A Combined Comcast-AT&T Could Make or Break Nets

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Comcast Corp. officials last Monday estimated they would save $300 million to $500 million annually in programming costs if they succeed in acquiring AT&T Broadband, by taking advantage of the latter's sweet carriage deals and negotiating better volume discounts for the merged entity.

That assertion underscores the clout a combined Comcast-AT&T Broadband would have to negotiate programming deals and add value to the developing networks Comcast already owns.

Then later in the week, AT&T's war with the Starz Encore Group over their affiliation agreement — anything but a sweetheart deal — escalated into a full-fledged and very public legal battle. Pending contract issues like that fueled skepticism about how much savings even a 22-million-subscriber mega-MSO could wring from programmers.

AT&T is trying to get out of its contract with Starz Encore, calling the deal "unenforceable" and saying some of its "terms are inappropriate and their prices are excessive," an MSO spokeswoman said.

Starz Encore's response last week was to file suit against AT&T, its corporate parent. The programmer is looking to collect $44 million in programming costs it claims the MSO owes it under a 25-year affiliation contract.

Comcast wouldn't comment officially last week on the AT&T-Starz Encore brouhaha. But according to one source inside the Philadelphia-based MSO, Comcast would inherit any contracts that AT&T Broadband has made — including the Starz Encore deal — if its bid is accepted.

Comcast already was well aware of the Starz Encore-AT&T deal, since it purchased roughly 1.5 million subscribers from AT&T in three separate deals earlier this year, the source said.

But the Comcast source played down the significance of the onerous Starz Encore-AT&T carriage agreement, suggesting the pact may be surmountable down the road.

"It looks to us as though [the Starz Encore contract] probably would have an impact that would amount to a percentage point of margin at the most," the source said. "There are lots of things that we have in common with Liberty; who knows what may be able to be renegotiated, traded or whatever.

"We've got a lot of room between the 18 percent [cash flow] margin they have and the 41 percent we have after overhead," the source said.

One MSO that purchased systems from AT&T in the past avoided assuming the Starz Encore deal by buying assets instead of stock. According to an executive with that company, an asset purchase allows the acquirer to avoid any liability for contracts the seller had reached prior to the sale.

Aside from the Starz Encore issue, a number of programmers were skeptical about Comcast's claim of $300 million to $500 million in annual program-cost savings after a merger. Both AT&T and Comcast have already forged favorable carriage deals because of their size.

"I'd be surprised if there is that much of an opportunity," one cable-industry veteran said.

In contrast, other cable-network executives argued that at 22 million subscribers, a merged Comcast-AT&T would be big enough to dictate the success or failure of any new programming service, and therefore have powerful leverage.

"With 22 million subscribers, they definitely will control the industry," says one affiliate-sales chief. "They can easily make or break any new network, or any network, if you're out of contract with them."

Said a second affiliate-sales executive: "The stakes to do a deal with them will be more difficult. You can't go somewhere else to make up those subs."

The scenario bodes well for the cable networks that Comcast either owns — or is in the process of acquiring — that don't have full distribution, such as The Golf Channel, Outdoor Life Network, E! Entertainment Television's Style and a second spin-off network E! plans to announce later this year.

"Those channels are probably cheering right now," one affiliate-sales head said.

During a conference call last week, Comcast president Brian Roberts talked about how an AT&T acquisition could provide the company's programming service with opportunities to jump-start growth.

"It allows us to take the fastest-growing part of the company, which is our content division, and really turbo charge it with 22 million customers as a platform," Roberts said. "And our record of doing this successfully has, I think, been fantastic, starting first and foremost with QVC."

During that same phone call on the AT&T bid, Comcast cable-unit president Steve Burke outlined the programming-related cost savings and revenue growth that Comcast expected to gain after an AT&T merger.

"We have identified in the range of $300 million to $500 million we can save on an annual basis over the next three years," Burke said. Those savings would result "by taking the 8.5 million Comcast customers and their contracts and bringing them up to the level of the AT&T contracts and then, over time, renegotiating all of the contracts based on the fact that we would be significantly bigger."

He also said Comcast had been able to boost revenue at the AT&T systems it took over this year by an average of $7 per subscriber, per month just from new subscriptions to Home Box Office, Showtime and Starz Encore premium services. The latter is part of Liberty Media Group, which is an AT&T Corp. tracking stock.

The Starz Encore lawsuit, filed in Arapahoe County, Colo., claims AT&T Broadband owes the premium service $44 million "in programming costs" under the terms of a 25-year affiliation deal signed in 1997 with Tele-Communications Inc., which AT&T later acquired.

Under that unusual agreement, AT&T must pay Starz Encore fixed annual fees for its programming services, regardless of how many AT&T subscribers take them. Most MSOs only pay per-subscriber fees for Starz and Encore — reportedly $3 and 77 cents a month, respectively, per subscriber — and not a hefty flat annual fee.

The fixed annual fees AT&T must pay to Starz Encore range from $270 million in 1998 to $360 million in 2003, and increase with inflation after that, according to a 1997 press release from Liberty. Liberty chairman John Malone was looking to bootstrap struggling Starz Encore with that deal, sources said.

On top of the flat fee, AT&T's Starz Encore deal also includes an escalator clause that allows the premium programmer to pass some of the "excess programming costs" for its theatrical movie deals on to the MSO. The $44 million that AT&T is now withholding represents those so-called "excess programming costs."

The MSO has continued to fork over traditional license fees to Starz Encore.

In its suit, Starz Encore wants the court to declare its AT&T contract valid and binding.

"We're not certain why they chose to file at this time," an AT&T spokeswoman said. "They've known our position for about six weeks. We are scheduled to meet with them soon, and still intend to meet with them. But they've tried to side-step the real issue here, which is the enforceability of the term sheet."

The suit was lodged after Malone stepped down from AT&T's board last week.

Comcast stands to inherit several other obligations from AT&T: the Denver MSO's deal to give Liberty Digital Inc. control of a 6-megahertz channel on its cable systems and a carriage deal for Oxygen. AT&T and Liberty Digital have been trying to nail down the details of their arrangement, which Liberty Digital maintains would be binding even if AT&T is sold.

"That obligation would travel with the acquirer," Liberty Digital president Lee Masters said. "That is what our attorneys believe."

AT&T has been distracted by its problems during the past few months and hasn't focused on the talks regarding the 6 megahertz, according to Masters. By contrast, if Comcast came in as owner it would probably be able to better focus on the issue and "make an economically rational decision," he said.

Former AT&T Broadband chief Leo J. Hindery Jr. also inked an aggressive carriage agreement for Geraldine Laybourne's Oxygen, while Comcast has yet to do a deal with the company.