%, or 14 million to 17 million homes out of 67 million basic cable subscribers. Now they see 30% in easy reach and discuss unhesitatingly about how to push penetration as high as 50%.

There's a lot of room for growth. Few operators are offering digital to all their systems. And one major MSO, Cablevision Systems Corp., hasn't even begun deployment.

"It's come on surprisingly well," says Charter Communications Executive Vice President Steve Schum, whose operation grew from nearly zero digital subscribers to 1 million in a year, penetrating 16% of its 7 million basic homes. Further, many "digital cable" networks get big kicks from DBS services EchoStar and DirecTV, which give them a potential audience of up to 15 million additional homes.

Networks are the beneficiaries. They first rushed to give cable operators some product to advertise and, of course, to block some upstart programmer from getting shelf space on cable systems.

But no network is moving quickly from an original business plan that assumed that limited distribution would handcuff them for many years.

Right now, pure-digital networks resemble Hamburger Helper. Executives pull stale, leftover shows out of their libraries and try to repackage them into a palatable meal. Lifetime Movie Network, HGTV's Do-It-Yourself Channel and any number of Discovery Network splinters are programmed that way. Distribution to 3 million to 10 million subscribers each means little license-fee revenue and practically no ad revenue.

Digital networks are holding their budgets to just $5 million to $10 million each. Home Box Office spends that much just promoting The Sopranos.

A&E Senior Vice President of Affiliate Sales David Zagin says no quick changes are in store for his company's two digital networks, the History Channel and Biography Channel Iternational. HCI, for example, is just getting to the point where it is acquiring programming exclusive to the channel in the United States, generally tapping foreign networks.

When each network hits 10 million subscribers, "it becomes a more viable package," Zagin adds, noting that the networks will probably be sold as a package with each other and their parent basic cable networks. "At 20 million subs, it possibly has some legs on its own to generate some ad-sales revenue." Right now, the digital channels are filled with a lot of promotional spots for A&E's other networks.

Consumers find the word "digital" sexy, but digital on cable has been fairly bland. The primary benefit of digital cable is compressing eight to 10 channels into the 6 MHz slot occupied by a conventional analog channel. Initially, the most aggressive operators were those most vulnerable to the 200-channel attacks by DBS. Their systems were inadequate, but they couldn't or didn't want to spend money to rebuild and increase the capacity.

That's particularly true for the somewhat-neglected Tele-Communications Inc. operation now owned by AT&T Broadband. But other operators got motivated after AT&T found that digital customers generated an extra $16 to $18 a month in revenue and $9 to $10 in cash flow. That's huge, given that basic customers provide an average $40 to $45 monthly revenue and $16 to $20 in cash flow.

AOL Time Warner has pushed digital into 14% of its cable homes, up from 4% in 1999. Cablevision is planning to put high-end digital boxes in the homes of about half its 3 million subscribers within three years, whether they buy digital packages or not, figuring they'll at least buy more pay-per-view movies.

Bilotti expects to see 20 million digital cable homes by the end of next year.

Few, if any, digital networks will reach 100% of those available homes. Another crimp on programming economics is how aggressively operators package digital services into news, sports, family or some other tier. A given tier might reach only 20% to 70% of a system's digital customers, merely 8% to 28% of the basic customers of a system with 40% digital penetration.

"All of our digital channels' business plans get us to around 30% on an aggregate basis," said Charles Humbard, general manager of Discovery Networks' six-channel digital operation. "Some MSOs are going to be more aggressive in tiering, so you're seen by fewer people."

That limits the gains of the other beneficiaries of digital cable: the established networks still scrounging for carriage. Even HGTV, with 60 million subscribers, will get full-time carriage for the first time on AOL Time Warner's Manhattan system this week. Previously, the network split a channel with Bravo, airing only from 7 to 11 a.m.

Hybrid networks would prefer wider carriage, but they'll settle for carriage on digital as opposed to nowhere. "There's no such thing as a bad eyeball," says Joseph Gillespie, COO of Paul Allen's computer and technology channel Tech TV. "I'd rather not have to, but, if I wound up with all-digital carriage, I could make a business plan out of it."