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PCs vs. TVs in the 21st Century

Companies are investing to deliver consumer broadband applications as the technology's penetration grows. But expectations about the industry's development aren't a good enough guide to the future.

    Residential broadband access was slow to take off, but companies are making major bets on building broadband applications to reach all those potential customers.

    The technology and its potential uses have been the main points of interest to date, but now companies need a realistic view of the economics that underlie broadband applications, the ways those applications will affect the industry?s development, and the size of the opportunities likely to emerge over the next few years.

    Some long-cherished beliefs--such as the idea that broadband would finally bring about the convergence of PCs and TVs in a single device--will be dashed. Companies have been trying to combine the two for years, and broadband added an even more appealing logic: As high-speed, always-on connections spread, one type of screen would be as good as another for viewing entertainment. Consumers, the thinking went, would favor the PC for its processing power, so PCs, in addition to handling e-mail, Internet access and routine computing tasks, would also become the way to access entertainment.

    Convergence, though, isn?t a possibility in the medium term. That much became clear from our analysis of the underlying economics of broadband applications, work with clients and interviews with applications providers and technology vendors across the broadband industry, as well as from a look at consumer behavior patterns and the capabilities of each technology. Instead, the competitive dynamics are so dissimilar that two dramatically different markets will coexist over the next few years for companies that develop and distribute broadband applications.

    Broadband nonetheless is poised to create many opportunities for providers of consumer applications.

    Streaming video is one application that really does offer a chance for
healthy revenue. Moreover, our findings point to quite different economics for the applications available on PCs and TVs, respectively, and for the companies that bring these applications to consumers. Companies offering interactive-TV applications are likely to reach profitability quite rapidly as TVs become more than simple receivers. Providers of PC-based applications offered over the Internet, by contrast, face open standards, high costs and consumers who are not used to paying for content. Depending on the platform and the complexity of the application, some companies will need to seek partnerships.

    The variety of broadband applications that will work well with PCs ranges from streaming audio and video to gaming, unified messaging, enhanced file sharing and virtual models and tours.

    Streaming video is one application that really does offer a chance for healthy revenue. PC users can watch a video clip, a movie or a live event and participate in two-way events such as videoconferencing and distance learning by connecting to a host World Wide Web site. Current adoption rates and new-technology launch rates, as well as evidence that interest in streaming doesn?t wane among users, suggest that the number of people who regularly stream video in the United States will reach 84 million by 2005.

    Users will contribute only about one-sixth of that revenue through subscription or pay-per-view fees. We estimate that just under half of the revenue will come from advertising. Much will be derived from familiar banner ads, but rich-media advertisements will play a role as well. An additional $2.3 billion will come from corporate sponsorship and the balance from commissions on consumer e-commerce transactions.

    Gaming is already big business. In 1999, people in the United States spent about $7 billion on PC and console game software--roughly the amount they spent on first-run movies. Gaming will continue to succeed across platforms, but it is online, PC-based gaming that will really benefit.

    What is more, broadband will promote new revenue models and approaches to distribution--for example, Web-based game portals, which allow users to play, either alone or with others, a host of games online, ranging from straightforward parlor card games to three-dimensional action extravaganzas. Because these new games run on the Web, they are available on impulse; no up-front software purchase is needed, and users can be charged on a pay-per-play or subscription basis. Electronic Arts and Sony have both demonstrated that a subscription model can succeed on the Web. The net result: Gaming should expand to a mainstream audience comprising more than 70 million users over the next four years and is likely to generate broadband-specific revenue of $2.8 billion in 2005.

    As communications devices continue to proliferate, unified messaging could be another winner. The extra bandwidth allows customers to get all their messages in a single mailbox. Messages can be collected together on a Web site accessible from any Web-ready device or delivered through voice telephony. This application requires a high degree of coordination among a number of different devices, so it thrives on the Internet?s open standards. The number of these mailboxes around the world is expected to rise to 100 million by 2005, generating revenue of $9.5 billion, according to the analyst company Ovum.

    Finding the profits
    However appealing these revenues look, profits will remain elusive over the next two to three years. The main culprit is the cost of bandwidth and hosting, driven by the volume of data transmitted and therefore far higher for broadband applications providers than for their narrowband counterparts. A PC-based applications provider must pay for the cost of distributing content from its Web site all the way to each user?s PC. Applications companies tend not to own a distribution network, so they generally need to buy bandwidth from third parties and have little control over prices.

    Gaming should expand to a mainstream audience comprising more than 70
million users over the next four years. Bandwidth and hosting costs have a particularly dramatic effect on providers of streaming video, which uses a great deal of bandwidth. Given current revenue expectations, a streaming-video provider can go out of business offering popular content unless the provider can obtain a bandwidth cost below one cent a megabyte.

    Furthermore, broadband applications are generally more expensive to develop than narrowband ones, so designing applications to take advantage of broadband?s power makes sense only when they are likely to reach a larger number of users. One leading PC-gaming company estimates that it needs an installed base of 15 million of them to create broadband-based games profitably.

    Finally, the notorious reluctance of Internet users to pay for anything is proving a difficult legacy to shed. Most companies trying to generate revenue with PC-based broadband applications are likely to have great difficulty creating revenue streams from sources other than advertising and e-commerce. Although these revenues do tend to be higher for broadband than for narrowband, they are not high enough to cover the increased costs.

    Such challenges notwithstanding, several kinds of companies are now in a position to make investments without too much risk.

    Large players such as portals are in a better position to negotiate for low-cost bandwidth because of their high volumes, and that may allow them to support heavy use of streaming video, generally in partnership with a video producer or content owner. Companies that own niche content are in a strong position, too. Narrowband Internet users already pay for some content, mostly at adult and gaming sites, and the better quality of broadband delivery will greatly increase revenues for providers in those fields.

    Finally, companies that own distribution networks can use their infrastructure to deliver high-bandwidth services at significantly lower cost than standalone competitors could offer. They also have existing customer bases to which they can supply services such as unified messaging or game-portal access--at little extra marketing cost to themselves.

    Companies without these natural advantages should be a little more circumspect, entering the market for PC broadband applications only when break-even scale seems within reach, some costs drop and it becomes easier to discern what customers will pay for.

    Interactive TV
    To a large extent, interactive-TV applications utilize television?s broadcast stream. Technologically, many interactive-TV applications are tightly tied to the video offerings of cable and satellite providers. These providers also benefit from the fact that, by definition, they have installed networks connected to each user?s television. Early trials and consumer research have consistently revealed a high latent demand for interactive-TV applications.

    Early trials and consumer research have consistently revealed a high
latent demand for interactive-TV applications. Applications written for interactive TV offer consumers several new options which are generally variants of narrowband counterparts. Some of these applications help navigate or supplement the broadcast stream. Other applications, such as video on demand (VOD), will give viewers greater control over what they watch, and when. Movies on demand are likely to prove popular, too, since many major movies and other events aren?t legally available to Web sites and, because pay-TV providers offer a much higher-quality picture and sound, and enjoy better economics and existing relationships with movie producers.

    Any large cable operator has enough installed bandwidth to offer VOD, and the cost of adding these capabilities is low. VOD also creates value and differentiates cable operators, even if its ability to boost revenue is limited because it can cannibalize pay-per-view and movie channel profits. The chief advantage is that a VOD offering will reduce the number of customers who change providers.

    Another kind of application, known as a "walled garden" (described below), is already providing Europeans with a controlled, secure alternative to the Web. In December 2000, BSkyB?s walled garden, Open, reported that it had upward of 2.5 million weekly users, representing more than half of BSkyB?s digital customer base of 4.7 million.

    The greatest potential for creating value with interactive-TV applications, though, is likely to come from enhanced broadcasting, an application that lets viewers request a rate quotation while watching an insurance ad, or watch a music video and in a few clicks order the compact disc.

    Enhanced-broadcasting applications can offer advertising, retail and fee-based revenue streams. Broadcasters can use games simply to increase ratings or offer games on a subscription or pay-per-play basis. Moreover, interactive content can be a very economical direct-marketing approach. The cost of creating basic interactivity can be as low as $10,000 per advertisement. Network operators and third-party providers will charge advertisers additional fees for enabling interactivity and processing consumer responses, and though no fixed model yet exists, a pay-for-performance arrangement is likeliest to emerge.

    Such enhancements could generate advertising revenue that could reach more than $80 annually for each enabled household. The matter of how the collaborators will share that revenue has yet to be worked out. What is clear, however, is that all other players rely on the pay-TV network operators. The challenge for these companies will be to cut the right deals for themselves early, so that they will be well positioned when the penetration of enhanced broadcasting begins to reach scale.

    Viewers already spend up to 15 minutes a household looking at straightforward electronic program guides on cable and satellite networks. Given how much use the guides get now, when broadband allows them to include advertising and commerce, they could generate incremental revenue for network operators of as much as $22 a household by 2005.

    Finally, walled gardens--proprietary TV-based portals that offer access to selected commerce, communications, gaming and information applications on a system controlled by pay-TV network operators--are already generating revenue in Europe. Early entrants include Canal Satellite and TPS Interactif in France and Open in the United Kingdom. Network operators set up, control and support walled gardens and are thus in a position to capture sizable revenues from several sources. Most walled gardens are still in the early stages of their development and therefore lack a revenue track record, but their initial revenues and the high customer satisfaction they have generated lead us to believe that they will have revenues of $3.9 billion in the United States alone by 2005.

    Network operators
    The lion?s share of the profit from interactive-TV applications is likely to go to a few large players as long as operators can exercise full control over the interactive content being offered to their customers.

    The challenge for these companies will be to cut the right deals for
themselves early. In large part, the network operators have an advantage in gaining revenue, because interactive-TV applications such as enhanced broadcasting are tightly linked to the network infrastructure. But network operators also have strong overall economic and logistical advantages. Regular subscription-TV service gives network operators a beachhead in consumers? homes. And all content that appears on a consumer?s television must pass through the network operators? infrastructure, providing a steady revenue stream for pay-TV service while interactive-TV applications are being developed. That revenue will allow most network operators to subsidize the cost of more-expensive interactive-TV-enabled set-top boxes.

    Those are just some of the advantages that will allow interactive-TV applications to reach profitability earlier than PC applications do. Network operators can also leverage existing payment standards, using billing systems that are already familiar to consumers. Furthermore, the integrated economics, revealed through an analysis of the individual applications, shows that cable operators are well positioned to extract some combination of rents, commissions and fees from any partners they allow onto their platforms. It is important, however, to note that the incremental cost of advanced set-top boxes requires operators to commit themselves to launching a number of interactive-TV applications to achieve positive returns.

    The non-network partners necessary for many interactive-TV applications will find that they have the most clout now while offerings are still being developed. Operators of new walled gardens are aggressively seeking to partner with the retailers and the financial institutions that have the strongest brands in their areas of coverage. Within four years, people in countries that have broadband infrastructures will be living with a range of applications that are going to change the mass-media experience and economics of PCs and TVs. For now, the advantage lies with broadband television, particularly the network operators, which have proprietary infrastructures and large-scale customer relationships on their side.

    For more insight, go to the McKinsey Quarterly Web site.

    Copyright © 1992-2001 McKinsey & Company, Inc.