Disconnect on Cost

1/18/2008 7:00 PM Eastern

Verizon Communications may be winning the hearts and minds of a growing number of former cable and satellite customers with its FiOS voice, video and data product, but at least one analyst believes that the service fails to deliver to one major constituency — its investors.

In a research report last week, Sanford Bernstein cable and satellite analyst Craig Moffett crunched some numbers on the FiOS service and came up with one all-encompassing conclusion: the economics around the FiOS rollout make little sense.

Based on Moffett’s estimates, rolling out FiOS could cost Verizon nearly $5,000 per home connected.

Moffett based his estimate on several factors — the actual cost of running fiber to a home, the cost of providing video service, advertising and marketing expense,Verizon’s cost of capital, subscriber acquisition costs and the time to terminal penetration (Verizon has estimated that it would take five years to achieve terminal penetration of 50%). Based on those factors, Moffett estimated that it would cost Verizon $4,984 per passing with 30% video penetration, dropping to $2,439 per passing at 50% penetration.

Moffett added that returns on capital for cable companies isn’t stellar — he called them anemic at best — but added that given valuations for most of the big cable operators ranging from $1,500 per customer to $3,000 per customer, they still outpace Verizon.

“Tellingly, competitor Comcast currently trades at an Enterprise Value of just $3,000 per subscriber, and at just $1,500 per connected home,” Moffett wrote. “With FiOS capital spending costs alone in the range of $4,000 per connected home, or two-and-a-half times the entire Enterprise Value of its closest competitor, Verizon’s FiOS surely faces a dizzying challenge in earning a desirable return for shareholders.”

Granted, one of the reasons for Verizon’s aggressive stance is to stem or compensate for increasing access line losses. The telco has been steadily losing access lines to cable telephony and wireless — access lines have dropped from 36.1 million in 2003 to 27.8 million in 2006, according to Moffett. Those declines are expected to accelerate in the coming years, to 25.9 million in 2007, 24.1 million in 2008, 22.5 million in 2009 and 21.1 million in 2010, according to Moffett.

Although rolling out a triple-play service like FiOS could win some of those customers back — and the incremental revenue from video and broadband could make up for at least some of those losses — Moffett believes that the massive cost of building a fiber to the home network doesn’t justify the near-term revenue gains.

Verizon has said that it intends to spend about $23 billion to roll out FiOS to 18 million homes within its footprint by 2010. So far FiOS passes about 9 million homes and the company has said that it has more than 700,000 FiOS video customers as of Sept. 30.

Most analysts believe that the phone giant passed the 1 million video subscriber mark in the fourth quarter.

And while Moffett praises FiOS from a customer standpoint — most recently Consumer Reports gave FiOS its first-ever perfect score for a video or broadband service provider — the analyst said that even with increasing penetration, it will be an uphill climb for the service to provide an adequate return on capital.

“In effect, Verizon is trading an unattractive picture of slow and steady declines in the wireline business for an even more unattractive picture of massive capital reinvestment at below-cost-of-capital returns,” Moffett wrote.

But Moffett adds that much like the cable industry, which overpaid for its massive upgrade in the 1990s, once the costs of the buildout are incurred, the economics get better.

“In the case of cable, however, marginal returns for cable operators are exceptional … because their sunk costs are already sunk,” Moffett wrote. “Eventually, Verizon will be in the same boat. Having overspent — just like cable — to build the network, the incremental costs to operate it simply aren’t that large. The difference, of course, is that Verizon remains many years from that inflection point.”

Figuring Out FiOS
Total Cost Per Home Connected
Penetration Rate Cost Per Home Connected
Source: Company reports, Bernstein estimates and analysis
Source: Sanford Bernstein estimates and analysis
Calculation of Total Cost Per Connected Home Including SAC
Penetration Rate 30% 40% 50%
Shared Video Cost$172$172$172
Cost Per Passing$817$817$817
Total Per Passing$989$989$989
Passing Cost Per Connection$3,297$2,473$1,978
Cost of Capital8.75%8.75%8.75%
Time To Terminal Penetration5.05.05.0
Average Time To Connect2.52.52.5
Time Value of Passing Cost$4,066$3,049$2,439
Connection Cost$718$718$718
Subscriber Acquisition Cost$200$200$200
Total Cost to Pass and Connect$4,984$3,967$3,357

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