News

Charge of the Light Brigade

7/18/2008 8:00 PM Eastern

Few things strike fear in the hearts of cable operators — and their investors — like the word FiOS.

Charter Communications remembers when Verizon Communications made the pitch for its FiOS TV voice, video and data service, in Keller, Texas, an initial showcase market, more than two years ago. “It was like nothing I had ever seen before,” said Kevin Allen, director of government relations for Texas, noting a flood of billboards, flyers and TV spots. “Everything you could possibly put a logo on, they did.”

Today, Verizon claims penetration rates exceeding 40% in the Fort Worth area, although Charter says its losses have not been anywhere near that. Moreover, Charter points out FiOS competes with only about 7% of the MSO’s overall footprint, representing fewer than 370,000 customers.

Still, FiOS “does have an impact,” Allen said, pointing out that Charter’s Fort Worth system did not offer voice service when Verizon first charged into the market. Now those Charter systems do. “It really boils down to the triple play — to give a real alternative to that same old telephone service you’ve had for years,” Allen said.

Voice* DSL FiOS Internet FiOS TV
Q4 2006 27.8 6.3 0.7 0.2
Q1 2007 27.1 6.5 0.9 0.3
Q2 2007 26.3 6.6 1.1 0.5
Q3 2007 25.6 6.7 1.3 0.7
Q4 2007 24.8 6.7 1.5 0.9
Q1 2008 24.1 6.7 1.8 1.2
* Consumer access lines

Source: Verizon Communications

These days the entire industry, including giant Comcast, is sweating Verizon’s FiOS, which may yet prove itself to be cable’s most lethal enemy.

To be sure, MSOs view other competitors in the video business — DirecTV, Dish Network and AT&T U-verse — as serious threats.

But FiOS is a different beast. Today, Verizon, intent on offering voice, video and data widely, is constructing an all-fiber network in an effort to trump cable operators at their own game. And unlike previous empty threats from the phone companies, this time Verizon is invading new markets almost weekly, including New York City last week. Indeed, FiOS is now the 10th-biggest cable operator in the U.S., and growing.

“Verizon is real and is taking some subscribers from us,” Comcast chief operating officer Steve Burke told analysts on the MSO’s fourth quarter 2007 earnings call in February. “We believe we’re taking a multiple of the subscribers from them on the phone side and they are taking from us on the video side. But Verizon is real,” Burke continued. “We track it very carefully and there is no question that their builds are where they said they would be and they are gaining penetration.”

FiOS has blitzed targeted markets in 16 states with advantages over cable. Fiber is superior over plain coaxial cable in terms of bandwidth capacity and cost of maintenance.

And FiOS is the only product that could beat cable companies on all three services, said one MSO vice president of technology planning, who asked to remain anonymous. “The FiOS architecture is really, really scalable,” the executive said.

The monster downside for FiOS: a $23 billion price tag that has become notorious on Wall Street. For that investment, Verizon plans to lay a fiber-to-the-home network passing more than 18 million premises by 2010. The full cost of FiOS will be about $4,000 per connected home, estimated Sanford Bernstein analyst Craig Moffett.

“Verizon’s FiOS, a massive bet on the next generation at the edge [of the network], seems destined to make customers happy but does so at returns far below the cost of capital,” Moffett wrote in a report this month.

While the investment risk to FiOS is huge given its tiny footprint and competitive odds, it had little choice.

FiOS represents the future in the wake of the collapse of the telephone company’s historical wireline business. At the same time it’s adding FiOS customers, Verizon is losing legacy phone customers as fast as ever. The telco shed 11% of consumer access lines in the past year, from 27.1 million to 24.1 million (see chart), a trend analysts expect to continue apace.

All this became clear to Verizon executives more than five years ago. In 2002, the telco’s brain trust concluded that Verizon needed an all-fiber network to provide a growth engine for the company, a strategy fully embraced by CEO Ivan Seidenberg.

“We could not find [an alternative] other than fiber [to the home] that gave us the service capabilities and operations savings opportunities that we felt were critical to our success,” said Mark Wegleitner, the Verizon Telecom unit’s senior vice president of technology.

At the time, skeptics labeled FiOS far too ambitious and risky. Now, many of the doubters have been proven wrong, and the FiOS wager is paying off.

Some on Wall Street had assumed Verizon wouldn’t be able to get more than 15% share of the video market, because the two major direct-broadcast satellite operators took roughly 30% combined.

“[Verizon has] been more successful to date than people thought. They’re making money and it works,” said Credit Suisse analyst Chris Larsen.

FiOS TV counted 1.2 million subscribers as of the end of March, putting it on pace to hit more than 3.4 million TV customers by the end of 2010 even if it just holds steady at its current average penetration rate of 19%. The company expects to FiOs to become cash-flow positive by the end of 2008.

The telco expects to soon begin marketing TV service in New York City to some 3.1 million residents, offering a true triple-play alternative to Time Warner Cable and Cablevision Systems.

Verizon is also circling key Comcast territories, pursuing cable franchises in Philadelphia, Pittsburgh and Washington, D.C. This month it won its first franchise in Washington state, in the Seattle suburb of Lynnwood.

In terms of bandwidth, it’s nearly impossible for cable to poke holes in FiOS. On the data front, Verizon now offers ultra-fast 50-Megabit-per-second Internet access to some 10 million premises in 16 states, while cable companies are scrambling to deploy DOCSIS 3.0 “wideband” service, which can theoretically deliver 160 Mbps or more, to keep up.

Comcast has already launched service in Minneapolis/St. Paul with the technology that provides 50 Mbps down and 5 Mbps up, and is looking to broaden the service to 20% of its footprint this year.

The MSOs — including Comcast, Time Warner Cable, Cablevision and Cox Communications — also have responded to FiOS with ad campaigns pointing out they’ve used fiber in their hybrid fiber-coax networks for years. In a competitive marketing spot Time Warner is running on the Web, the best slam on FiOS scripted for actor Mike O’Malley is that “they pretty much have the weird name covered.”

But even as Verizon is shelling out top dollar to bury fiber or string it from poles over much of its territory, the true cable-crushing power of the multibillion-dollar network lies dormant.

FiOS, with newer gigabit passive optical network (GPON) equipment, can deliver 2.5 gigabits per second downstream to a single home, upwards of 250 times what DOCSIS 2.0 cable modems typically pump out today.

Wegleitner himself acknowledges there’s no real market for such super-fast connections.

“Very few single applications need 100-Mbps performance today, unless you are really into high-speed data transfers, like movie downloads,” he said. But he points out that concurrent usage by multiple PCs and other devices in the home will drive up demand.

“Think interactive gaming and video calling here if you like,” he said. “If you don’t think we are there yet, I think you will agree we will be very soon.”

Analysts studying FiOS’s cable strategy say it doesn’t deliver any knockout blows to cable from a customer perspective. “Customers don’t care about the technology,” Oppenheimer & Co. analyst Tim Horan said. “It’s all going to depend on the new applications that will take advantage of the bandwidth.”

He added, “In the next three- to 10-year period, FIOS clearly will be the best network. But we still don’t really know how meaningful that will be.”

Today the differences between FiOS and cable service offerings are in desirable — but not “must-have” features — such as multiroom digital video recording (playing back shows in other rooms).

Another advantage for FiOS’s long-term strategy: Fiber doesn’t corrode the way copper does. “Will this last 30 or 50 years? We don’t know exactly,” Wegleitner said. “What we’re hoping to ensure is that the most expensive part of the outside plant remains viable.”

For now, Verizon is running into reinforced competition from the MSOs, after racking up initial gains. The triple play has allowed cable operators to hold on to customers in the face of the FiOS onslaught, Oppenheimer’s Horan said. “The MSOs are clearly two or three years ahead on the triple play.”

Indeed, Cablevision, the MSO with the most exposure to FiOS, actually gained 2,000 net video subscribers in the first quarter of 2008. “In areas where the telcos compete with us in video, their impact on us is still single digit, even after more than two years of head-to-head marketing,” Cablevision COO Tom Rutledge said on the operator’s first quarter call.

That’s in spite of Verizon’s heavy marketing, including an offer of a free 19-inch HDTV to new triple-play subscribers during the period (caveat: many customers complained about delays in receiving the promised TVs). Cablevision has also responded competitively by boosting high-definition service, touting a lineup of 60 free HD channels by Aug. 1.

Today, it appears FiOS mainly wins or loses customers based on old-fashioned qualities like pricing, customer support and billing. Or because of historical grudges. Chris Ptacek, who lives in Massapequa, on New York’s Long Island, said he jumped at the chance to subscribe to FiOS TV and Internet services when they became available.

To Ptacek, the HD picture quality is better with FiOS, and as a professional photographer he likes the 5-Mbps uploads he gets with FiOS Internet. But, he said, “the fact of the matter is, I just hate Cablevision. Calling up the cable company over the years and complaining about the billing — I was just tired of it.”

Customer dissatisfaction cuts both ways. Cablevision customer Linda Lanza, in Islip, N.Y., decided to move to a FiOS triple play in November 2007. Verizon had promised Lanza she wouldn’t have to change her number, but when the FiOS installer showed up (on a Sunday) he gave her a new phone number. Then the first bill came. Instead of the $129 promised for the triple play, Verizon’s tab was $411, which included installation charges that Lanza said she was told would be waived.

“We got one B.S. story after another from Verizon,” Lanza said. “I had FiOS one solid month before I switched back to cable.” (Asked to comment on Lanza’s account, Verizon said that at the time, discounts and refunds for some customers were “delayed by a matter of weeks as billing systems for separate services were synched.” The telco said the delays have since been eliminated.)

But was FiOS a better service? “I don’t know,” Lanza said. “The aggravation overruled everything else.”

March