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Reprogramming European cable

McKinsey experts shine a spotlight on the dire straits of European cable companies. The problem is not just debt--that's bad enough--but a strategy that has resulted in widespread problems for an entire industry.

Europe's cable operators are undoubtedly suffering. After borrowing heavily in the mid-1990s to roll up small players and upgrade digital systems intended to help them sell bundled services, they now find themselves counting losses rather than the profits they expected. The industry's "triple-play" bet--that customers would jump at the convenience of buying television, Internet and telephony services from a single provider--hasn't yet paid off, for consumers have failed to summon enough interest to make it succeed.

Not surprisingly, attention has focused on the operators' enormous debts. NTL, a U.S. company that is Europe's fourth-largest operator, declared bankruptcy in May 2002, exchanging $10.6 billion of debt for equity and wiping out its equity holders. United Pan-Europe Communications, Europe's third-largest operator, defaulted on its bond payments and was delisted from Euronext (the combined stock exchange of Belgium, France and the Netherlands) when its debt exceeded its shareholder equity. Ish, a German cable operator, has filed for Chapter 11. These are just a few of the many companies across Europe that are struggling. But merely restructuring this debt won't get them out of their predicament. The problem is strategy.

To survive, companies must create new business models for themselves quickly. Under current conditions, many of them should consider dropping the monopoly-operator system (common in Europe and the United States), which excludes other service providers from their networks, and follow the lead of mobile-telecom operators and ISPs by sharing networks. Sharing, mobile-telecom companies have found, increases the size of the total market, lowers the costs of the operators, improves their use of capital and spreads risk. It could do the same for cable operators.

During the dot-com boom, European cable companies were far from alone in believing that consumers would quickly adopt digital services and welcome the convenience of the triple play. But this wasn't their only illusion. They also thought that capital spending would decline swiftly once the networks were upgraded and that service and installation costs would remain stable. The result, they supposed, would be rapidly expanding operating margins that offset the debt incurred both to fund the upgrades and to fuel the consolidation inspired by the pursuit of economies of scale. Faith in the triple play's potential kept cable operators investing, even as capital expenditures and the associated debt for network upgrades--new set-top boxes, IT systems and digital products (from premium programs and television shopping to interactive games)--rose beyond anyone's expectations. Yet a cash-flow analysis reveals how little promise the triple-play strategy has in today's market conditions.

Current realities
Cable operators now serve 60 million customers in Europe and generate more than $9.84 billion (10 billion euros) in annual revenues. But most of the major operators have a negative cash flow--a state of affairs that wouldn't end even if all debt and spending on network upgrades were eliminated.

Admittedly, the triple-play approach does better in some European markets than in others. Each market can be placed in one of four clusters, delineated by the extent of the market's cable networks, the level of subscriber penetration, the average revenues per customer, and the competitive and regulatory environment. But no matter where cable companies operate, the triple-play strategy they have pursued is unsustainable. With two of the clusters as examples, this business model fails on a cash basis: The cost to companies of maintaining their current triple-play customers and of acquiring new ones exceeds the revenue from existing customers. In other words, every marginal customer is unprofitable.

The industry's "triple-play" bet--that customers would jump at the convenience of buying television, Internet and telephony services from a single provider--hasn't yet paid off, for consumers have failed to summon enough interest to make it succeed.

The problem is that the market hasn't developed as expected. On the revenue side, the triple play requires average monthly receipts of roughly $30 to $100 per customer, depending on the cluster, to be profitable. But so far companies have earned only 9 euros to 15 euros across most of Europe; the highest figure, in the United Kingdom, is 60 euros per customer. While some companies continue to hope for more, recent history suggests that they do so in vain: The take-up rates of broadband, cable telephony and premium television services, such as special sports and movie channels, all have been disappointing.

When European companies planned their expansion into digital television, they saw the United States as the only market large enough for comparison. Although U.S. customers might now spend an average of $45 a month on cable, they took 30 years to reach this level, and they spend so much because as few as five free-to-air channels are available to them, while movies and professional sports are increasingly offered solely on premium channels. In Europe, by contrast, government regulation ensures that there is plenty of high-quality free-to-air television--including European football and other highly popular content. European cable operators thus can't offer enough compelling programs to draw viewers to their channels. Moreover, strict pricing regulation in Europe limits the cable operators' ability to develop tiered-pricing models, such as targeted programming packages, that might drive revenue growth.

In the days when broadband and other digital services were to be the engines of that growth, television seemed less important. But the adoption of broadband has lagged far behind the levels projected during the dot-com boom. Meanwhile, except in the United Kingdom, consumers see no great reason to change suppliers and have shown little interest in cable telephony. Cable operators will thus find it hard to make either market grow. Furthermore, the operators face strong competition from entrenched telephone companies selling their own version of broadband DSL--which has the lead in Europe and is poised to become the standard for home use, much as cable is winning in the United States. In telephony, those same telephone companies have the scale to defend their markets vigorously.

On the cost side, expenditures are still too high, though many cable operators are trying to reduce them by renegotiating the price of set-top boxes and by expanding more slowly. (Setting up a new customer with digital services costs, on average, at least twice as much as an analog installation, for example.) A further problem is that digital interactive products suffer five to ten times as many faults as analog ones, so repair costs are higher, and it becomes necessary to have more intricate--and expensive--operational capabilities and network monitoring.

The call-center costs of the cable operators have increased because they must respond to the more complicated queries that arise from bundling several complex products. Finally, the sales and marketing expenses of these companies, which until now had little need of such expertise, have gone up; for example, in Belgium, Germany and Switzerland, the cable operators have had no direct relationship with the customer because cable service is often included in apartment rent. So these cable operators now desperately need to educate a public that is reluctant to purchase their services.

Light at the end of the tunnel
European cable companies are thus troubled by a vicious cycle of negative cash flow and continually rising debt. The industry is far from stable, and operators will have to reassess their strategies constantly. And whatever the future holds, cable companies must make big changes if they wish to be a part of it.

Some might choose not to abandon the triple-play strategy, but in that case they will have to restructure their debt and carry out a complete operational overhaul. The required reforms are not, on their own, new or impossibly difficult. They include a reduction in capital expenditures, the improvement of marketing and operational efficiency, efforts to ensure that operations and management support the triple play, and the development of performance metrics that reward these new goals rather than focusing, in the industry's traditional manner, on financial deal-making. Since these reforms must all be implemented simultaneously, however, they represent a formidable challenge. Many companies will fail to make them or won't make them quickly enough to avoid near-term bankruptcy.

What else could cable operators do? Besides restructuring their debt, some of them feel that the solution is to delay further investments until the economics are clearer--although this strategy opens up the possibility of losing the market to competitors, including satellite-television operators and telecom companies offering DSL and various telephony packages. Other cable companies will be tempted to try to boost their revenues by either developing or aggregating content such as television programming or broadband-specific applications. The problem here is the expense and that cable operators generally lack the necessary skills to do this.

There is also a third option: a "multiple-access" strategy. In this case, a cable operator allows other companies to offer one or more elements of the triple play (or additional services such as music or gaming) over its network. Cable operators, given their monopolistic history, might dislike the idea of multiple access, but economic pressures should bring some of them around. The strategy's virtue is that it addresses both the revenue and the cost sides of the negative cash-flow problem and is workable anyplace where networks have been completely upgraded or where customers are attractive enough demographically to make continuing upgrades worthwhile. Networks in most of the United Kingdom, the Benelux countries, Switzerland and parts of France lend themselves to multiple access.

Since the networks of most companies haven't been completely upgraded, many would want to combine multiple access in upgraded areas with a pure cost-cutting strategy in nonupgraded ones. In parts of France and large swaths of Germany, companies can stabilize their finances until conditions improve by offering relatively low-margin and low-growth analog television, without premium channels, broadband or telephony.

Wholesale prices must cover the costs of the cable operator but can't be so high that its partners' economics become unworkable.

The results of companies in other industries show how successful a multiple-access strategy can be. For example, in the United Kingdom, the smallest mobile-network operator--One 2 One, which was recently renamed T-Mobile--made an agreement with Virgin, a retail conglomerate with strong brand and marketing expertise, to offer telephone service over One 2 One's network. The result was a 10 percent boost in the compound annual growth rate of subscribership across it.

Another example of such strategies was the relationship between Energis, a U.K.-based telecom network owner that sells its own services, mainly to businesses, and Freeserve, a consumer ISP. Energis provided network infrastructure and maintenance for the network that Freeserve's customers used for connections to the Internet, while Freeserve focused on marketing and most customer service. Although financial details are not available, the benefits Energis gained are clear. The company could amortize its network costs over a greater quantity of traffic at a very low marginal cost, and its network, formerly underused in the evenings and on weekends when Freeserve's traffic is heavy, was paid to carry traffic it otherwise wouldn't have seen--with none of the costs of acquiring new customers or providing them with service.

Cable operators should explore similar arrangements with retailers--especially if they have strong marketing skills or large customer bases; potential partners include media companies, traditional retailers (such as Dixons, the electrical-store chain that initially backed Freeserve), and telecom companies. The advantages could be numerous. New entrants will bring marketing skills that could increase the market's size by increasing the overall penetration of digital-cable services. Average revenue per customer should rise too as partners compete to develop new services--music, games (which are increasingly popular online), or a service that combines charges for wireless and cable telephony calls in a single bill.

By adding such services, operators can exploit the expertise they already have, enabling them to reduce their reliance on triple-play products. By expanding the use of their networks, they can amortize their costs over a growing quantity of traffic. In addition, these companies can share customer service and setup costs with their partners, as well as the risk of upgrades. Any further capital investments, however, should be aimed at tightly targeted markets. Finally, the pressure for flawless execution in many business areas will be relieved; network maintenance, for example, might become more complex, but marketing, in which some cable operators are notably deficient, will become less important. Multiple-access agreements, while complicated to negotiate, are feasible: Under Freeserve's recent deal with NTL, that operator will offer Freeserve-branded broadband access and give Freeserve the right to sell digital television and cable telephony on its network.

The experience of the ISPs suggests that cable companies must provide for two vital elements to make such arrangements work. First, contracts must ensure high-quality network operations and fairness to retailers; the operator will be required to guarantee service quality for all users of its network, particularly when it has a retail presence that competes directly with those of its retail partners. Second, the division of activities between retailers and the network provider must be defined clearly. The cable operator, for instance, should retain network operations and maintenance but each retailer should carry on customer marketing and acquisition separately. Billing, customer service and the like should be open to negotiation according to each partner's strengths and financial resources; many cable operators already have appropriate facilities, which can be offered to the retail partners in return for extra payments. An additional new challenge for cable operators will be the associated business-to-business billing and account management.

As for contract terms, wholesale prices must be sufficient to cover the costs of the cable operator, but not so high that its partners' economics become unworkable. This point might seem obvious, but some shared-network agreements--including several in the United States between Baby Bell telephone companies and their competitors--have faltered precisely by failing to observe it. The division of retail price increases or of fees related to new services, such as gaming, is likely to require compromise, which will be particularly difficult to reach when a network must be upgraded to offer a new service because risk would have to be shared.

As European cable companies adopt the multiple-access strategy, they are going to find that their operating models will change. The cost of maintaining networks and of servicing customers will rise because multiple-access networks are complicated to manage. But this increase should be more than offset by the lower cost of sales and marketing as new partners take on a large share of those activities. Clearly, the scale of the reduction will depend on how far back the cable operator is willing to step: Those maintaining a retail presence will have higher costs than pure wholesalers will. But the extra revenue and greater network usage should have a dramatically positive effect on cash flow.

In the current dire financial circumstances, Europe's cable companies can't go on as they have. A combination of debt restructuring, big cuts in capital spending, and, for many, network sharing offer the surest path to survival.

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

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