SBC's Serious Now

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Struggling to preserve its eroding local telephony base, SBC Communications Inc. made a move to offer its own triple play of voice, video and data services, striking a deal with EchoStar Communications Corp. to provide satellite-delivered video to customers in 13 states.

The deal, an exclusive one for SBC, will enable the San Antonio, Texas-based regional Bell operating company to offer the full product bundle of voice, video and data, and could put a serious dent in high-speed data offerings from cable companies.

While SBC has been one of the more aggressive RBOCs on the high-speed data front — it has dropped promotional pricing for its digital subscriber line service as low as $25 per month in some markets — many analysts saw the move as a means for SBC to protect its lucrative local telephone base.

Since 2000, SBC's network-access lines have declined from 61.2 million to about 56 million today.

While past agreements between direct-broadcast satellite service providers and regional Bell operating companies have come and gone unsuccessfully, the players this time say this deal is different.

SBC will co-brand the service — dubbed SBC Dish Network — and will manage the joint venture, enabling customers to place their orders, arrange for installation and activate service with a single phone call. In addition, customers would receive a single bill for their television, telephone and high-speed-data service.

In return, EchoStar gets another sales channel in some of its most deeply penetrated markets for little or no cost. As part of the deal, SBC has agreed to invest about $500 million in the No. 2 DBS provider, in the form of a 3% convertible note, due 2010, that is convertible into 6.87 million shares of EchoStar common stock at $72.82 per share.

EchoStar chairman Charlie Ergen, in a conference call with reporters, used fast-food analogies to describe the deal, likening EchoStar to The Coca-Cola Co.

"If you can imagine that we're Coca-Cola and we've been selling Cokes in cans and bottles in grocery stores," Ergen said, "we're now strategically taking a step beyond that and saying we're willing to sell the syrup. And [SBC has] a lot of flexibility in how they sell that syrup in their value meals, whether they sell it in a small-, medium- or large-sized cup."

But the EchoStar chairman quickly got serious, adding that the SBC deal is a crucial part of its strategy.

"We want to continue to improve our product, particularly as it relates to our cable competitors, because they have done a great job in the past two or three years improving their product," Ergen said on the call. "We can't stand still."

The deal is equally important for SBC, which has seen its lucrative local telephone service base erode as cable operators gain market share with their own cable-based telephony offerings.

Targeting Cox

One of the most aggressive MSOs on the telephony front has been Cox Communications Inc., which has about 783,000 digital telephone subscribers in its markets. About 40% of Cox's customer base is in SBC territory.

In a conference call with reporters, SBC chairman Edward Whitacre made no bones about SBC's newfound clout once the agreement takes effect next year.

Although Whitacre wouldn't not specify how many telephone customers SBC lost to Cox — "It was more than we would like," he said — but he added that gaining a video product makes the playing field more level.

"This puts us on equal footing with Cox," Whitacre said. "We'll be able to offer a video product and be a strong competitor with them."

Cox doesn't release telephony subscriber numbers for specific cities, but as of March 31, it had 103,416 digital telephony customers – a 33.4% penetration rate – in Orange County, Calif., another SBC market.

Cox spokeswoman Laura Oberhelman said while Cox takes the SBC/EchoStar alliance seriously, it poses no serious immediate threat.

"Their announcement indicates they savor our strategy," Oberhelman said, "While we do take this seriously, it really doesn't change our strategy."

While SBC is expected to offer significant discounts to attract video customers, Oberhelman added that Cox would not be roped into a price war in its SBC markets or anywhere else.

"History shows we've never competed on price," Oberhelman said. "We provide the consumer with the best value."

Others exposed

And it's not just Cox that could take a hit. Credit Suisse First Boston analyst Lara Warner said that aside from Cox, Insight Communications Co. and Charter Communications Inc. have the highest exposure to the SBC-EchoStar deal. Warner estimated that about 65% of Insight's homes passed and 52% of Charter's homes passed are in SBC territory.

While Charter has a limited telephony offering — it is testing voice-over-Internet protocol in Wisconsin — and Insight offers an AT&T-branded service in several markets, Warner said the bigger threat may be in the loss of video and high-speed data customers.

"Wider distribution of Dish product does not bode well for the cable industry," Warner wrote in a report. "Historically, EchoStar has operated with two primary distribution channels — retail and direct. The relationship with [SBC] brings a third, equally dangerous distribution channel."

Investors also appeared to see a clear threat, driving Cox stock down $1.30 per share to $31.90 on July 21, the day the deal was announced. The stock continued to slide in subsequent trading, down another 33 cents, to $30.99 per share in 4 p.m. trading July 24.

The rest of the cable sector seemed to weather the deal pretty well. While most cable stocks dipped during the week, there were no dramatic downturns, mainly because investors were a bit skeptical as to how the deal would affect high-speed data subscriber addition rates.

How much hit?

There are still several questions remaining surrounding the deal, especially involving costs. While SBC is expected to offer video service at a significant discount, several analysts wondered how much of a hit the RBOC is willing to take.

Warner estimated that if SBC collects $50 per month in gross revenue and passes on $20 in programming costs and $12 in fees to EchoStar, it would net about $18 per month in revenue.

But with video's subscriber-acquisition costs at about $400, Warner estimated a 22-month payback period for SBC in start-up costs alone.

But not all analysts saw the agreement as being bad for cable. Banc of America Securities analyst Doug Shapiro cited the many times RBOC-DBS alliances were announced and came to no avail. And Shapiro also wondered if the joint venture would cut into EchoStar's customer base.

"Is EchoStar economically indifferent between a wholly-owned subscriber and an RBOC-owned sub?" Shapiro asked in a research report. "If not, then to some degree the deals could cannibalize EchoStar."

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