Virtual MSO - A Look at the Opportunity

On the heels of the Needham analysts Laura Martin and Dan Medina's report "The Future of TV" (.pdf link) come stories about Apple and Google planning to offer something that sounds like a virtual MSO -- a plan to offer a bundle which includes live channels direct to end users over the Internet. As my friend and former colleague Will Richmond notes, this story has flared up many times over the past year or so, with Sony, Microsoft and Intel famously among the potential cable disruptors.

Hopefully new virtual MSOs will not represent a new path into the home for poltergeists.

The Needham report provides an exceptionally clear-eyed look at the television ecosystem and makes a few points that I had not seen made as clearly anywhere else. It also provides a useful context to consider the opportunity for a so-called "virtual MSO".

• Multichannel television is about 85% penetrated to households.
• Most of the popular cable networks are controlled by a relative handful of major programming companies (Disney, Time Warner, CBS, Viacom, Fox, Discovery, Comcast/NBCU, Scripps, A&E and AMC).
• The programmers bundle their channels together for sale to distributors.
• To the extent that programmers are willing to sell their services to new providers, they will expect the new provider to carry all of their channels in the "basic" package and pay full "rate card" prices.
• The existing multichannel providers have
• superior pricing on content, and
• less restrictive packaging terms, and
• a much more substantial local advertising sales business which can take advantage of the local avails that cable networks provide with their service, and
• their own pathways to their customers, so they can provide a consistent service quality. 
• The major programmers are not interested in seeing cable as a whole become unbundled. It is not unusual for a programmer to require that a new distributor sign up many other third party cable networks as a condition of an affiliation agreement with a major programmer. 
• Some programmers have restrictions in their affiliation agreements with current distributors that do not allow them to sell their services to over-the-top providers (or provide disincentives if they were to do so).

So, where does this leave our potential virtual MSO?

• Entering a possibly saturated market.
• Signing on to higher content costs.
• Receiving little or no packaging flexibility.
• Having a minimal ability to offset content costs with advertising.
• Being dependent upon a third party (the consumer's ISP) to deliver the service with acceptable quality.
• Being dependent upon that same ISP to provide the consumer with service with no bandwidth cap so that the substantial use of the service (i.e., watching television) does not require the consumer to spend extra on its ISP service.
• Likely having to launch without some popular channels.

Some of the issues the new entrants will face are temporary, but some are more fundamental. With scale, the new entrants will likely improve their content costs and advertising sales businesses. The packaging restrictions limit creating a significantly different content offering. The service quality and bandwidth cap issues look thorny.

Not surprisingly, given these difficult tasks, the virtual MSO business is only being stalked by companies with deep pockets -- Google, Intel, Microsoft, Sony and Apple fit that bill. Perhaps they are willing to run this business on little, or no, or negative margins for a good period of time to establish it.

That list of potential entrants dovetails nicely with the only obvious unimpeded opportunity for the virtual MSO: to improve the television interface. I think are opportunities in this and I am not alone in this feeling. Apparently Intel has made progress on this front. The incumbent distributors' widely deployed set-top boxes with their grid-style electronic program guides are not especially helpful for consumers navigating hundreds of channels. The widely deployed set-top boxes with DVR storage in the consumer's home have limited capacity, are subject to failure and can rarely be accessed outside of the consumer's home, often they can only be accessed on the single set to which the box is connected.

The skills that some of these new potential entrants have also dovetail nicely with this opportunity: Apple makes great interfaces, Google is the leader in running the sort of enormous data centers that a cloud DVR would require, Microsoft has some of Apple's advantages and some of Google's (both to a lesser extent). Sony still makes great consumer devices and Intel's chips undergird systems for all of these players. For each, that's a good start.

However the intersection of the opportunity and the constraints may be small. It doesn't make sense to make a first-class interface and launch it with a low-end product. Meanwhile launching a high-end product with uneven quality of service and lacking some top channels might also be problematic and the threat of future bandwidth caps doesn't help.

Fundamentally, to sort-of channel Steve Jobs, if you can't offer a product that is much better than what is out there already, why are you doing it?

At the same time, the multichannel interfaces are a moving target. It is clear that the distributors know that their interfaces are not-so-good and that the DVR would be better placed in the cloud than in the consumer's home. Comcast's new X2 guide software, unveiled at last month's Cable Show, is working on both of these issues. Other distributors are making similar efforts, like Cox's FlareWatch product/experiment (see my prior post).

The launch of iPad apps, led by Time Warner Cable and followed by many other distributors, are another way the distributors are updating their interfaces and, this also suggests another path for Apple, Google, Intel and the others.

These apps have been ported to devices beyond the iPad. In the case of TWC TV's app, it is available on portable devices such as the iPhone, Android phones and tablets and the iPod touch, but it is also available on the Roku, a television-connected box and Microsoft's Xbox game console and is rumored to be coming to the Apple TV. Clearly Time Warner Cable is more interested in making its service more available and hence more useful to consumers than protecting the revenue stream from additional set-top box rental and additional outlet charges.

But isn't carrying the cable operator's app on an Intel-powered box a tiny victory for Intel or Apple compared to the huge win of creating a virtual MSO?

Perhaps it is, but looking at Intel's issue more broadly, the creation of the virtual MSO seems much less important. Intel does not have a strategic need to distribute video content. Intel does have a strategic need to sell more of its chips, which by and large are not used in cable set-top boxes, nor in the Apple TV or Roku boxes. Similarly, Apple and Sony are primarily in the business of making consumer devices.

If the operators will create apps for the boxes of Roku, Apple, Sony and Intel, it would not appear that there is the same need for these companies to create their own services competitive with cable, particularly if they are essentially relegated to providing me-too services.

Under this scenario:

• The multichannel operator wins by making its service available on more devices, which inevitably will compete to make their boxes and interfaces more attractive, reducing the distributors' dependence on expensive proprietary set-top boxes which much be purchased, inventoried and supported and whose software tends to evolve slowly. The interface is still controlled by the operator since it has to authorize the subscriber (and no software developer would release an app that the operator won't authorize).
• The consumer benefits by having the option to buy a relatively inexpensive Internet streaming box (some Rokus cost as little as $50) and not having to rent a cable box (effectively $14.25 monthly for me on Time Warner Cable's system in Manhattan -- see picture below).
• The consumer electronics company has an easier time getting its box into a consumer's home.

1 additional outlet costs almost as much as HBO

To the extent that there is a more promising virtual MSO opportunity available down the road, Apple, Sony, Intel or whomever can then use its installed base of boxes to jump start that business. Famously, Apple did not make the first MP3 player or smartphone, they waited until what they could make was a material improvement on the state of the art.

While the Google TV box could employ the same strategy, that may not be sufficient for the company. After all, Google is primarily a services provider rather than a device provider, it is already in online video via YouTube and it has the deepest pockets of all. As the Diffusion Group notes, Google's search expertise could be bring a new paradigm to television navigation. Also, Google's experience serving up more relevant advertising might give it a leg up over the incumbent cable ad sellers, once it had meaningful scale, of course.

Another view, not inconsistent with mine: Jeff John Roberts, GigaOm