Ops Downplay Impact of Verison DSL Discount

5/11/2003 8:00 PM Eastern

Verizon Communications Inc.'s decision to drastically reduce its prices for digital subscriber line service shook cable investors last week, but the shock seemed to subside after operators downplayed the new threat.

Last week, Verizon said it would slash the price for its DSL service to $34.95 per month, down 30% — and $10 a month less than the average monthly charge for cable-modem service.

Cable stocks were hammered May 2, when Verizon announced the plan. Some lost as much as 4% of their value.

Big sliders

Among the biggest decliners in 4 p.m. trading on May 2: Comcast Corp., down $1.27 (4.2%) to $28.91; Cox Communications Inc., down $1.36 (4.1%) to $32.04; and Cablevision Systems Corp., down 75 cents (3.3%) to $22. Comcast and Cablevision regained some of that ground by May 7, when they finished at $28.95 and $22.17, respectively.

Cox continued to slide, finishing at $31.27 on May 7.

Verizon expects to roll out the new DSL pricing scheme in select markets May 13. This is the second time a regional Bell operating company has dramatically reduced its DSL price to spur sales.

Earlier this year, SBC Communications Inc. reduced its DSL pricing to $25 per month in some markets.

Cable operators tried to talk down the impact of a possible price war for their most lucrative service.

On a conference call with analysts to discuss its first-quarter results, Cox CEO Jim Robbins said new pricing strategies by competitors would have no impact on his company's plans.

"There is no change in our strategy," Robbins said. "We believe in selling a bundle of services. There is pricing flexibility inside that bundle.

"Also, there is a question as to the sustainability and profitability of our competitors' actions."

Cox senior vice president of marketing Joe Rooney was more blunt.

"The SBC offering has more strings attached to it than Pinocchio," Rooney said, adding that it is only for new customers who have to sign a one-year contract and the discount is only valid for the first year.

"Price is only one variable," he added. "If price was the most important thing, we'd all be driving Yugos."

Insight Communications Co. — which competes against SBC in Midwestern markets — said last week it posted 20,000 net digital subscribers, 23,500 net cable modem subscribers and 7,100 net telephony subscribers, despite rough winter weather in many of its markets.

President Kim Kelly said Insight hasn't yet felt an ill effect from lower DSL pricing. "I'm not seeing any pricing pressure on that product," she said. "Modems are a real bright spot."

Hardball coming

To some observers, Verizon's decision to cut prices means the RBOC is ready to play hardball with cable.

"It sounds to me like a great offer from the consumer perspective, and it is kind of is high time, really," said Jupiter Research broadband analyst Joe Laszlo. "Even back a few years ago when the DSL guys raised prices and everybody wondered, 'Well, is it monopoly asserting its power?' I was always of the mind of it was more of a question of needing to control demand until their networks were built out to where they could handle large numbers of subscribers coming online."

The recent FCC shift to curtail discount requirements for competitive DSL access providers may have also fueled the move.

"With the threat of DSL regulation receding a bit, they may be actually following through on their quasi-promise to the FCC to say, 'Leave us alone and we will deploy it faster and better and get more people signed up,' " Laszlo noted. "So it may be that the consumer will end up winning after all."

Key margin driver

Cable-modem customers have outpaced DSL subscribers by almost a 2-to-1 margin. At the end of last year, there were 10.6 million cable-modem customers, compared to 5.4 million DSL subscribers.

While many see the price reductions as a means to protect the RBOCs' local and long distance market share, any loss of momentum on the cable-modem side would be perceived as a problem.

With increased programming costs, a slowdown in digital subscriber additions and an accelerated move to show free cash flow — cash after paying for interest and capital expenditures — analysts are counting on continued growth in the high-speed sector, with its hefty profit margins.

On average, profit margins in high-speed data range between 50% and 60%, with some MSOs reporting data margins as high as 80 percent.

In a report issued two weeks ago, Gupta wrote that high-speed data service will account for nearly 50% of cable industry cash flow growth in 2003, rising to 54.4% in 2004.

Cable-modem service is becoming increasingly attractive as the cost of providing service falls. Cable modems, once priced as high as $200 each, are now priced around $40 to $50 apiece. And installation costs are dropping as more and more customers are opting to self-install the service. Cox Communications Inc., for example, said last week that about 35% of its high-speed data customers self-install their modem.

Enviable spot

Gupta added that cable is in an enviable position in the high-speed market. With overall high-speed data [both cable and DSL] penetration at about 15% in 2002, he believes the market is too young for any DSL pricing drops to affect cable's dominance.

Gupta also said first-quarter high-speed data subscriber additions at most of the top MSOs exceeded expectations.

"There are two ways to get revenue growth — pricing and units," Gupta said. "Until cable operators feel it on the unit side, they're not going to respond."

Cable likely won't feel a drop off in subscribers until next year, Gupta added. At that point, cable could respond by offering a tiered service, he added.

In the next 12 to 18 months, Gupta said, tiering will be more prevalent on the cable side. Currently, only Charter Communications Inc. is offering widespread tiering for cable-modem service.

In addition to offering lower priced tiers, cable companies could also add a higher-speed service at a higher price point, Gupta added.

Diminishing Returns
As the high-speed Internet business matures, it's expected to contribute a lower percentage of cable operators' overall cash flow. Here's a breakdown of estimates by MSO.
MSO 2003E 2004E 2005E 2006E
Source: Salomon Smith Barney

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