Theres Still Gold in Rural Cable Systems

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When Rifkin & Associates Inc., the Denver-based cable
operator, opted to sell about 400,000 of its subscribers to Charter Communications Inc.
earlier this year, many people thought it was a good deal.

But when the company said it would keep about 100,000
subscribers in its R&A Management LP subsidiary -- mainly in small markets scattered
about the country -- many in the industry may have been shaking their heads in disbelief.

Although R&A's decision to continue to operate in
smaller areas flies in the face of the current cable strategy of metropolitan expansion,
Rifkin believes the tactic can make a pile of money in second-tier markets. And he is not
alone.

Fueling R&A's decision to concentrate on secondary
markets was its experience with customers in small systems – they want the same
services as people in larger cities and they're willing to pay for them.

R&A's systems run the gamut of the cable universe: some
have as many as 60,000 subscribers, others as few as 100 customers.

"We really believe very strongly that we can make
small markets look big," said R&A president and chief operating officer Jeffrey
Bennis. "The appetite is very strong for new services – digital, broadband,
fiber things."

Bennis added that small markets are especially hungry for digital services, with
first—year penetration levels reaching 20 percent to 25 percent in some markets.

"That generates $20 to $25 in incremental revenue per
customer," Bennis said. "With the new digital overlay system from HITS [AT&T
Broadband and Internet Services' Headend In The Sky], you're able to take digital into
just about any system."

At present, Bennis said, digital is limited to systems with
at least 3,000 subscribers. However, the company is working to bring digital to operations
with 1,000 or fewer customers.

Key to that strategy is being able to connect different
systems together with fiber optics, Bennis said. Operations can still be interconnected
even if they are not directly adjacent to one another, he added.

"If we're in West Virginia and we have 10 systems,
we're going to try to connect them," he said. "If there is a system between us,
we plan on connecting with fiber between them."

R & A vice chairman and chief executive officer Kevin
Allen agreed, and added that the cost of interconnecting headends is declining.

"The technology is moving our way," Allen said.
"Interconnection is a critical piece and the cost of interconnection is coming
down."

In the past, Rifkin has focused on markets that need
upgrading, and its subsidiary's strategy is no different. The company said it looks for
systems that need some work and have a customer base starved for advanced services.

And though it would seem like lending institutions would
balk at financing upgrades for small systems, the opposite appears to be true, Bennis
said.

"We think the banks bought into the rural market
opportunity very aggressively," Bennis said. "They see the potential there and
they don't see a huge amount of risk. There is a very, very aggressive bank market out
there lining up to do deals."

And though the banks see opportunity in small-market cable
systems, they don't lend to just anybody. The first thing they look for is a solid
management team, said Bennis. Next is a sound business plan and a solid core customer
base.

Bennis said it is R&A's goal to grow the business back
to its original 500,000-subscriber level.

"We'd like to look at 500,000 customers or more,"
Bennis said. "They don't have to be contiguous. The better clustering we can get
helps the broadband philosophy, but we're not going to be daunted by the number of
regions."

Allen also alluded to the possible purchase or creation a
telephone company, which would provide local and long distance service to a wide swath of
R&A customers.

"We're going to look at any and all
opportunities," Allen said. "This management team is too young to sit on the
beach. We're looking at all the opportunities to put together another platform, whether
that be building [cable] plant, becoming a CLEC [competitive local exchange carrier] or
buying a CLEC."

But small markets are not always a bargain, especially in
the deal climate of the past few months, where cable valuations of $4,000 per subscriber
or more are becoming commonplace. Deals of that size are also beginning to creep into the
smaller markets.

A prime example of that was Cox Communications Inc.'s
purchase of midsize Tyler, Texas-based operator TCA Cable TV Inc., in a deal valued at $4
billion in cash, stock and debt. That works out to about $4,115 per subscriber.

The list of smaller MSOs continues to shrink, with two
recent deals by Charter Communications Inc. Charter agreed to purchase Los Angeles-based
Falcon Communications LP in a cash, stock and debt deal valued at about $3.6 billion. The
same day, Charter also reached an agreement to buy Fanch Communications in a transaction
valued at about $2 billion.

Deals of that magnitude can also drive up the price of
smaller MSOs, a fact not lost on Bennis. And though large deals tend to boost the price of
small markets, Bennis said, there is a big difference between what a company should pay
for a large operator and a small one.

"Small markets differ from a valuation standpoint in
that the ability to get in there with new services costs a fortune," Bennis said.
"It takes a vision to spend many multiples of capital [on upgrades] over several
years. You've got to believe the customer is going to be there."

Despite the higher prices, however, Allen said lenders have
not shied away from the market, mainly because most of these larger deals are not debt
financed.

"The bet has really been an equity bet," Allen
said. "The people who are paying high prices are paying them with their own
stock."

And though finding financing is not difficult, operating a
patchwork of rural systems is not an easy task. It takes a special kind of operator -- one
schooled in the management technology of the day.

Operators can't figure out how to run a series of small
systems on the kitchen table, as was the case 30 years ago – what's required is the
help of computer systems and software that even the big boys use.

Mediacom LP chairman Rocco Commisso is a firm believer in
the future of small operators. And he has to be, since small cable systems have been his
bread and butter since he formed the company in 1996.

Mediacom, a Middletown, N.Y.-based MSO with about 725,000
subscribers, has concentrated on second-tier markets with great success. The company also
has been in an acquisition mode -- it purchased Triax Communications LLC in April for $740
million -- and continues to look for appropriate properties.

Commisso said his criteria for a potential acquisition
target may differ from the larger operators, but not by much. While Commisso is willing to
buy systems that need a capital infusion to upgrade, he isn't willing to pay a lot for
them.

The Triax acquisition, which worked out to $2,100 per
subscriber, was the largest in Mediacom history. However, Mediacom generally pays less
than $2,000 per subscriber for most of its buys.

At the top of Commisso's list is the ability to
interconnect headends between nearby systems.

"With 500 subscribers per headend, you can't do very
much," Commisso said. "You can't do digital, telephony, or high-speed data
because the fixed costs are so significant. But if you can interconnect headends to where
you have 5,000-, 10,000-, 15,000- or 20,000-subscriber clusters, there's no difference
between small and large markets other than demographics. What's the difference if a
consumer pays $30 in Missouri as opposed to $30 in Westchester County [N.Y.]?"

Next, Commisso said it is vitally important for a small
operator to invest in upgrading cable plant -- fast.

"It all comes down to speed of execution," he
said.

He used a system the company has in Kentucky as an example.
Within 18 months of buying the property – which had a trap system with no
addressability – the system is now at 750 megahertz, is addressable, and offers
digital and pay-per-view service.

Commisso agreed that the recent deal frenzy has driven up
prices for small systems as well as larger ones. But Mediacom will not get wrapped up in
the fray. "We're very disciplined," he said.

Waller Capital Corp. senior vice president Joseph Duggan
said that although the prices are getting higher, there are still opportunities for
smaller operators.

"I'm not sure there is a huge difference in buying
power among any of these systems [small and large]," he said. "And I'm not sure
you're going to see a fall-off in the take of services [in smaller systems]. They still
want the Internet in Paducah."

But the way to make a small system profitable is to run it
almost like a large MSO – cluster markets where you can, take advantage of
efficiencies like consolidating headends and offer as many advanced services as is
fiscally possible.

Duggan added that of the utmost importance is making sure
that the management systems in the operation are as up to date as possible.

"[Fanch Communications chairman] Bob Fanch was a guy
who always impressed me," Duggan said. "He could track the number of headends in
his systems with a simple [computer] keystroke. He had a [computer] profile on every one
of his systems. If you're doing quantity ordering, checking channel lineups, you have to
use modern management information and control systems to do it."

One thing that most of the successful small operators have
in common is a low amount of debt. And that's for a reason – highly leveraged
companies can't put a lot of money into capital improvements and expect to get a decent
return.

But the advantage for a rural system is that upgrading
doesn't necessarily mean going to 750 megahertz, two-way. For a lot of rural systems, 450
megahertz is more than enough.

While that may contradict the current trend in the industry
to upgrade to provide advanced services and telephony, many rural systems can do the same
simply by partnering with other providers for Internet and telephone services. And with
AT&T Broadband's HITS service for small systems, digital services can be a reality for
even the smallest operations.

Despite the affordability of HITS service, smaller markets
face a strong competitor in direct-broadcast-satellite services like DirecTV, which can
offer small market customers hundreds of channels at a relatively low price. But Duggan
said if an operator can provide a decent number of cable channels in conjunction with
local broadcast channels, they will be able to capture a big enough share of the market.

"Local news is very important – watching the
Denver off-air station is just not going to do it for them," Waller said. "What
[small cable operators] are losing to them is growth. Small operators have a tough time
getting under 15 homes per mile."

Allen, agreed, adding that an operator with a modern system
with good customer service has little to fear from DBS.

"Once you get to 60 channels, we see the competitive
advantage of DBS go away," Allen said. "They [DBS] are not going to have local
channels, data and other services. Initially you saw more DBS in poorly cabled areas or
areas that were completely uncabled. The way we look at it, our rebuild plans are pretty
staggering. You can't sit on a 35-channel system any longer."

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