Economics of Digital: Not Everyones Sold

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Determining the real cost of a digital set-top isn't
as straightforward as it used to be.

As recently as a few years ago, equipment-buying patterns
were fairly predictable, but that's not the case these days.

Two weeks ago, Tele-Communications Inc. struck a
complicated deal with BankAmerica Corp. and Intuit Inc. that could yield the MSO subsidies
of as high as $50 per installed box.

And other partners that want to lock up exclusive space
inside TCI's "walled garden" of interactive services that run on
advanced-digital boxes are also expected to pony up box-subsidization cash.

Plus, TCI potentially owns 18 percent of its primary
hardware supplier, General Instrument Corp. And the 15 million-unit order that TCI placed
with GI stipulates a declining price each year, based on cost savings associated with
silicon integration. The boxes that TCI takes in 2000, for example, will cost the MSO $260
apiece, and not $300.

"So the weighted, volume price really comes down very
nicely in a year where deployments potentially reach ubiquity," said John Malone,
chairman and CEO of TCI, at the company's recent analysts' meeting in Denver.

Malone described an economic model for the forthcoming
advanced-digital set-tops that earns about $22 per household in incremental revenues.

From that -- and ignoring the capital costs of the boxes
themselves, because they will likely move to an off-balance-sheet model -- Malone
subtracted cash expenses per household to come up with a per-household revenue figure for
digital services.

The expense side came to $5.75 per digital household in
incremental expenses:

• $3.80 in "intercompany" costs, meaning
costs paid to TCI's "family" for the electronic program guide, for
programming from Headend in the Sky, for satellite-signal delivery from the National
Digital Television Center and to programmers in which TCI has affiliate interests, Malone
said.

• Malone also subtracted $2.20 in fees paid to
"Hollywood" for the use of pay-per-view movie and event titles. Another 47 cents
went to outside costs, "so that the only money that flows outside of the TCI empire
is that 47 cents per month," Malone said.

Subtracted from the $22 per household earned in revenues,
"that's damn near a doubling of cash flow for the average customer," Malone
said.

Malone's economic model is what is driving the
MSO's aggressive digital-video-launch schedule, which is targeted to serve up to 1
million TCI customers this year.

But other MSOs -- even those that signed on as part of
TCI's sweeping, 15 million-unit deal with GI earlier this year -- aren't
convinced.

At least two of the nine MSOs involved in the GI deal
privately said that they weren't pleased with what they called "GI's
blue-light special," when they were given 12 hours in December to decide whether or
not they wanted to get favorable pricing on advanced-digital set-tops in exchange for
agreeing to take equity warrants in GI.

And some just don't like the economic model that is
facing them.

Carolyn Crawford, executive director of investor relations
for MediaOne, is among them.

During a briefing to financial analysts in Vail, Colo.,
last month, Crawford said the reason why MediaOne is sticking with advanced-analog
set-tops for the bulk of its systems is because of the cost of the boxes.

"The cost of a digital set-top box is nearly three
times that of an enhanced-analog one," she said, adding that most high-end customers
want three set-tops, or $1,200 worth of gear, at a $400-per-box cost.

"The return [on digital set-tops] is measured in tens
of years," she said.

Because of that, MediaOne has not shifted its plans toward
heavy use of digital video.

"Our revenue per customer is at parity with [revenues
from] digital offerings over cable," Crawford said. "With digital, we're
faced with spending $300 or $400 to get a $10 lift [in revenue], versus spending $150 for
an enhanced-analog box."

That's why MSOs other than TCI -- which are also
further ahead on 750-megahertz upgrades that enable them to offer 110 analog channels --
are not deploying digital video quite as quickly, she said.

Crawford did say that digital video will be economically
feasible someday -- especially when advanced features like e-mail and Web surfing are
available, and when the cost per box falls below $200.

"Then, we may have a different equation to look
at," she added.

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