Something Else That’s Cool About DVRs

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Digital video recorders have long been thought to be a key arrow in the quiver of cable operators battling to win subscribers from satellite-service providers. But the high-tech boxes have another role, according to an analyst report released late last month: cash cow.

While some investors have worried that the additional capital required to launch DVRs — which can cost upwards of $200 more than a traditional cable box — would cut into an MSO’s ability to generate free cash flow (cash flow after capital expenditures and interest payments are made), Sanford Bernstein & Co. cable analyst Craig Moffett said in the report that the costs were more than justified.

44% MARGIN

According to Moffett, DVR boxes can bring in annual returns on invested capital of as much as 44%.

That’s still short of the 80% margins that some operators enjoy from high-speed Internet service, but it is comparable to the 40% returns that most MSOs expect from voice-over-Internet protocol telephone service.

In his report, Moffett said that with the tax benefits of purchasing DVRs — operators can recover a federally mandated 11.25% return on undepreciated capital for such capital expenditures — MSOs could recover 60% of the cost of each box without even charging for the service.

Add the $9.99 monthly revenue from DVR and the return soars to 44%, Moffett wrote. At a $4.99 monthly rate, the return is still a healthy 17.6%.

And not charging at all for the service represents a cost of just $35 per subscriber — a manageable cost.

Capital expenditures will increase for DVR boxes, but for the most part it will have little effect. Moffett estimated that if Comcast decided tomorrow to roll out DVR boxes to 10% of its digital subscriber base of 8 million customers (which would be extremely aggressive), it would only amount to about $160 million in additional capex.

“It’s not a break-the-bank capital investment,” Moffett said.

TIME WARNER IN THE LEAD

Several cable operators have either started rolling out DVRs or have expressed plans to do so. So far, the most aggressive operator has been Time Warner Cable, which had 458,000 DVR boxes in the field at the end of the first quarter — roughly 10% of its digital customer base.

Other MSOs that have rolled out DVRs, albeit at a less aggressive pace, include Comcast, Cox Communications Inc., Charter Communications Inc. and Insight Communications Co.

Mediacom Communications Corp. began launching DVRs in April, and expects them to be available to 70% of customers by the end of the third quarter and 90% by year-end.

Comcast would not release DVR customer numbers, but has rolled the product out to 35 markets since November 2003.

Charter began launching DVRs in December and currently has the product — via both S-A and Motorola set-tops — in 17 markets. Charter is charging $9.99 per month for the service, available only to digital-cable customers, for either a standard DVR box or an HD/DVR box.

Charter corporate director of marketing and new products Page Shaper would not release DVR subscriber figures, but said take rates for the product have been good. While it still may be too early to determine the ultimate churn-reduction impact of DVRs, she added, so far results have been positive.

“DVR boxes are obviously more [costly] than the digital set-top box,” Shaper said. “We expect them to pay back through increased customers and reduced churn.”

USEFUL LIFE IS KEY

Key to the ultimate return of the DVR boxes is the useful life of the equipment. While most computer hard drives last about three years, several cable operators have estimated that DVR boxes embedded in set-tops will last five years or more.

Whether a box will run out of storage space is more of a concern than whether the hard drive will wear out mechanically.

Charter said it has solved that problem, at least temporarily, by including a port on the side of the set-top box that allows for the addition of an external hard drive.

“We haven’t had an issue with hard drives failing,” Shaper said. “It hasn’t been a concern for us.”

Cox began rolling out DVRs last year in four markets and was expected to expand the service to another four by the second quarter. In the first quarter, Cox said it added 75,000 DVR and HDTV customers.

According to Cox vice president of product marketing and management David Pugliese, of those DVR connects in the period, 65% were upgrades from existing digital subscribers and 35% were either upgrades from analog service (11%) or new cable customers (24%).

So why aren’t operators shouting these returns from the rooftops? It is more an issue of equipment availability than anything else, Moffett said in an interview.

So far, only Scientific-Atlanta Inc. has made dual-tuner DVR set-tops widely available. Motorola Inc., which showcased its dual-tuner DVR at the National Show in early May, has been slower to make the boxes available.

INVENTORY ISSUES

Moffett said that the Motorola DVR set-top is likely a third-quarter product for most MSOs.

“It’s simply an operational issue,” Moffett said. “They’ve had to wait for Motorola boxes to be available.”

Time Warner, which mainly uses S-A boxes in its systems, has been rolling out dual-tuner DVR set tops for about a year. So far, Time Warner claims, about 10% of its digital customer base has DVRs.

“This is a phenomenally attractive service,” Moffett said. “And unlike any other offering, there are no variable costs associated with DVRs.”

Moffett added that contrary to popular belief, DVR service should compliment video-on-demand, rather than take customers away.

“Video-on-demand is much more capital-efficient, because it’s a shared resource,” Moffett said. “The tendency is to view video-on-demand and [DVRs] as if they are a substitute for each other. But it’s not at all clear that customers are going to see them as a substitute.

“You could argue that customers who have a [DVR] will become increasingly demanding of content being available when they want it anytime of day or night,” he added. “That’s exactly the customer for whom video-on-demand has the most value.”

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