This Cable Mega-Merger Could Actually Be Good for Consumers

Consumers are terrified of Comcast's plan to buy Time Warner Cable and create a cable giant. Maybe they shouldn't be.

Feb 22, 2014 at 9:30AM

Consumer advocates have come out almost unanimously against Comcast's (NASDAQ:CMCSA) proposed acquisition of Time Warner Cable (NYSE:TWC). Anti-merger arguments have taken a number of forms, none of which are especially convincing. However, the main complaint is that cable prices are constantly increasing, which is a sign that cable firms already have too much market power.

In fact, the opposite is true. High cable prices are a consequence of the immense market power of TV channel owners, who can demand exorbitant retransmission fees while forcing cable operators to bundle large numbers of channels together.

If anything, Comcast's increased size should put it in a better position to fight back against programmers, which could slow the dramatic rise in cable TV prices.

Cable prices on the rise
An FCC study found that expanded basic cable prices rose from $22.35 in 1995 to $61.63 for the year ending on Jan. 1, 2012. The number of channels included in those packages rose from 44 in 1995 to an average of about 150 today, but that's a small consolation for most pay-TV customers. Few, if any, people actually watch 150 channels!

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Cable prices are on the rise, but your cable company may not be to blame.

Most experts expect cable prices to continue rising precipitously. In early 2012, NPD forecast that the average pay-TV package would rise from $86 per month in 2011 to $123 per month in 2015 and then to a stunning $196 per month by 2020. (Stripping out premium channels, NPD expects a typical bill to rise from $65 per month to $110 per month over that time frame.)

With cable TV prices rising steeply, it's natural to blame cable companies. However, cable operators also compete with satellite-TV and telecom companies, and customers of these other pay-TV companies are seeing equally steep price increases. This suggests distributors like Comcast may not be the real source of rapidly rising pay-TV prices.

Comcast's financial results provide another hint that something else is going on. In 2006, Comcast's cable business generated an operating cash flow margin of 40%. In 2013, after seven years of continual increases in prices, the cable segment's operating cash flow margin was 41%. That's not much of an increase. If Comcast isn't keeping most of this extra revenue, where is it going?

The power of cable networks
The answer is that as your cable bill goes up, cable channel owners are laughing all the way to the bank. Comcast -- already the largest pay-TV provider in the country -- reported that program expenses (the amount it pays to content owners to carry their cable channels) increased 8.6% last year. Comcast expects another 9% to 10% increase this year.

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Comcast may be big, but it still can't negotiate with channel owners on an even footing.

Comcast's inability to exert any sort of control over its program expenses shows just how much the balance of power is skewed in favor of content owners. Content owners who control must-see TV properties are constantly pushing the envelope on pricing, betting that pay-TV operators will not risk alienating some subscribers by dropping a popular channel. So far, that's been a great wager for content owners.

Sports domination
Sports channels are typically the worst offenders on pricing. Many sports fans will desert any pay-TV provider that loses access to a major regional or national sports network. Moreover, channel owners can present pay-TV operators with a take-it-or-leave-it offer to put their channel on every expanded basic package or not offer it at all.

This gives sports network owners lots of bargaining leverage. As a result, industry experts estimate that sports now represents 50% to 60% of total programming costs for most pay-TV operators.

Walt Disney's (NYSE:DIS) ESPN is the most expensive basic cable channel by far. SNL Kagan estimates that Disney collected $5.54 per subscriber each month from pay-TV operators last year. That just includes the basic ESPN channel; other ESPN-branded channels like ESPN2, ESPNews, and ESPNU cost extra.

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Disney's ESPN and other sports channels probably take a big chunk of your cable bill.

Regional sports networks are also getting huge paydays. In the New York area -- where I live -- there are four regional sports networks. Combined, they take a cut that totals more than $10 per month for each subscriber. Nationwide, regional sports networks have been able to increase their subscriber fees nearly twice as fast as pay-TV operators have raised customer prices.

Bundling for profit
Another scourge of consumers is bundling, which is the main driver behind the explosion of channels on standard expanded basic cable packages. However, cable companies themselves aren't the cause here, either. Cable channel owners with multiple channels can force pay-TV operators to offer lots of unpopular channels in order to get access to a few more popular ones.

For example, in addition to controlling the ESPN family of channels, Disney also owns the ABC network, the Disney Channel, and ABC Family. On top of that, it owns half of A&E Networks, which operates A&E, The History Channel, Lifetime Network, The Biography Channel, and several others. Disney can essentially force cable providers to pay to put all of those channels in their standard packages, even though some of them are not particularly popular.

Time to fight back
In short, cable costs have gotten out of control because pay-TV providers like Comcast have had no ability to stop the escalation of programming fees. Even broadcast networks that give away their signal for free are starting to demand steep retransmission fees to be carried on cable. SNL Kagan estimates that these fees could surpass $7 billion by 2018, or roughly $6 per month for every cable subscriber.

There's no guarantee Comcast's purchase of Time Warner Cable will reverse this trend, but it won't hurt. Comcast has every incentive to keep cable prices down; the jump in cable prices has caused the total pay-TV customer base to stagnate at around 100 million households, despite continued household formation. In other words, a growing segment of the population is making do without traditional pay-TV services.

With 30% of the pay-TV market, Comcast would have more leverage in negotiations with cable channel owners. (Last summer, Time Warner Cable tried to fight against fee increases demanded by CBS and was not very successful despite its position as the No. 2 cable operator.) If nothing else, cable channel owners would feel more pain from blackouts if they were losing 30% of their subscriber fees at once, rather than just 10% or 20%.

Foolish wrap-up
The main reason consumers are terrified of the Time Warner Cable buyout is that they fear it will lead to even higher cable bills. That's not likely to happen. Since Comcast and Time Warner Cable do not compete against each other anywhere, their merger won't affect the competitive balance.

In fact, the exorbitant subscriber fees demanded by cable channel owners are the biggest driver of skyrocketing pay-TV prices. Comcast's purchase of Time Warner Cable will give it more heft in negotiations with these content owners, which could slow the rate of program expense growth. For this reason, cable consolidation is more likely to help consumers than to hurt them.

Who will rule the next generation of TV?
You know cable TV companies are in trouble. But do you know how to profit from the rise of Internet TV? There's $2.2 trillion out there to be had. Currently, cable grabs a big piece of it, but that won't last! And when cable falters, three companies are poised to benefit. Click here for their names. (Hint: They're not Netflix, Google, and Apple.)

Adam Levine-Weinberg owns shares of Apple, is short shares of Netflix, and has the following options: long January 2015 $390 calls on Apple. The Motley Fool recommends and owns shares of Apple, Google, Netflix, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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