The Cox Conundrum

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Atlanta— He’s still unpacking boxes in his new office and can’t find “the red book.”

Patrick V. “Pat” Esser is looking for a collection of opinions, information and exhortations that he has been compiling since he knew for sure he would become president of Cox Communications Inc. on Jan. 1.

The spiral-bound student notebook contains his handwritten narration of more than 50 interviews he has conducted since the end of July, when James O. “Jim” Robbins said he would retire at the end of this year, after taking the cable system operator from 1.3 million subscribers in 1985 to 6.6 million 20 years later.

He has highlighted key pieces of advice from executives that he has talked to both inside and outside Cox. On this “listening tour,” he has sought counsel from vendors, other operators and industry experts. And he has inserted slips of paper that have come across his desk from employees, or from printouts of the more than 100 responses he’s received from workers to postings on his personal Web journal.

He has asked all of them four questions: What are the most important tasks for Cox — now a private company — to tackle over the next 18 months? The next five years? And what should and shouldn’t change about how Cox operates?

The notes underpin a presentation he would make the following Tuesday to the cable company’s senior managers in Atlanta.

“They’re going to hear about the importance of building market share,’’ he said. “I want a wire connected to every home I pass. I want every home I pass to be a customer of ours in some form, in some fashion.’’

One hundred percent penetration of each of its markets is a simple objective to state, but not so simple to execute. Unlike Robbins in 1985 or David Van Valkenburg, who preceded him, Esser does not face the specter of potential competition in pay television and communications services in every household he wants to serve. He faces its reality — from the sky, in the form of satellite-delivered services, and on the ground, with the imminent arrival of a complete line of TV, phone and Internet services delivered by telephone companies.

These are enterprises whose own revenues can exceed the entire cable-TV industry. And they’re firms that must switch businesses, as the price of local and long-distance telephone calls falls to near zero.

Beyond that looms the arrival of Internet players such as Yahoo Inc., Google and America Online, over the very high-speed Internet connections that Cox sells. These companies reach far more eyeballs than any individual cable company (see chart, page 17) and are shaping up to be formidable suppliers of video and communication services, including instant text, video and audio messages.

“Yeah, it’s scary,” said independent media analyst Richard Greenfield.

The question facing Esser — and almost any other cable operator — is, according to Greenfield: “Are you running a business for the next 12 months, or the next 12 years?” And if it’s the latter, is there a service whose revenue you might be willing to sacrifice — like voice communications — to “really hurt your competition?’’

In effect, what revenue would you forsake to connect a wire to every home you pass?

THE BOOK OF ROBBINS

Esser — and the cable industry at large — might not have this strategic conundrum to face at all, if it weren’t for Robbins.

Robbins, who served two tours of duty in Vietnam and graduated from the West Point of U.S. capitalism (the Harvard Business School), for the last 10 years has argued that cable firms can be “better phone companies than the phone company.”

That was a far-out idea even as recently as February 1995, when the industry’s research consortium, CableLabs, tried to get its members at its winter conference to focus on “opportunities” in telecommunications.

Robbins and his boss, Cox Enterprises Inc. chairman and CEO James Cox Kennedy, not only listened, but acted. By September 1997, Cox had introduced what it called “lifeline” telephone service in Orange County, Calif.

The initial service was billed as Digital Telephone service, but used a conventional technology: circuit-switched telephony. That meant that Cox would use a complete circuit to allow any two households to talk to each other. That method wastes capacity, compared to true digital telephony, in which calls are broken up into packets of data. In that way, many calls can be crammed into a single circuit.

By the end of 1999, Cox had signed up 26,000 customers in Orange County, just south of Los Angeles. That was 18% of the households in the Anaheim area. Across the country, Cox had signed up 100,000 customers. The voice business was real.

By March of this year, Cox would report 1.3 million subscribers to its voice services. By December, Time Warner Cable would report its 1 millionth voice-over-Internet protocol customer. By year’s end, Time Warner, Comcast and all the major cable companies will count 5.5 million telephone subscribers, according to investment firm Sanford C. Bernstein & Co.

The payback? Telephone giants — Verizon Communications Inc. and AT&T Inc. (the former SBC Communications Inc.) — are being driven into the television business. Verizon already sells 180 channels of TV for under $45 on a fiber network in Keller, Texas.

AT&T has landed a statewide franchise in the same state and is about to launch a television service it calls U-verse in San Antonio, where it is based. By the end of 2007, AT&T expects to operate in six or seven states.

And cable companies weren’t the only entities emboldened to take on the phone companies. Internet competitors such as Vonage Holdings Corp. and Skype Technologies S.A. began driving prices down, with the former pricing unlimited long-distance calling at under $30 a month and the latter making it possible to call anywhere in the world for no charge, if both parties had computers and its software.

Cox, Robbins said, shouldn’t worry about phone companies. “They could do all sorts of short-term pricing, and all sorts of publicity and all sorts of politics, but in the long run we [would be] able to provide a better value, a better mousetrap for the consumer.”

And phone companies will find it “an exponentially more complex leap into video than the cable guys going into dial tone,” said Ted Henderson, a Denver-based analyst with investment bank Stifel, Nicolaus & Co.

But Robbins may have left Esser with a competitive and corporate conundrum on his way out the door, nonetheless.

To date, Cox has been able to generate approximately $50 a month in revenue from each of its telephone customers. That will be hard to protect, as Skype upgrades the software it provides its users over the high-speed Internet connections Cox and other cable companies sell. And other players get into the game, such as Yahoo, which announced its own Skype-like service this month. In Connecticut, for example, Charles Dolan’s Cablevision Systems Corp. offers its current TV and Internet customers all-you-can-eat local and long-distance telephone service for as little as $14.95 a month.

Greenfield, in fact, argues that cable operators like Cox should “take more drastic action” and cut out any voice pricing from their calculations when pricing bundles of services. The object, he said, should be to create “all-digital networks” that move everything from TV shows to Web pages to voices in packets of data. And only aggressive pricing will “secure” the data connection that carries all these services into the home, he said.

Which means: Esser can increase his share of market and get more households in markets his wires serve to sign up for Cox services. But he may have to sacrifice revenue, in order to get every household he passes to include a customer.

THE BOOK OF TESTS

Court TV CEO Henry Schleiff had barely stepped in his office door in 1998 when he received a “drop notice” from Cox.

His network was a blip on cable’s consciousness. Absent a trial of the wide interest of the O.J. Simpson murder intrigue, the network was only able to pull in one-tenth of 1% of the households that could receive its programming.

Schleiff tried to sell Robbins and other Cox executives on the turnaround that he was embarking on, starting with the showing of reruns of a hot off-network broadcast series, Homicide: Life on the Street.

But the message to Schleiff was: “Henry, we hear this from a lot of other networks about how great they’re going to be. So I trust you, but I need to see proof.’’

A year later, Court TV was being watched by four-tenths of 1% of households in prime time in the systems that still carried it. And Cox restored the legal drama channel to its lineup.

Such hard-nosed challenges to deciding what networks it would carry reached its zenith last year, when Cox — alone among major system operators — challenged the rate increases sought by the most successful of special-interest video channels, ESPN.

Sports titan ESPN was seeking 10-year agreements in which its rates would bump up 20% every year. Cox said no.

“This was really straightforward for us,’’ said Robbins. “Had we succumbed to the contract that ESPN was teeing up, we wouldn’t have had a business.’’

The fact that a cable company with 6 million subscribers would be willing to drop even the most golden of cable channels, if profits couldn’t outpace costs, sent a shock wave through the industry — and through ESPN’s executive staff in Bristol, Conn.

Instead of 20%, the two parties signed a contract calling for annual increases of 7% — a deal which is still “very, very expensive,’’ said Robbins. That would effectively double payments to ESPN by the end of the nine-year pact.

But it still would give permission to other cable companies — and Esser — to just say no when a programming network tries to steamroll an operator with steep price hikes. Even though he had acted alone, Robbins established that costs could be controlled. Robbins later would try to avoid being known “as the guy that put a stick in the eye of ESPN,” but regarded it as one of a “significant achievement’’ in his 20 years atop Cox’s managerial ranks.

Paying only for networks that could pay their way and taking on telephone companies, however, are only two of the imperatives that Robbins leaves with Esser. The third: Figuring out how to bundle services to customers at prices more attractive than any rival can offer.

THE BOOK OF CUSTOMERS

When Cox introduced voice services in 1997, it also introduced high-speed Internet access. And it introduced a concept that was radical at the time: the “triple play.’’

Robbins was trying to solve a relatively simple problem: How to fend off competition from satellite services. No rocket science was required to figure that you bundle together services that one-way satellite services can’t offer and do so at prices that you don’t think they can match — even if they find partners for phone and Internet services.

One pipe, three services, one low price. It was a tack that would have made Sam Walton proud. But it was obvious that the biggest praise it would get would be mimickry.

The idea behind the $99 bundle of phone, TV and Internet services — now commonplace among cable, satellite and telephone-company rivals — wasn’t to undercut competitors on price, in Robbins’s book. The point was to keep subscribers from defecting.

“Cox figured out earlier than anyone in the industry that battling churn was job one; that satisfied customers who were given a bundle of services were not just more profitable,’’ said Sanford C. Bernstein analyst Craig Moffett, “but a lot stickier.’’

Esser’s fundamental goal is to have every household in every market become “sticky” and subscribe to at least one service that his company provides. That could be television programming, telephone service, Internet access or, soon, wireless communications.

Increasing market share is critical to Cox growing under Esser, because the operator is purposely cutting back on the number of households it serves.

Under Robbins, Cox concentrated on buying and retaining systems adjacent to each other in major markets such as New Orleans or San Diego. But as Robbins exits, it’s paring back, selling off systems serving more than 940,000 subscribers in Texas, the South and California. That means Esser will be hard-pressed to achieve the economies of buying programming and equipment that Comcast Corp., with 20.5 million subscribers, or Time Warner Cable, with 11 million, can achieve. Or the profit that matches.

But Esser is confident Cox can still be profitable. And cable investor and analyst Paul Kagan, chairman and CEO of Kagan Capital Management, agreed. “You might be able to negotiate some better programming costs if you’re 12 million, than when you’re 6 million,’’ he said. But “I’m not concerned.”

In one sense, Esser’s strategic vision is simple tactical blocking and tackling. “We have a lot of capital invested in this business, in the ground. It’s fixed. I’m just improving the return on that capital, by connecting more homes in the market,’’ he said.

In effect, he figures there’s as much as 30% revenue growth, if he can get all households he passes to buy from Cox.

Getting 100% of homes passed to be customers is almost impossible to achieve. The Cox approach, by the Esser book, is to make life easy on new customers. Every service that it offers, from TV to data to voice, is handled by a single customer-service rep, a single technical infrastructure and a single truck roll.

To Esser, execution now is the name of the game, not vision, as it was in Van Valkenburg’s era two decades ago. He has, in fact, little time for strategizing.

He must fix his thoughts on the details of delivering on promises to customers. Elegantly put, Esser said he will be “more anal than Jim is.’’

He will have some protection in managing by excruciating detail. As he assumes the reins at Cox, he no longer has to worry about public shareholders. Parent Cox Enterprises paid $8.9 billion a year ago to take the cable business private, after its stock hadn’t moved past $30 a share for about two years.

Even if going private is “a sign that the [Cox] family is very, very bullish on the cable TV business,’’ as Daniels & Associates CEO Brian Deevy contends, Esser won’t have an easy task keeping Cox Enterprises or its CEO, Kennedy, happy.

THE BOOK ON ESSER

Instead of satisfying Wall Street analysts, Esser will have to explain his success or failure to the Cox family, particularly Kennedy. In private. Because, even though Cox has gone public more than once, there’s only one circumstance under which the cable operations will again be opened up to inspection by outside shareholders: “Me being dead,’’ said Kennedy.

That means Esser will be under the Cox family microscope, while fending off the emerging competition from Verizon, AT&T, other phone companies and the Internet video players. For the first time, cable companies will have competitors that have, as Van Valkenburg put it, “totally parallel products of video, voice and data’’ services.

This means Esser may have more freedom to make decisions that mean spending money now, for profit later. Expenses “you have to think long and hard about, if you’re public,’’ Van Valkenburg said.

But, perhaps more critically, Esser will be challenged to retain and incent his top talent. Cox’s success during the Robbins era also became its Achilles heel.

First, executives rarely move on, making it hard for younger managers to move up. Robbins was in place for two decades. Esser, who had been executive vice president of operations, cracked through this glass ceiling, but is not going to name a chief operating officer. Other executive vice presidents of operations — most notably Maggie Bellville in 2001 — have found the grass greener outside Cox’s verdant headquarters campus.

“Unless Pat gets hit by a truck, you’re not going to get over that,’’ said Van Valkenburg.

And second, now that Cox is private, there are no publicly traded shares of stock to offer executives as an incentive to stay on.

When last it was public, Cox overcame that problem by establishing an internal stock market and issuing shares that could be redeemed by top executives at a strike price set annually.

In time, that will take place this time as well, Esser said. Meanwhile, he must deal with the Pandora’s box that Robbins himself helped to open. He has to figure out how to differentiate Cox from constant attacks from phone, satellite and Internet rivals.

Indeed, more than one player will be offering the company’s signature “triple play” — or even “four-play,” when mobile TV and voice communications are figured in — of services, in every market where it plays.

“I don’t think any cable company is strategically safe today,’’ says David C. Andersen, a former Cox executive who is now a senior vice president at St. Louis-based cable operator Charter Communications Inc.

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