MBA Professional Assignment

CASE: TIME WARNER CABLE

Those who cannot remember the past are condemned to repeat it

—George Santayana

Managers who cannot apply managerial economics are destined for failure

—Michael Baye and Jeffrey Prince

The case-study method is a useful pedagogy for applying managerial economics to real business scenarios. Two things are required for this approach to yield optimal results. First, since hindsight is always 20–20, put yourself in the shoes of decision makers at the time of their decisions—July 2016 in this case—rather than at the time you read the case. This is your job. Second, the case being studied must involve economic issues that transcend time. That’s our job.

Time Warner Cable is a timeless case that was written especially for Managerial Economics and Business Strategy. Regardless of whether you’ve covered a single chapter or every chapter in the text, the case provides an opportunity to apply tools from managerial economics to a real-world business situation. The case includes a plethora of issues and may be used in a variety of ways to hone your decision-making skills.

For example, your instructor may choose to use the case as a capstone experience where you and/or team members present your analysis and make recommendations for the company. For this reason, when you read the case, you will observe that it provides information about the company and its business environment, but it does not identify specific problems or ask specific questions. As in the business world, the onus is on you to identify key issues and to defend your recommendations. Different students are likely to focus on different issues and to make different recommendations, depending on the chapters covered and their mastery of the material.

Alternatively, or in addition, your instructor may use this case as “an extended problem” throughout the course to illustrate concepts developed in specific chapters. The case includes a variety of memos—some at the end of the case and others available online at  www.mhhe.com/baye9e —that permit you to apply concepts on a chapter-by-chapter basis.

We hope you enjoy the case. Remember that an important component of any case exercise is to use the information provided along with your knowledge of managerial economics and business strategy to identify key issues and to guide your recommendations and decisions. Consider this a practice run for when you leave the classroom and enter the business world.

Time Warner Cable1

Note to Students: Please read the information on the previous page before working through this case.

HEADLINE

When Andreas finished his MBA 10 years ago and joined the company, he envisioned an exciting career in a growing industry. However, economic and technological changes have been rapid, and he has already been through spin-offs and mergers. Now, thanks to Time Warner Cable’s most recent merger, he is potentially poised to join Charter Communications. He recently met with the Executive Board, and the Leadership Team singled him out for having “tremendous leadership potential.”

While it felt good to be recognized, Andreas faces significant pressure to turn things around. Cable television is plagued with declines in video subscribers that seem unlikely to stop. The other product and service markets in which his company competes are highly competitive. Andreas is not interested in spending the next 20 years of his career plugging leaks in subscribers and market value; rather, his goal is to create sustainable growth through innovative business strategies.

The evolution of the industry has left Andreas—and his superiors—with a plethora of questions requiring immediate answers. He is glad that his MBA equipped him with the economic and business tools needed to deal with new problems—problems that didn’t even exist back in the day. Sadly, Andreas’s immediate predecessor lacked these tools and lost his job following the merger. He has no intention of following in those footsteps.

Andreas closed the July 1, 2016, edition of The Wall Street Journal on his laptop. He set aside his morning coffee to review the company’s operations before replying to the first memo in his inbox.

BACKGROUND

In order to better understand Andreas’s challenges, it is useful to trace the evolution of his company and to provide a brief overview of the Cable Television and Broadband Internet market segments in which Time Warner Cable operates.

Time Warner Cable History

Time Warner Cable traces its roots back to 1968 with the founding of American Television and Communications (ATC). In the 1970s, Time Inc., primarily a magazine publisher, would acquire ATC. In 1990, Time merged with film and television producer Warner Communications to form Time Warner, Inc.

Time Warner, Inc., grew throughout the 1990s, notably by acquiring Turner Broadcasting Systems in 1996. By the end of the decade, Time Warner, Inc., would be one of the largest media companies in the world, owning well-known and varied entities including Warner Bros. film, Home Box Office (HBO), Turner Broadcasting System (CNN, TBS, and TNT), Time Magazine, The Atlanta Braves (Major League Baseball), the Atlanta Hawks (National Basketball Association), the Atlanta Thrashers (National Hockey League), and DC Comics.

In January 2000, Time Warner, Inc., agreed to merge with Internet company AOL in a deal initially valued at more than $250 billion. AOL, formerly America Online, came to prominence in the mid-1990s as one of the first and fastest-growing dial-up Internet providers. In addition to Internet access, AOL was one of the largest content providers, and by 1997 about half of all U.S. homes with Internet access had it through AOL. The AOL Time Warner merger was seen as symbolically important as well, as it was the largest merger between a traditional media company and an Internet-based media company. The excitement would not last long, however, as the merger was poorly timed. The dot-com bubble burst in 2000, driving down share prices of all companies, but especially Internet-based businesses. Questions of accounting irregularities with respect to advertising revenue dogged AOL. In 2002, AOL Time Warner posted a $98.7 billion loss, in what remains the largest real loss in global corporate history.

During the next decade, AOL Time Warner would retrench and focus on its media holdings, especially the cable networks and movie studios. In 2003, it dropped AOL from its name, and over the next few years, most of the former AOL top executives left the company.

In 2009, Time Warner, Inc., spun off both AOL and Time Warner Cable. Management cited the fact that Time Warner Cable was relying more and more on its Internet and communications business and becoming a multiplatform communications company rather than a media and entertainment business. In March 2009, shareholders of Time Warner, Inc., received separate shares of Time Warner Cable stock and Time Warner Cable was officially separated from the media conglomerate.

Since the spin-off, Time Warner Cable’s stock price has done extremely well, posting a sizable return. While it has helped that the overall stock market rallied during that time as well, shareholders generated an annualized return of more than 30 percent from 2009 to 2016, as illustrated in  Figure 15–1 .

FIGURE 15–1 Time Warner Cable’s Stock Price, March 2009–2016

Cable Television History

Cable television in the United States goes back to the late 1940s when inventors used cables to carry broadcast signals in regions where traditional over-the-air signals were blocked by mountains. Modern cable began in the 1970s with the development of cable programming Page 470networks including HBO (1972), ESPN (1979), and Nickelodeon (1979). In the decade that followed, cable adoption would increase from 16 million households to 53 million households by 1990.

During the 1980s and early 1990s, cable television system operators were largely functioning as monopoly utilities. Cable systems rarely competed over the same geographic areas, and there was little competition from satellite or alternative carriers. As a result, cable had 90 percent of the video subscription industry. The Telecommunications Act of 1996 significantly deregulated the cable industry, allowing for increased ownership between media companies and cable companies.

Consumer growth slowed in the late 1990s and 2000s, as the market reached maturity and competition increased. Satellite companies improved their technology and offerings, leading to increased competition. However, revenue growth and profitability still improved, as cable companies were able to sell increased services. The increased adoption of high speed Internet, high-definition television, and digital video recorders (DVRs) and increased channel offerings all contributed to increased industry revenue.

Broadband Internet

Residential Internet access only gained widespread adoption in the mid-1990s as consumers subscribed to a service provider and used a dial-up modem to connect to the Internet. Connection speeds were slow and unreliable and, initially, customers had plans that limited the number of minutes that users could spend online. Broadband Internet is a term for access to the Internet through cable, digital subscriber line (DSL), or fiber optic cable that allows multiple signals or types of traffic and that maintains a constant connection to the Internet. As recently as 2001, less than 10 million American households were accessing the Internet through a high-speed connection. By the end of 2013, this had grown to over 80 million.

The primary providers for broadband are cable companies and telephone companies. Cable operators collectively have about a 58 percent market share, while telephone companies have the remaining 42 percent.

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In 2015, the FCC raised the threshold for download and upload speeds necessary to be considered “broadband.” The new minimum download speed is 25 megabits per second (Mbps) and the minimum upload speed is 3 Mbps. The FCC notes that with increasing large data files and multiple services, households need greater speed to take full advantage of Internet access. Under the prior definition, only 6.3 percent of U.S. households didn’t have access to broadband service from at least one provider. The new definition increases this to almost 20 percent. Given the increase in video content and other large data, and the changing usage of Internet services, consumers will likely continue to expect faster Internet speeds.

While these levels of Internet speeds are available to most Americans, the adoption rate of high-speed access (by the FCC’s new definition) is still less than half of all U.S. households. Still, companies are investing in higher speeds and promoting greater capabilities. Comcast announced a 1 gigabit per second (Gbps) service for which it is currently upgrading its hardware and service. Google Fiber also promotes 1 Gbps speeds, and an important element of competition is likely to continue to be faster speeds.

BUSINESS AND MARKETS

Time Warner Cable operates in the cable television industry in five primary geographic areas: New York, the Carolinas, the Midwest, Southern California, and Texas. The company serves 16 million residential and business customers who subscribe to one or more of its video, high-speed data, and voice services. Its revenue in 2015 was $23.7 billion, generating a profit of more than $1.8 billion.  Exhibits 1A  and  1B  in the  Appendix  have financial highlights for Time Warner Cable.

Cable television providers generally provide three services: video programming, Internet service, and home telephone. While providers frequently offer bundles of two or three of the services, they are distinct segments with different competitors and market trends.

Video Programming

Cable companies’ primary business is providing multichannel video services to home consumers. Residential video services make up 41.8 percent of Time Warner’s revenue, although this percentage has fallen from 56.1 percent as recently as 2010. Video revenue declined by 5 percent in 2014 and by 1 percent in 2015.  Figure 15–2  provides a breakdown of Time Warner’s revenue sources. Industry forecasts vary, but the consensus view is that video revenue will continue to decline at a rate of about 1 percent per year for the next five years.

FIGURE 15–2 Time Warner Revenue Sources, 2015

Most cable companies offer more than 300 television channels, many of them available in high definition (HDTV). A growing service area for cable is the offering of video on demand. This includes showing network shows on an on-demand basis, as well as movies or other events on a pay-per-view basis. Cable companies are also enhancing revenue by competing in the movie rental market segment, going against online providers such as Netflix, as well as DVD rental businesses like Redbox.

High-definition content and access are increasingly important as 77 percent of households in the United States have at least one HDTV, and about 46 percent have more than one. Fees for HDTV, multiple receivers, and digital video recorders (DVRs) are an important source of revenue for cable companies, and one that has grown dramatically since 2000. These are a major reason that the average monthly revenue per cable subscriber has grown to $76 for video services alone (see  Exhibit 2A ).

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A noteworthy trend in subscription digital television is the unbundling of channel packages. This trend is being driven largely by consumers who view the large number of channels as excessive, especially as prices continue to increase. The typical consumer watches only 17 channels on a regular basis, while basic cable packages have grown to over 100 channels.

The bundling of channels has been a part of cable television since its inception. In the 1980s, cable offerings were typically a couple dozen channels, and the cable bill was between $20 and $30. Consumers were willing to accept bundled pricing, and cable operators didn’t have the easy technology to offer à la carte pricing. Typically, cable companies offered a basic package, along with a small list of premium offerings (e.g., HBO and Showtime Networks). Over time, as the number of channels increased and prices continued to rise, consumer groups began pushing the Federal Communications Commission (FCC) and Congress to mandate unbundled offerings. Proponents of unbundling sought to give consumers more power to not pay for products they weren’t using, as well as to not have to pay for cable programming that they deemed offensive. In 2013, Senator John McCain introduced the Television Consumer Freedom Act of 2013, which would have made it more difficult for cable companies to bundle channels. While the bill died in the Senate, the potential for government action still exists.

Cable companies have historically preferred keeping bundled offerings, although over time the number of bundles and tiers has grown. They have resisted any regulatory efforts to mandate à la carte pricing on the grounds that it will stifle the ability of new networks to be launched. Since new channels get added to existing bundles, they have the opportunity to be seen by all of the subscribers and can generate commercial and subscription revenue. If consumers are charged for each channel, few will subscribe to new channels without proven content or brand awareness, creating high barriers to entry.

Networks also prefer bundled offerings since they create a greater subscription base for their channels. Further, through bundled programming, networks can use the leverage of their popular channels to get cable companies and subscribers to take all of their channels. For example, it is widely believed that Disney uses the popularity of its ESPN channel to ensure that their wide varieties of other ESPN properties (e.g., ESPN2 and ESPNews) are included in popular packages.

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Competitive pressure is leading some providers to begin offering unbundled or smaller (“skinny”) bundles to their consumers. Dish Network offers Sling TV and Verizon TV offers FiOS, both of which offer a small bundle of only the most popular channels at a reduced price. In 2015, ESPN filed suit with several providers claiming that the separation of its channels from basic cable bundles violated the terms of its contracts. As competition in the industry evolves, further unbundling and fragmented offerings are expected to be more common.

Internet Services

Demand for Internet services has grown dramatically and become an important service for cable companies. As noted in  Figure 15–2 , high-speed data makes up 37 percent of Time Warner Cable’s revenue. Further, revenue grew by 11.3 percent per year from 2010 to 2015 (see  Exhibit 2B ). This reflects both an increase in the number of subscribers (6.0 percent) and an increase in revenue per subscriber (5.4 percent).  Exhibit 2C  shows the number of subscribers by service.

Time Warner Cable offers six different packages for Internet plans, mainly varying by download speed and price. The “Everyday Low Price” tier offers a download speed of up to 2 Mbps for $15 per month. On the high end, the “Ultimate” tier includes download speeds of 50 Mbps, and access to WiFi hotspots, for $70 per month. The other plans range somewhere in between. In addition to offering these as a stand-alone service, they are also frequently priced as bundles with video programming and home telephone service.

Increasing demand for high-speed data is a positive for cable operators but will also require significant investment on the part of the companies. Online traffic has been growing at a much faster rate than network capacity.

Telephone

Along with video and Internet access, cable companies offer home phone service through their Internet connections. The service is similar to Voice over Internet Protocol (VoIP), but communications are maintained on the companies’ private IP networks. Companies typically charge a flat monthly fee for telephone service, including long distance within the United States and to many international destinations. Long distance to other countries is billed on a per-minute rate, but the rates tend to be as low as one cent per minute.

The residential telephone industry is highly competitive, due in part to the shrinking size of the traditional service market. The number of households abandoning home telephone service for strictly wireless plans increased from 20 percent in 2008 to over 40 percent by 2014, and this trend will likely continue as saturation of the wireless industry continues to increase. Not surprisingly, young adults are leading the wireless-only trend with less than a third of young households having residential phone service. In addition, households at or near the poverty line are much more likely to be wireless only.

In spite of declining overall residential telephone service, cable companies are actually increasing the number of customers subscribing to voice services. The number of residential VoIP customers increased from 19.7 million in 2008 to 37.7 million by the end of 2013. By expanding and marketing services to existing video customers, and offering attractive bundles of video, high-speed Internet, and voice services, they have been able to expand market share.

Time Warner Cable serves approximately 6.3 million residential voice subscribers, generating revenue of $1.9 billion in 2015. Average revenue per subscriber is $27 per month (see  Exhibit 2A ), but this has been declining over the last several years. Comcast’s experience has been similar; voice customers are increasing by 3 percent per year, but revenue is decreasing due to greater discounting of bundled services.

COMPETITION

Competition for video programming distribution comes from direct broadcast satellite (DBS) providers, telephone companies, and online video services. In the 1980s and early 1990s, cable had over 90 percent share of the households that subscribed to a service (see  Exhibit 3 ). However, due to improved technology (smaller and more reliable satellite dishes and increased channels), DBS experienced significant growth from late 1990s on. DBS now accounts for more than 34 percent of video subscribers. In addition, growth in competition from telephone companies, primarily Verizon and AT&T, has given them more than an 11 percent share. The result is that cable companies collectively have little more than 50 percent of the video subscription market, a share that has seen a strong downward trend over the last 20 years.  Figure 15–3  shows the changes in number of subscribers for different types of Multichannel Video Programming Distributors (MVPDs).

FIGURE 15–3  MVPD Subscribers by Service Type, 1993-2013

The result is that consumers have more choices than ever. Virtually every household in the United States has access to two satellite companies. In addition, over 99 percent have access to a cable company. Of those, another 50 million (37 percent of households) have access to a telephone service that provides digital video and online services.

Cable Companies

While cable companies compete in the same industry, one cable company rarely overlaps the geographic footprint of another. Consequently, there is very little direct competition between cable companies.  Exhibit 4  provides video revenue and subscriber information for the key industry players.

Comcast

Comcast is the largest cable television operator with 27.7 million customers for its video, Internet, and voice services. Comcast has the most customers for high-speed data (23.3 million), followed by video (22.3 million) and voice (11.5 million). Of the 27.7 million customers, 10.1 million of them use all three services. Headquartered in Philadelphia, Comcast’s largest presence is on the East Coast. Other large geographic markets include Page 475Florida, Atlanta, Denver, Northern California, and the Pacific Northwest. Due to its strong presence in highly concentrated areas, Comcast has the largest reach of any cable company, passing by 55.7 million homes and businesses.

In addition to its cable business, Comcast is a media company due to its NBCUniversal division. In December 2009, Comcast announced its intention to purchase majority ownership in media conglomerate NBCUniversal, which was owned by General Electric. Due to the size of the merger, the FCC and the U.S. Department of Justice needed to approve the deal. A number of groups expressed concerns that Comcast would use its ownership in NBCUniversal to prevent or restrict NBC-owned networks from Comcast’s competitors. The deal was approved by regulators in 2011 with some conditions regarding the negotiations of NBCUniversal retransmission fees with rival carriers and how the company would deal with online video content. In February 2013, Comcast purchased the remaining interest in NBCUniversal from General Electric to make it a wholly owned subsidiary.

While acquiring NBCUniversal made Comcast a media company, cable operations (including video, high-speed data, and voice) still represent the largest portion of its business, generating revenue of $46.9 billion. The NBCUniversal subsidiary earned revenue of $28.5 billion from cable networks ($9.6 billion), broadcast television ($8.5 billion), films ($7.3 billion), and theme parks ($3.3 billion). NBCUniversal owns 15 cable networks, including USA Network, E!, Syfy, MSNBC, CNBC, and Bravo.

Comcast/Time Warner Cable Proposed Acquisition

In 2014, Comcast announced its intention to acquire Time Warner Cable in a deal that valued Time Warner at $45 billion. The proposed deal was a stock swap, so that shareholders in Time Warner would have received newly issued shares in Comcast. The acquisition would have given the combined company about 33 percent of all paid video customers and 40 percent of the wired broadband market.

Comcast presented the acquisition as an opportunity for the company to increase services, reduce costs, and increase innovation. While the combined company would have been significantly larger, there was little direct competition between Comcast and Time Warner, so the companies argued that competition to consumers would not be diminished by the acquisition. However, critics reacted negatively to the proposed merger on the grounds that the combined entity would have greater leverage in dealing with suppliers and greater control of the domestic broadband market. Further, Comcast was frequently rated as one of the worst companies in the country in terms of customer service. As a result, there was a consumer backlash against the company growing significantly larger.

In April 2015, it was reported that the U.S. Department of Justice announced it would file an antitrust lawsuit opposing the merger due to the reduced competition. While a formal complaint was never made by the government, there was speculation that the decision to oppose the merger was based on concerns that the merged company would have the ability and incentive to inhibit future competition from streaming video. Shortly after the news reports of the government opposition, Comcast withdrew its offer and the acquisition attempt died.

Charter Communications

Charter Communications is a cable company with 6.2 million customer relationships for its services, including high-speed data (5.2 million), video (4.3 million), and telephone service (2.6 million). Revenue for 2015 was $9.7 billion, a 7.1 percent increase over the prior year, although it posted a loss of $271 million. Charter’s customers are geographically dispersed, but some of its larger markets are in the South, California, Michigan, Minnesota/Nebraska, and the Pacific Northwest.

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After the Comcast/Time Warner merger fell through, Charter looked to put together a deal of its own. In May 2015, Charter announced that it would seek to acquire Time Warner Cable and Bright House Networks, a smaller cable operator, for a total of $67.1 billion.

The deal was facing significant scrutiny from regulators as the merged entity could have a combined 17.8 million high-speed-data customers. Regulators were concerned that a cable company with a large market share could pressure cable networks to keep much of their content away from online video services. In April 2016, the Antitrust Division of the U.S. Department of Justice announced that it was allowing Charter’s acquisition of Time Warner Cable and Bright House Networks to proceed with conditions. 2

Other Cable Players

A number of other smaller cable companies are still competing in these markets. Cox Communications, Cablevision, and Bright House Networks all have more than a million subscribers each, while about another dozen cable companies exist with less than a million subscribers. Many of these smaller systems are either confined to a small geographic region or comprised of customers gathered when larger firms had to divest customers following a merger.

Satellite

Direct broadcast satellite television competes directly with cable companies for video content. By nature of the technology, virtually any household in the United States has access to satellite television service. In fact, due to limited cable and telephone service areas, about 500,000 (mostly rural) households have access to only satellite services.

AT&T DirecTV

DirecTV is the largest direct broadcast satellite service with 20 million U.S. subscribers, plus another 19 million in Latin and South America. In 2015, AT&T acquired DirecTV in a $49 billion deal, creating a combined firm with 25.4 million video subscribers. Within months of the completed deal, some were questioning AT&T’s investment in a video provider when subscription revenue seemed like it was going to decline. AT&T was hoping to use its large retail presence to increase video subscriptions to DirecTV where it currently did not have a video service to provide. In addition, it hoped to take advantage of other DirecTV assets including the NFL Sunday Ticket, an exclusive agreement to show all NFL football games.

One of the benefits of the merger might be to increasingly leverage DirecTV’s content to AT&T’s mobile customers. However, there are definite complications with this plan. The NFL has a deal with DirecTV to show the Sunday Ticket, but it also has an exclusive deal with Verizon, AT&T’s largest competitor, for mobile access to NFL content. As the lines between video, Internet, and wireless content continue to get blurred, complications like this will continue to arise.

AT&T also hopes that its size as the largest multichannel video distributor in the United States will help it lower programming fees charged by cable networks. Being able to take advantage of its size will be critical to returning value to shareholders after the high price paid for DirecTV.

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Dish Network

Dish Network provides services at a lower cost, generally with fewer channel options than most cable packages. Dish generated $15 billion in revenue in 2015, with a subscriber base of 13.9 million users. In addition, Dish markets broadband services that are bundled with Dish video programming. Broadband services are subcontracted to other carriers.

Dish Network began offering a new service in 2015 known as Sling TV. Sling TV is a service that provides traditional multichannel programming through an Internet connection. Customers do not need a satellite or an existing relationship with Dish to sign up for the service. The base package price for Sling is only $20 per month, with additional channel packages available for $5. While Dish Network has 13.9 million paid video subscribers, it does not disclose how many of those are for satellite television and how many are for Sling TV. Analysts estimate that Sling TV has fewer than 500,000 subscribers after its first nine months of availability.

Sling TV is generating some controversy in the industry, as some are concerned that bypassing traditional cable or satellite services will be bad for the long-term health of the industry. This is not the first time that Dish has created controversy in the industry. Networks were not happy when Dish launched the Hopper DVR, a service designed to allow viewers to easily skip through commercials during playback of recorded content. Networks including Disney (ABC and ESPN) and Fox sued Dish Network over the technology. Some of these lawsuits have been settled, but others are ongoing.

Telephone Providers

Telephone providers have invested significantly to begin competing for multiple household services. By upgrading their wiring to fiber optic cable, telephone lines can carry digital signals, including digital video and Internet, as well as voice. Due to the technological investment, digital services are only available to 46.4 million households in the United States. In virtually all of these households, customers have their choice among a telephone provider, a cable company, and the two satellite providers. Two telephone companies, Verizon and AT&T, are the largest players in this segment. 

Verizon

Verizon is a communications company focused on wireless and wired communications products and services. Wireless service and products make up 69.7 percent of Verizon’s business. The remaining portion is divided between FiOS, its fiber optic communications network, and traditional wired home telephone and Internet service. FiOS service is offered in 13 states, and offers video programming, high-speed data, and voice services.

Verizon FiOS promotes “Custom TV” plans in which consumers can choose differing basic packages depending upon their tastes. One of the choices excludes sports channels and instead offers a wide variety of channels at a modest cost. Since sports programming channels tend to be some of the most expensive cable offerings, allowing consumers to opt out of these channels has the potential to increase the value for cable customers. In 2015, ESPN filed a lawsuit against Verizon claiming that the carriage contract mandated that ESPN be carried as part of the basic service, and that the exclusion from the Custom TV plans violated this contract. Resolution of the matter is pending.

AT&T

AT&T is a very large communications company whose largest business is wireless communications. However, it has two services that compete with the cable business: DirecTV and Page 478U-Verse. As mentioned previously, DirecTV is a direct broadcast satellite business acquired by AT&T in 2015. U-verse is a fiber-optic network that provides video, high-speed data, and voice service in 21 states.

Other Companies

A handful of other telephone companies, including Consolidated Communications and Cincinnati Bell, offer competing services. A notable entrant is Google Fiber, which began offering television and Internet services in 2013. Google is choosing to enter selective markets, mostly certain suburban areas surrounding larger cities, including Kansas City, Austin, and Atlanta. With only 54,000 television subscribers as of January 2016, and availability in only a handful of markets, Google Fiber is not yet a competitive threat.

Online Video Distributors

The popularity of online video content distributors (OVDs) may be the greatest threat to the traditional cable model. Increased Internet download speed has led to considerable growth in the streaming of video since 2011, when Netflix announced its focus on streaming video.

One of the contributing factors to the popularity of online video was the increase in the prevalence of Internet-connected televisions. Currently, the majority of U.S. households have at least one television that is connected to the Internet, either directly (i.e., Smart TVs) or through a device such as a gaming system, Blu-Ray player, or streaming media device (e.g., Google Chromecast, Roku, Apple TV). The number of adults watching online programming through a connected TV at least once a week has increased to over 30 percent and is growing rapidly.

Netflix

Netflix began as a DVD mailing service in the late 1990s, generally competing with video rental stores. In 2011, Netflix shifted focus to its streaming video service, and shortly thereafter began developing its own original content.

The 2011 transition from DVD to online video was not a smooth one for Netflix. It initially announced a plan to spin off the DVD business to a new company that would be known as Qwikster. After significant backlash from its customer base of 24 million at the time, it abandoned the spin-off plan. But Netflix chose to go forward with separating the DVD and online video business models, forcing customers to either choose one of the two plans or pay separately for both. Previously, online video was included with the DVD plan. The transition would cost the company a million subscribers, and the stock price declined by 44 percent. However, this proved to be a short-lived problem, as the company quickly expanded its online content and subscriptions grew quickly.

Netflix streaming video service has 43.4 million paid memberships in the United States. Its content includes movies, TV series, and original programming. Revenue has grown by 20 to 25 percent per year for each of the last three years.  Figure 15–4  shows the growth in memberships and revenues over the past three years.

FIGURE 15–4  Netflix Domestic Streaming Members and Revenue, 2013-2016

In addition to an increased subscriber base, Netflix is becoming more popular with its subscribers. In 2015, subscribers logged a collective 42.5 billion hours of viewing, which amounts to an average of 1.8 hours per day per subscriber.

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Amazon Prime Video

Recently, Amazon.com has begun competing more aggressively in providing video content. While best known as an online retailer, Amazon is competing with cable through its Amazon Prime Video service. Amazon Prime members pay $99 per year and get access to free two-day shipping, discounts, and special offers, as well as access to video content through the Amazon Video service. In addition to movies and television series, Amazon is producing original content. While it does not disclose the number of Prime members, analysts estimated this figure to be around 50 to 55 million in the United States.

Hulu

Hulu is a similar service to Netflix, with the distinction that it is jointly owned by a group of traditional television network companies, including Disney-ABC Television, Fox Broadcasting, and NBCUniversal (a subsidiary of Comcast). This ownership results in a differentiated market strategy where Hulu focuses on showing recent episodes of currently broadcasting television series, as early as the day after they originally air on network or cable television. Hulu carries much less original content and fewer movies than competing streaming services. Pricing for Hulu is currently $7.99 per month, or $11.99 for a commercial-free membership.

The move to original content has been a dramatic and successful one for Netflix, Amazon, and Hulu. At the 2016 Golden Globes, four of the six nominees for Best Series came from either Amazon or Hulu. Meanwhile, Netflix earned the most nominations across all categories of any company or network. Further increasing their critical profile, both Netflix and Amazon are aggressively purchasing distribution rights to well-received films at film festivals such as the Sundance Film Festival. This is part of a growing trend whereby companies seek out exclusive rights to broadcast content, rather than mere replay rights.

Google/YouTube

In late 2015, Google announced the launch of YouTube Red, a subscription version of its YouTube video sharing service. For $10 per month, members can view videos without ads, Page 480as well as download videos. They announced that they would launch more TV-style content from existing YouTube creators.

Some smaller cable and satellite operators also moved to incorporate online video content within their services. In 2015, Dish Network began including Netflix and YouTube through its satellite service. Cablevision packages also include access to Netflix and Hulu services.

In addition to these services, there are plenty of other potential entrants into the online video market. Apple is planning to debut a new service, and dozens of small companies with little brand name are poised to come in with competing content and services.

SUPPLIERS

Cable companies are primarily in the business of reselling video content to consumers. As such, they are highly dependent on the entities that produce the content, and negotiations over pricing and conditions are a key element to the success of their business model.

Cable Networks

Cable providers are facing increasing costs for programming from cable content providers. These effects are strongest in sports programming, where broad sports channels (ESPN, NBCSN), league-run channels (NFL Network, MLB Network), and regional channels (Big Ten Network, Fox Sports Regional Channels) are all increasing in popularity. The channels are spending large sums competing for the broadcast rights of the most popular sporting events and passing the costs along to cable operators.

Cable networks charge programming fees to cable, satellite, and telephone service providers for the rights to carry their networks. These fees total more than $28 billion and account for 38 percent of the revenue of cable networks. The majority of their revenue currently comes from national, regional, and local advertising. While advertising revenue is still steady, the number of consumers either switching to online content or watching recorded television without watching commercials is putting pressure on advertising dollars.

As the number of cable television subscribers begins to decline, cable network revenue will be negatively impacted as well. As a result of limited growth in advertising, higher costs of production, and declining cable subscribers, cable networks are charging higher programming fees to companies that carry their programming.

As a result of this pressure, programming fees have been rising for cable companies. Time Warner’s programming fees are rising by an average of 5.5 percent per year. Meanwhile revenue from video is declining. The result is that the gross margin from video has fallen from 60.2 percent in 2010 to 44.4 percent by 2015. Furthermore, the forces generating pressure on margins show little signs of relinquishing.

Broadcast Networks

Traditional broadcast television remains an important player in the video industry. Networks such as ABC, CBS, Fox, and NBC and their local affiliates make up 30 percent of viewed programming. This figure is down from 80 percent of all programming in the late 1980s.

Cable companies are required by the FCC to negotiate with more popular local television stations over retransmission fees. That is, local network affiliates can demand payments in order for cable companies to carry the rights to broadcast their network programming. In the early years of cable, networks were rebroadcast on cable with no fees. This changed in 1992, Page 481as Congress passed a law allowing commercial broadcasters to not allow cable carriers to carry their stations without consent (as well as potential compensation). For years, retransmission fees were either zero or very small. However, over the last decade these fees have skyrocketed.

Total retransmission payments from cable and satellite companies to network affiliates were $200 million in 2006, but had risen to $6.7 billion by 2016. Further, projections by industry analyst SNL Kagan are that these fees will amount to more than $9 billion industrywide by 2020.

Sports Programming

The popularity of sports in American culture also drives a lot of the economics of the cable industry. As fans want more access to live sporting events on their television, sports leagues are driving up their broadcast rights fees to very high rates. Networks and broadcasters then use the popularity and exclusivity of their programming to demand higher programming and retransmission fees. The National Football League (NFL) and the Olympics provide two examples of this phenomenon.

In 2014, the NFL generated $7.3 billion in revenue from television contracts, up from $3 billion in 2010, an annualized increase of 24.8 percent per year. Driving these payments is the popularity of televised football, as NFL games dominate the TV ratings throughout the season. High ratings lead to high advertising and sponsorship dollars for the networks. As a result, networks are willing to pay for broadcast rights to the games. ESPN pays $1.9 billion per year for the rights to show Monday Night Football. CBS, Fox, and NBC all pay large fees for the rights to Sunday games, while CBS also pays to show Thursday night games. Meanwhile, DirecTV pays $1.5 billion per year for NFL Sunday Ticket, which allows the broadcast of all games to its subscribers. Football’s continued increasing popularity makes it unlikely that this trend will reverse anytime soon.

Another example of sports programming is the broadcast deal for the Summer and Winter Olympic Games. NBCUniversal has secured the U.S. broadcast rights to the Olympic Games through the 2032 games, paying $1.23 billion for the 2016 games alone. By securing the rights to such a high-profile event, NBC increased its leverage with video providers. The games are generally spread across a number of NBC networks, including NBCSN, MSNBC, CNBC, and Spanish-language station Telemundo. Cable companies that want to provide full coverage of all the Olympic events need to make sure that their cable bundles include all of these channels.

The increased payment for content is making traditional broadcast networks and their cable counterparts more aggressive in demanding retransmission fees from cable and satellite providers.

Carriage Disputes

Carriage disputes are disagreements between cable, satellite, or telephone carriers and a broadcast or cable network over the terms of retransmission. These disputes often result in intense negotiations as well as occasional blackouts when disputes cannot be resolved in a timely manner.

One example is the 2013 dispute between Time Warner and CBS over fees for carrying three premium cable networks: Showtime, The Movie Channel, and The Smithsonian Channel. Without a contract in place, Time Warner stopped carrying the channels, as well as the CBS network, in several cities, beginning on August 2, 2013. The blackout affected about Page 4823 million subscribers and lasted for about six weeks. Customers were upset by the loss of programming, especially due to the popularity of the NFL. CBS is one of the major carriers of NFL football games, and the blackout coincided with the beginning of the 2013 NFL season. During the third quarter of that year, Time Warner Cable lost 300,000 subscribers, about half of which were attributed to the blackout. In addition, the company was forced to issue credits to Showtime subscribers for the lost content during the blackout.

Over-the-Top Content

While the costs of programming content have increased, there also has been a movement by some companies to bypass subscription services and offer content directly to consumers. Known as Over-the-Top (OTT) content, cable channels and content providers are increasingly moving to selling their services directly to consumers through websites and mobile applications.

Besides OVDs such as Netflix and Hulu, in 2015 popular cable channels began offering OTT content. At that time, HBO (which is owned by Time Warner, Inc.) launched its HBO Now service. Consumers can subscribe directly and access all HBO content through the Internet and an enabled device for $15 per month. This was the first major cable network to offer content directly through the Internet without requiring the subscriber to also subscribe to a cable or satellite service. Competing channel Showtime followed suit with its own OTT service, along with a partnership to have it carried (for an extra fee) to Hulu’s customers.

Sports leagues are also considering moving in this direction. Major League Baseball (MLB) sells direct access to games through its MLB At-Bat service, although due to agreements with networks, local games are blacked out to consumers. The NFL partnered with the website Yahoo! to broadcast an NFL game played in London, England. To this point, network contracts have limited the sports offerings directly to consumers, but there are concerns that this will change.

MARKET TRENDS AND CONSUMER BEHAVIOR

In addition to the issues outlined, there are a number of market trends that managers need to be aware of when making decisions in the industry. Here are a few of the recent and current trends and technologies that are influencing competition and consumer behavior.

Digital Video Recorders (DVRs)

DVRs are becoming increasingly important to cable operators. Consumers enjoy the ability to pause live television and also to record content and watch it at a later time, a process known as “time-shifting.” While time-shifting technology has been available since the widespread adoption of the VCR in the 1980s, the convenience and simplicity of DVRs make it much easier and more common. This service increases the value of cable to consumers, and the fees associated with DVRs provide an additional revenue stream to cable companies.

However, there are drawbacks to increasingly recorded content and time-shifted viewing. First, the move away from watching live shows in real time and toward recorded content on-demand makes more consumers embrace the Netflix and YouTube models of video consumption. Showing current content is the competitive advantage of cable television, and de-emphasizing this will only make online video providers more appealing. Second, cable providers and networks rely in part on advertising dollars from commercials. The use of DVRs allows consumers to skip commercials at a higher rate. In response, networks need Page 483to get creative in embedding more advertising within the programming, or demand higher programming fees from cable carriers. There is evidence that both of these are happening and will continue to increase.

Cutting the Cord

One of the factors intensifying competition in the cable industry is the growing number of households that are canceling subscription video service. These customers are nicknamed “cord-cutters” for their decision to cut service from traditional video services including cable and satellite TV. Increasingly, cord-cutters are relying on video services from the Internet, including Netflix and Hulu.

The first-ever decline in the overall number of households receiving any kind of multichannel video subscription service (including cable, satellite, and telephone) occurred in 2013. The number of subscribers declined from 101.0 to 100.9 million households. While the reduction was quite small, it signaled a potentially troubling trend in the industry. Currently, some analysts estimate that the percentage of households subscribing to any multichannel video service has fallen to as low as 80 percent from over 88 percent in 2010.

More than a few analysts are predicting a very gloomy outlook for cable operators. If the multichannel video service penetration rate has really fallen by 8 percent over the last few years, there is plenty of evidence to suggest that this trend could continue or even accelerate. After all, channels like HBO and Showtime have been providing OTT packages for less than a year and services like Netflix and Amazon Prime Video are continuing to gain popularity. It is not inconceivable that the size of the entire market for multichannel video could fall to as low as 60 percent of U.S. households.

Cable companies also need to worry about “cord-shavers,” consumers who downgrade their video packages to only basic channels. These consumers then tend to supplement their viewing with online video services or OTT packages.

Part of the reason that sports programming is considered so important to cable companies is that sports fans prefer to watch the programming live rather than as a recording. Consequently, sports programming is widely seen as a hedge against both cord-cutting and the skipping of commercials.

Going Mobile

Mobile wireless services have shifted from a luxury to a necessity, and wireless technology companies are investing heavily to facilitate this transition. Mobile devices have gone from being primarily used for voice, e-mail, and web browsing to now including video entertainment, social media, and mobile commerce.

LTE networks deliver download speeds for mobile devices between 5 and 12 Mbps and are available to 98 percent of the population, up from 67 percent in 2012. While fixed and mobile broadband are used in different ways right now, there is likely to be a convergence. As of now, mobile Internet access does not have the speed or capacity to compete with fixed broadband.

REGULATION IN THE CABLE INDUSTRY

U.S. cable companies are subject to a number of laws and regulations that are largely overseen by the Federal Communications Commission (FCC). The following are a few of the significant regulatory areas that impact the operations and strategic decisions of Time Warner and its competitors.

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Carriage of Broadcast Television

The FCC mandates that cable companies devote some of their stations to local broadcast television channels that elect to be carried for free. These so called must-carry channels include smaller local channels as well as community and public access television. These channels are separate from broadcast channels that demand retransmission fees in order to be shown on a cable system.

Cable Pricing Regulation

The FCC regulates and limits the rates that cable companies may charge for basic cable service and equipment in communities that do not have “effective competition.” Effective competition is based on the number of competitors and market share that the cable company has. In the case of Time Warner, more than 85 percent of the local markets in which it competes are subject to effective competition and therefore not subject to pricing regulation by the FCC.

Net Neutrality

The FCC is charged with regulating communications including transmissions across the Internet. In a series of regulations, the FCC has adopted “net neutrality” regulations for Internet providers. Some of the provisions of net neutrality are that Internet providers may not block access to lawful content, applications, or services and may not unreasonably discriminate in transmitting lawful network traffic. This includes a ban on prioritizing some Internet traffic over other traffic in exchange for payment.

Net neutrality is a complex set of policy issues that has largely pitted telecommunications companies against Internet content sites and consumer groups. Telecommunications companies argue that allowing services like Netflix the ability to pay for better Internet speed for their customers would allow for more investment in technology and faster service for customers. Netflix, Amazon, and other Internet content sites argue that telecommunication companies will be able to charge high fees that will have to be passed on to consumers. Consumer groups are concerned about high fees, but also that the fees will serve as significant barriers to entry for new companies that would like to provide video content.

In March 2015, the FCC reiterated some of the net neutrality regulations and took the step of reclassifying broadband Internet access as a utility service, subject to increased regulation. Several groups representing telecommunications providers have filed a lawsuit against the FCC challenging the ruling. The litigation is ongoing.

Connect America Fund

As part of the American Recovery and Reinvestment Act of 2009, the FCC was directed to create a national broadband plan that would increase high-speed Internet access to Americans. The Connect America plan set the goal of providing download speeds of 100 Mbps to at least 100 million households in the United States. While some of the funding came directly from Internet providers through taxes and fees, the plan also had the benefit of increasing the potential number of customers for cable companies, for all services.

CHALLENGES

The cable television industry faces tremendous competition due to rapid technological change. Video subscription rates are declining, programming fees are increasing, and competitive threats are everywhere. While high-speed data service is a bright spot, customers Page 485are demanding faster speeds and greater access. VoIP telephone service is still growing for cable companies, but increasing competition and a declining demand for traditional residential voice services generate concerns about how long this market will remain profitable.

Andreas is well aware of these challenges but is resilient in the belief that cable companies can continue to provide a valuable service for their customers, while also generating value for their shareholders. He knows that to do this, they will need to continue making the best decisions on a day-to-day basis. After opening his laptop, he begins reading the memos in his inbox.

APPENDIX: EXHIBITS

		2015	2014	2013
Revenue:
Video		9,907	10,002	10,481
High-speed data		7,029	6,428	5,822
Voice		1,931	1,932	2,027
Business Services		3,284	2,838	2,312
Other		1,546	1,612	1,478
Total Revenue	23,697	22,812	22,120
Costs and Expenses:
Programming and content		5,815	5,294	4,950
Sales and marketing		2,379	2,192	2,048
Technical operations		1,669	1,530	1,500
Customer care		900	839	766
Other operating		4,796	4,729	4,876
Depreciation		3,560	3,236	3,155
Amortization		136	135	126
Merger related costs		203	225	119
Total Costs and Expenses	19,458	18,180	17,540
Operating Income	4,239	4,632	4,580
Interest Expense		1,401	1,419	1,552
Other income		150	35	11
Income Tax provision		1,144	1,217	1,085
Net Income	1,844	2,031	1,954
(In millions)
Source: Time Warner Cable 2015 10K
EXHIBIT 1A Time Warner Cable Consolidated Statement of Operations

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		2015	2014
Assets
Current Assets:
Cash and Equivalents		1,170	707
Receivables (Net)		916	949
Other Current Assets		373	383
Total Current Assets	2,459	2,039
Investments	65	64
Property, plant and equipment, net	16,945	15,990
Intangible assets	26,451	26,535
Goodwill		3,139	3,137
Other assets	218	370
Total assets	49,277	48,135
Liabilities and Equity
Current Liabilities:
Accounts payable		656	567
Deferred revenue		224	198
Accrued programming expense		985	902
Current maturities of L/T debt		5	1,017
Other current liabilities		2,079	1,813
Total current liabilities	3,949	4,497
Long-term debt	22,497	22,604
Deferred income tax liabilities	12,830	12,291
Other liabilities	1,002	726
TWC shareholders’ equity
Common stock		3	3
Additional paid-in capital		7,481	7,172
Retained earnings		1,925	1,162
Accumulated other loss		(410)	(320)
Total TWC shareholders’ equity	8,999	8,017
Total liabilities and equity	49,277	48,135
(In millions)
Source: Time Warner Cable 2015 10K
EXHIBIT 1B Time Warner Cable Consolidated Balance Sheet

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	2010	2011	2012	2013	2014	2015	Annualized Growth  Rate
Video	70.46	73.18	74.64	74.90	75.85	76.54	1.7%
High Speed Data	37.00	38.32	39.66	43.92	46.95	48.11	5.4%
Voice	37.08	36.89	35.68	34.40	32.35	27.56	–5.8%
Customer Relationship *	99.77	101.67	103.57	105.28	106.24	106.77	1.4%
Source: Time Warner Cable Annual Reports (2010–2015)
EXHIBIT 2A Time Warner Cable - Average Monthly Revenue per Subscriber
	2010	2011	2012	2013	2014	2015	Annualized  Growth  Rate
Video	10,577	10,589	10,917	10,481	10,002	9,907	–1.3%
High Speed Data	4,121	4,476	5,090	5,822	6,428	7,029	11.3%
Voice	1,905	1,979	2,104	2,027	1,932	1,931	0.3%
Business	1,107	1,469	1,901	2,312	2,838	3,284	24.3%
Other *	1,158	1,162	1,374	1,478	1,612	1,546	5.9%
Total Revenue	18,868	19,675	21,386	22,120	22,812	23,697	4.7%
($ in millions)
Source: Time Warner Cable Annual Reports
EXHIBIT 2B Time Warner Cable – Revenue by Service

	2010	2011	2012	2013	2014	2015	Annualized Growth Rate
Residential Video	12,257	11,889	12,030	11,197	10,789	10,821	–2.5%
Residential High Speed Data	9,469	9,954	10,935	11,089	11,675	12,675	6.0%
Residential Voice	4,385	4,544	5,024	4,806	5,284	6,320	7.6%
Business Subscribers *		486	563	624	687	752	11.5%
Total Customer Relationships **	14,496	14,511	15,237	15,008	15,198	15,881	1.8%
(Subscribers in thousands)
Source: Time Warner Cable Annual Reports
EXHIBIT 2C Time Warner Cable – Subscribers by Service

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	1993	1998	2003	2008	2013
Cable	94.9%	85.3%	74.9%	64.9%	54.5%
Direct Broadcast Satellite (DBS)	0.1%	9.4%	21.6%	31.9%	34.2%
Telephone and Other MVPDs	5.0%	5.3%	3.5%	3.2%	11.3%
Source: Federal Communications Commission and author calculations
EXHIBIT 3 Multichannel Video Programming Distributer by Type
	2015 Revenue (billions)	Video Subscribers (millions)	Key Business and Notes
Cable Companies
Time Warner Cable	$23.7	10.8	Time Warner is in a pending deal to be acquired by Charter Communications.
Comcast	$74.5	22.3	In addition to its cable business, Comcast owns NBCUniversal, which includes TV and film production, broadcast and cable networks, and theme parks.
Charter Comm.	$9.7	4.3	Charter entered into an agreement to acquire Time Warner Cable and Bright House Networks, a smaller cable company. The deal has yet to go through.
Cox Comm. *	$10.4	4.0	Cox is a privately held Cable Company.
Satellite Providers
AT&T / DirecTV	$20.3	25.4	AT&T’s acquisition of DirecTV has led them to have the highest number of video subscribers. Revenue figure is for Entertainment group, which is comprised primarily of DirecTV and U-Verse.
Dish Network	$15.1	13.9	Dish has a direct broadcast satellite service, as well as an Over the Top service providing multichannel content through Internet access.
Phone Companies
AT&T	$20.3	25.4	Revenue figure is for Entertainment group, which is comprised primarily of DirecTV and U-Verse.
Verizon	$37.7	5.8	Revenue is for Wireline services, which includes residential telephone, video, and high speed data.
Internet Companies
Netflix	$6.8	43.4	Netflix streaming video service had 43.4 million paid memberships in the US as of the beginning of 2016. Content includes movies, TV series, and original programming. Revenue growth for Netflix domestic streaming service was between 20–25% for each of the last three years.
Amazon **	$107.0	50.0	Amazon does not disclose the number of Prime members, analysts estimated that there were around 50 million US members as of early 2016.
Google/YouTube	***	***	In late 2015, Google announced the launch of YouTube Red, a subscription version of its YouTube video sharing service. For $10 per month, members can view ad-free videos and download videos.
Hulu	$1.5	9.0	Hulu is jointly owned by Disney (ABC and ESPN), Fox Broadcasting, and NBCUniversal television.
Sources: Company reports and author calculations
EXHIBIT 4 Key Industry Players