Each month nearly 5 percent of digital subscribers either downgrade from it or cancel altogether--twice the churn rate of basic cable.
Most of the defectors switch either to satellite TV or to TiVo-type services that enable them, for the upfront cost of a $200 to $400 digital video recorder (DVR), to not only watch what they want when they want it but also to skip pesky commercials. No wonder the penetration rate of digital cable has leveled off. It doesn't measure up to the competition.
Yet the cable industry might still have a shot at redeeming its multibillion-dollar investment. Regional trials show that video on demand--the old dream of delivering movies or programs to viewers when they actually want to watch them--has tested encouragingly well with cable subscribers. In these tests, viewers have watched television more and deserted their cable companies less. They are even willing to pay an extra $10 to $14 a month for the privilege.
The one hitch is that television networks and studios--on which cable systems depend for on-demand content--live in mortal fear that any new digital scheme, whether for on-demand or TiVo-type services, will jeopardize their advertising revenue and any brand recognition they have with consumers. The objections of the networks might soon be overcome, however, if cable systems compensate them for lost advertising by sharing the revenue from on-demand services.
Digital cable's woes
The present leveling off of subscriber growth, at about 30 percent penetration, is the last thing cable systems want following their expensive digital upgrades. What are the reasons for the slowdown? It seems that many viewers are less than thrilled at the thought of paying more money just to get a better picture and an on-screen program guide for the same shows they received with analog TV. In a sure sign of dissatisfaction, customers for digital cable are more likely to abandon it or to downgrade than are customers for services such as basic analog cable, high-speed Internet connections and direct-broadcast satellite.
So far, the networks and their advertisers have been wary of offering programs in environments that make it easy to skip through commercials.
The reason is that cable customers, tired as they might be of basic cable programming, seem to be energized by on-demand services. This enthusiasm is evident in the frequency with which customers tune in: HBO on Demand subscribers, for example, watch 12 of its shows a month. For cable companies in general, viewers choose video-on-demand programs twice as often as they choose pay-per-view shows, which run at set times (1.5 to 2.5 orders a month versus 0.7 to 1.0 orders a month).
Subscribers in market tests also make their eagerness for on-demand services plain in other ways. Viewers tend to get more drawn into a series when they are assured of watching the latest (or a missed) episode at their own whim. Cable companies report that digital-cable on-demand offerings are pushing penetration 5 percent to 10 percent higher in some markets and improving retention rates by 30 percent to 40 percent. Interestingly, DVR owners upgrade their cable and satellite services more frequently. And TiVo's reported retention rates are astronomically high: 97 percent versus 70 percent to 80 percent for direct-broadcast satellite, basic cable and cell phones.
The formula for high margins and a favorable return on investment is more subscribers who stay subscribed longer. McKinsey analysis indicates that reduced churn in digital subscriptions and an incremental increase in revenue from premium channels and video-on-demand programs would probably give cable companies substantial returns above their cost of capital as well as an investment payback within 3.7 years at most or, more likely, within a year.
Why do networks and studios fear on-demand services? So far, the networks and their advertisers have been wary of offering programs in environments that make it easy to skip through commercials, as it is with on-demand services and with the comparable DVR technology, which also began to take off in 2002. Recent research indicates that almost 42 percent of the owners of DVRs (such as those who subscribe to TiVo) skip ads frequently and that 27 percent claim to do so all the time; these people thus watch more programs but see fewer ads. On-demand services from the cable companies could give viewers a similar ability to omit commercials, but participating networks, and even the studios, could retain greater control through the use of upfront advertising and the ability to disable the fast-forward function during interstitial slots.
Viable business model
What would a viable business model for on-demand services look like? We believe that cable companies, networks and studios must collaborate to share the wealth generated by increased subscriptions. Such a collaboration is going to force the cable companies, which will drive the process as they look to protect their digital investment, to take the following steps:
Channels that rely on syndicated content and older films could see audiences fall as on-demand content captivates more viewers and reduces tolerance for "what's on.
Work out an ad model. Some cannibalization of advertising is inevitable. But cable companies and networks can limit the damage by experimenting with advertising that cannot be skipped, by placing a limited number of ads at the front of programs (similar to trailers before movies), by using product placement or by developing customized advertising that viewers might actively choose to view. TiVo studied the viewing habits of its DVR owners during the 2003 Super Bowl and found that some ads--for example, those for beer and films--were not only skipped less often than others but also even replayed more often and watched by more people than the game itself.
Price it right. Cable companies must find the pricing sweet spot for on-demand services and encourage people to upgrade to more lucrative plans (which might, for example, include HBO's "The Sopranos"). Nonpremium channels, to make up for a 10 percent loss of linear-channel advertising, would have to sell subscription plans to only 6 percent of its viewers who watch free programs on demand.
Measure the result. Together, cable companies and networks should learn to measure the level of delayed, on-demand viewing as part of a TV program's total audience.
To protect copyright holders such as networks and studios from having their content "Napsterized"--copied and distributed on the Internet in on-demand digital environments, it will be necessary to maintain vigilance with secure copy protection and encryption technologies.
On-demand services are only now emerging from the early disappointment of a slow launch and disappointing content. Viable best-of-breed on-demand offerings could create a virtuous circle for both cable companies and networks. For cable companies, they would help drive migration to the new digital platform, decrease the churn of consumers downgrading to analog and reduce defections to satellite-TV operators, which are offering DVRs embedded in their set-top boxes but lack the bandwidth for true on-demand services.
For networks, on-demand services would be of help in cultivating new shows and warding off further penetration by the dreaded DVRs. Networks with the winning formula of unique, compelling shows popular enough to draw viewers away from scheduled TV will be able to capture a greater share of the viewers' time and loyalty--a benefit that will surely be important during the next round of carriage fee negotiations with cable operators.
Channels that rely on syndicated content and older films could see audiences fall as on-demand content captivates more viewers and reduces tolerance for "what's on," a process likely to further increase the value of networks offering on-demand services while cutting the value of those that don't.
The alternative might be a vicious circle in which cable companies, networks and viewers all lose. In this scenario, the cable companies launch DVRs, which could make ad revenue fall steadily, thereby hurting all networks. The lower revenue would degrade the quality of network programming, and this development would in turn make customers unwilling to pay for digital cable, thus hurting the cable companies. Meanwhile consumers would either defect to satellite delivery or bear the brunt of the cost of lost revenue, with each household paying, by some estimates, as much as $250 more a year.
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