Dustup On The Set Top

General Instrument's cable hegemony is over

Until recently, General Instrument Corp. had reason to be smug about its dominance of the market for cable-TV equipment. Its set-top boxes are in 53% of the 62 million U.S. homes that have cable. Revenues reached $2.4 billion last year, more than double 1992's $1.1 billion. Operating margins have remained a rich 14%.

But General Instrument is facing a sudden spate of problems, and rivals see that as a well-deserved comeuppance. For years, the Chicago company has raked in big profits by supplying cable operators with complete systems for receiving satellite signals, putting them on the cable network, and making sure "pirates" couldn't watch for free. The catch: Buyers of GI's systems were locked in to GI as sole equipment supplier, and that caused problems. Buyers griped about high prices, short supplies, and late delivery of new products.

Now, GI has been victimized by a delay of equipment purchases by its mainstay customers, the cable operators. At the same time, GI is two years behind schedule with its flagship DigiCipher II digital security system. The company trails in the exploding market for home satellite TV. And it has suffered a wave of resignations of key officers in the past two years, including a CEO and two successive heads of its core Communications division. "Pride goeth before a fall," intones Richard Doherty, founder of Envisioneering Group, a Seaford (N.Y.) consultancy. Investors have begun to take notice: While the overall stock market has soared, GI shares have tumbled 35% from their high of 41 5/8 last July.

In GI's hot seat is Richard S. Friedland, an 18-year company veteran. He became chairman and CEO in July, when Daniel F. Akerson stepped down to try investment banking at Forstmann Little, the outfit that took GI private and then public again in the early '90s.

COMEBACK KID. Friedland is upbeat about GI's future, saying the company is financially healthy, with deep management and strong technology. By the end of the year, he expects to be shipping 50,000 state-of-the-art DigiCipher II set-top boxes a month to Tele-Communications Inc. Friedland says GI's digital cable systems will have more capacity, better security, and more flexibility to customize content than competing satellite systems. As for the departures, Friedland notes that one key executive has returned: VideoCipher pioneer Woo Paik, who left for Qualcomm Inc., came back this year as executive vice-president for technology.

Right now, digital satellite TV is booming. General Motors Corp.'s Hughes Electronics is in the lead, with a direct-broadcast satellite system that carries programming from DirecTV Inc. and U.S. Satellite Broadcasting Co. (USSB). Together, they serve more than 1.4 million households, according to Satellite Business News, and they do it without using any GI equipment. General Instrument supplies gear for the No.2 satellite-TV system, a consortium of cable operators called Primestar Partners, serving 1.1 million homes. But in January, Primestar delayed a $500 million purchase of digital equipment from GI--a delay GI says will cost it $20 million to $25 million in profits this year. More recently, Primestar decided to find a second company to share in supplying its set-top boxes.

GI has had problems with diversification, too. Last year, GI attempted to enter the market for phone gear with an $85 million acquisition of Next Level Communications, a Rohnert Park (Calif.) maker of fiber-optic equipment. In March of this year, a Texas jury ruled that Next Level's founders had misappropriated trade secrets from a previous employer. The jury ordered Next Level and its founders to pay $369.2 million in damages. GI plans to appeal.

Emerging industrywide standards for digital video pose another threat to GI, whose business has until recently been built entirely on proprietary technology. The standards assure that products from different manufacturers will work together, allowing the entry of more rivals. GI's DigiCipher II technology, for example, is a proprietary variant of a widely adopted image-processing standard called MPEG 2. "MPEG 2 is really everywhere," says Guy Lauvergeon, director of the image processing business unit at SGS-Thomson Microelectronics Inc., No.1 manufacturer of MPEG 2 chips. If price is all that counts, MPEG 2 is likely to win out over DigiCipher II on sheer volume.

HACKER-RESISTANT. Friedland does have one ace up his sleeve: security. GI's DigiCipher II builds in extra security features to prevent consumers from swiping signals they're not entitled to. With years of experience combating hackers, GI can give cable companies the security that programmers demand.

"We think we're the world leader in encryption," says Friedland--and he could be right. VideoCipher II Plus, the analog ancestor of DigiCipher II, has never been broken, despite intensive hacking by pirates. Says Friedland: "Our policy is zero tolerance." By contrast, hackers quickly broke the security system used by Hughes Electronics for DirecTV and USSB. News Datacom, the maker of the system used by Hughes, confirms that it has had to use "electronic countermeasures"--special satellite signals--to kick pirates off the system. If pirates get too numerous, News Datacom plans to bump them off by mailing out "smart cards" for the set-top boxes of all legitimate subscribers.

The question is whether Friedland can parlay GI's security advantage into sales. Giant TCI says it still plans to buy up to 1 million DigiCipher II boxes, starting late this year instead of 1994 as originally planned. Other companies have been reluctant to make commitments. Hewlett-Packard Co. and Scientific-Atlanta Inc., which have licenses to make DigiCipher II boxes, say they won't do so without firm orders. "We're really interested in going where the high volumes are," says Casey Sheldon, brand manager for interactive products at HP. Time Warner Inc. isn't interested in DigiCipher II, says Time Warner Cable Senior Vice-President James A. Chiddix: "Wherever possible, we're trying to avoid proprietary technology."

With his old monopoly business model out the window, Friedland needs to work hard to convince cable operators that GI's equipment provides real advantages over the competition. If he doesn't succeed, he might find that GI's picture is growing dim.

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