FCC Approval Clears Way for AT&T-Comcast Merger

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1 Gartner Dataquest Alert FCC Approval Clears Way for AT&T-Comcast Merger On 13 November 2002, the U.S. Federal Communications Commission (FCC) granted conditioned approval to the merger of AT&T Broadband and Comcast to a new entity, Comcast. The FCC approval allows the transfer and control of licenses and authorizations from both companies to the new entity and creates the largest cable system operator in the United States and likely the world, with 21.6 million basic cable TV customers. It joins the No. 1 cable systems operator, AT&T Broadband, with 13.1 million basic cable subscribers, and the No. 3 operators, Comcast of Philadelphia, Pennsylvania, with 8.5 million. Specifically, the FCC conditioned its approval on the following: The companies place their interests in Time Warner Entertainment, L.P. (TWE) into an irrevocable trust at the completion of the merger The new Comcast fully divests itself of any interest in TWE within five-and-a-half years of the merger's closing (the TWE Proposal) The merged entity is prohibited from any involvement in video programming activities associated with the TWE entity. (Comcast owns substantial programming interests in its own right.) Other issues that were raised in the merger review, such as the opening of cable TV systems to unaffiliated Internet service providers (ISPs), will be considered in separate FCC proceedings. The FCC said it was satisfied that the TWE settlement between AT&T and AOL Time Warner had taken care of most of the noncompetitive issues surrounding the merger and that the merger would have a positive impact on the deployment of broadband services (which is an important FCC policy goal). Not all the Commissioners agreed, however. Commissioner Michael J. Copps voted against the merger order, arguing that the "sheer economic power created by this megacombination and the opportunities for abuse that would accompany it outweigh the very limited public interest benefits." In addition, a number of consumer interest groups such as Media Access Project, the Consumers Union, the Consumer Federation of America and the Center for Digital Democracy were opposed to the FCC's decision, and may go to the U.S. Court of Appeals in Washington to seek to overturn the FCC's decision. Gartner Dataquest Analysis The U.S. Justice Department followed shortly after the FCC announcement saying that it too would not challenge the merger. The parties have set 1-December-2002 to close the deal, now valued at about $30 billion. November 15, Gartner, Inc. 1

2 The New Comcast The lynchpin for approval of this industry merger depended on AT&T and AOL Time Warner taking care of the ownership issues in the TWE partnership. This was accomplished previously in an agreement between the two companies: AT&T selling its 27 percent stake in the TWE partnership to AOL Time Warner in exchange for $2.1 billion in cash, $1.5 billion in AOL Time Warner stock and a 21 percent economic stake in a new company, Time Warner Cable, which will hold onto TWE's cable TV assets. In addition to cash and stock, the deal called for the merged Comcast-AT&T Broadband to carry AOL's Internet service over all the company's cable networks, as one of several multiple ISP offerings. At $38 per subscriber per month, this was a very rich price tag by any standards for AOL Time Warner and, at minimum, represents the sheer market power of the new company in terms of total number of homes passed by the combined footprint of their broadband networks. Beyond this, the two companies bring significant assets to the merged firm. The new Comcast will own, operate and serve almost 22 million cable subscribers (27 million with the TWE properties), and have its networks pass approximately 39.2 million homes. Comcast alone has the largest continuous, contiguous cable footprint in the industry, stretching from Northern New Jersey to Virginia. This brings significant efficiencies in terms of network architecture, headend consolidation, equipment warehousing, as well as advertising synergies within a broad, high-density media market and region for advertisers. On the broadband access side, the merged entity has within its portfolio almost 3.3 million highspeed Internet subscribers, or about 5.5 percent of the 60.3 million U.S. online households, based on Gartner Dataquest consumer online research conducted in June This will make it one of the largest ISPs in the United States. Challenges for the Merged Firm While the transaction has been hailed by each company's executives as a way to create value and position the merged company for future growth, Gartner Dataquest sees significant challenges ahead for the new giant cable company, including the following: Stemming the losses to digital satellite competitors Competition from competitive digital video programming providers is dampening basic subscriber growth rates, in some cases to less than 1 percent per quarter. In many cases, digital satellite competition is outright stealing customers away from cable, causing negative subscriber growth. This is happening most in areas where "un-upgraded" systems cannot compete with satellites' superior offering. Most cable operators, with the exception of Cox and Comcast, reported declining third quarter 2002 subscriber growth. All attributed declining customer totals to the brutal competition direct broadcast satellite (DBS) providers are waging. Cable will be tasked to find formulas that will work against satellite, whether that means adjust pricing more competitively, finding a way to provide a more robust digital offering, offering more original or exclusive programming, coming to market with highly competitive bundling strategy for video, voice, data and on-demand services. November 15, Gartner, Inc. 2

3 Maintaining its lead in broadband high-speed Internet market The market for high-speed access services continues to grow (albeit at slower rates), and cable is still winning the race against DSL and other access modalities. However, to keep the pressure on against DSL, cable must move swiftly to offer a diversified suite of services at the high and low ends. This means an array of lower-priced, high-speed Internet to successfully migrate dial-up users over to highspeed connections at near-dial-up prices, or to appeal to higher-end users, such as subsidized or bandwidth hogs that are doing peer-to-peer applications, cable must remain innovative in the advanced data services space. In this context, cable companies must also provide true businessclass services and bundled network-based services/applications for larger/growing companies needing more than simple higher-speed access to the Internet not a strength to date. Maintaining share of broadband application revenue within the cable universe As broadband access moves into the mainstream, many revenue-generating services and applications are made possible. Home networking, interactive games, video and audio downloading, content on demand, t-commerce, and so on represent just the tip of the iceberg for this emerging category. The challenge for cable operators is to find a way to keep this broadband service/apps revenue in-house, even as a host of competitive content providers clamor for a share of this emerging segment of the market now enabled by broadband connections. It might achieve this through smart bundling with content providers, as well as strategic partnerships or mergers. Move decisively to capture a share of customers for competitive data services in the small and midsize business (SMB) market Cable has spent billions upgrading networks for robust digital video and high-speed broadband data services. However, with the addition of innovative new technologies, such as DOCSIS 2.0, switched Gigabit Ethernet or in some cases passive optical network (PON) technologies, targeting areas with the most demand (demand-based capital), cable may be able to serve the "gray zone" of the SMB market using existing hybrid fiber-coaxial (HFC) infrastructure. This gray zone is located above the telecommuters/small offices/home offices (SOHOs), but fewer than 200 users. With more symmetrical bandwidth capabilities, which include higher capacity/capabilities in the upstream path, Internet Protocol (IP)-enabling technologies and software management tools for self-provisioning, cable could have a shot at capturing high-revenue/low-price-sensitivity end users that demand symmetrical business-class services. Cable operators such as Cox and Comcast are already attacking portions of this gray zone of the SMB market using the HFC architecture. With a wider footprint of continuous, contiguous cable systems, the new Comcast could be poised to gain some efficiencies in this particular segment of the data services market. What's Next for the New Comcast? Gartner Dataquest expects Comcast will swoop down rapidly into AT&T Broadband's systems with an operational template to get nonperforming systems up to the operational metrics they are accustomed to, which includes raising operating margins to the 40 percent-plus range within three to five years. Comcast executives are standing by in all regions to put their imprimatur into place as quickly as possible. As discussed by Brian Roberts and his team on the last earnings conference call, Comcast's priorities are to hit the ground running with operating structure and people to achieve a number of goals. These include: Focusing on cash flow Achieving positive operating cash flow is the goal here, and the sooner the better, according to Comcast. November 15, Gartner, Inc. 3

4 Focusing on the video business, not telephony, as a first priority No doubt, competitive offering from EchoStar's DISH Network and Hughes' DirecTV are starting to show results as in subscriber churn away from cable. It's hand-to-hand (more like wire-to-wireless) combat out there, and cable must be on the offensive with the right price-value packages and bundled offerings to stem subscriber losses to satellite. Rebuilding/upgrading the lagging AT&T systems within two years It will take several billion dollars more at least to achieve this, despite the estimated $7 billion AT&T had to spend after it bought these systems from TCI. Caveat emptor? Certainly, the most erosion to satellite competitors is happening in systems that are not upgraded to high-bandwidth, two-way communications capabilities that enable advanced services such as digital TV, high-speed Internet, HDTV channels and on-demand programming. The big question is, will it be too late by then to get these customers back if they tie up with competitive bundles from either telecommunications companies or satellite providers? Increase marketing and diversification of advanced services, such as high-speed data, digital TV and on-demand services The merger of Comcast and AT&T Broadband could also have implications for other cable operators looking for more scale and wider operating footprints. The next likely candidates suggested as ripe for combination have included AOL Time Warner and Cablevision, the splitting up of the assets of Adelphia (if it survives at all), and the potential for Cox to throw its hat in the ring for a mixed bag of cable systems. The future of Charter Communications could also be at risk, as there have been rumblings and press reports that Paul Allen, the company's largest shareholder, could take what will now be the third largest cable operator, with 6.6 million customers, private. Gartner Dataquest believes that by 2010, there is the distinct possibility that four large cable operators will own and operate most U.S. cable subscribers. The new Comcast is expected to continue to focus on the deployment of advanced services, that are primarily video- and data-centric vs. telephony-based. We don't anticipate any massive roll out of either new IP telephony or additional circuit-switched cable telephony markets in the next two years. However, as the regional Bell operating companies (RBOCs) are now aggressively bundling DSL services with their fixed and mobile voice packages, the new Comcast must pick and choose wisely where they direct their dollars to remain competitive with the telecommunications companies' competitive onslaught. Comcast says it will take about two years worth of time and as yet untold dollars to upgrade the lagging AT&T Broadband systems to operational metrics more in line with Comcast's own. However, with the type of competition cable is facing from satellite on the video side and from telecommunications companies on the data and voice side, will this be too late to reclaim customers lost to either competitor? Comcast will direct its capital expenditure at technologies that will enable the advanced services that generate strong revenue and high margins. While AT&T Broadband has states that its telephony operations are operating "in the black," look for cable telephony services in general to take a back seat to other concerns as the newly merged entity makes sure the core video and increasingly important broadband data businesses remains healthy and competitive. By Patti Reali and Charles Carr November 15, Gartner, Inc. 4

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