Verizon's Big TV Bet Pays Off

Investors battered the company's stock for years. But now they're beginning to show support for CEO Seidenberg

Two years ago, Verizon (VZ) CEO Ivan Seidenberg's aggressive push into the pay TV market was widely dismissed as an expensive corporate boondoggle. Many investors and analysts fretted that even if Verizon could overcome the thorny technological and regulatory challenges of providing TV over fiber-optic cables, the costs were simply way too steep for the potential profit. Seidenberg, in perhaps the most ambitious effort by any phone company in the world, wanted to spend tens of billions of dollars to go head to head with cable companies in their core business. The credit-rating agency Moody's (MCO) cited the project's "highly uncertain returns" when it downgraded Verizon in 2005.

Now, Seidenberg's big bet is starting to pay off. Revenues from the effort are surging, and Verizon's TV service is helping to stem the loss of telephone customers to cable rivals. Verizon is adding nearly 2,000 television customers a day, seven days a week. Even Comcast (CMCSA), Verizon's largest cable competitor, is publicly acknowledging that it's feeling the heat. "The telecom companies have had their fits and starts, but Verizon is real. Verizon is taking video customers from us," said Stephen Burke, Comcast's chief operating officer, at the Goldman Sachs (GS) communications conference in New York.

Seidenberg may be just getting warmed up. At the end of the second quarter, Verizon had laid enough fiber cable to offer TV service to 3.9 million homes. But by the end of 2010, the company expects to have fiber in at least 18 million households in its traditional East Coast territory, more than four times the potential customers it has today. If cable rivals such as Comcast and Cablevision Systems (CVC) are under pressure now, it's only going to get worse. "We have a really great platform that is seeing tremendous acceptance in the marketplace," says Seidenberg. "Every one of our metrics is improving quarter over quarter."

Investors Come Around

Seidenberg's strategy is to dominate the new technology that was supposed to put the phone companies at risk. By investing in fiber, he has the ability to offer essentially unlimited bandwidth. The company has the capacity to offer consumers Internet connections of 100 megabits (Mb) or more should they demand it. And the fiber network, called FiOS, allows Verizon to provide superclear TV signals without resorting to compression. Rivals from AT&T to the cable companies typically compress some of their channels because they have less bandwidth.

Verizon's chief isn't in the clear. The TV business hasn't turned profitable yet, and real vindication won't come until it does. Verizon expects that to happen next year on the basis of EBITDA, or earnings before interest, taxes, depreciation, and amortization. It expects to turn an operating profit in 2009.

But once-skeptical investors are now putting their money behind Seidenberg. Verizon's stock is up about 18% over the past six months, to more than $44. That's more than double the return of the Standard & Poor's 500-stock index and telecom rival AT&T (T). On Sept. 28, David Barden, telecom analyst at Banc of America Securities (BAC), raised his 12-month price target on Verizon to $50, forecasting an increase of another 12%. "We believe the stock can gain as the market develops an appreciation for…FiOS to transform into a positive growth contributor," says Barden.

Spending Its Way to Success

The TV strategy has been a very personal one for Seidenberg. He championed the pricey approach of stringing fiber lines into millions of homes and stuck to his guns even as investors battered his company's stock. Meanwhile, under former chief Ed Whitacre, AT&T, took a more conservative route, using a lower-cost combination of fiber and copper wire to deliver television service. Now Verizon has more than 500,000 paying TV customers, while AT&T has 100,000. "AT&T has been slower off the bat," says Comcast's Burke. "They have a tougher row to hoe, because they have not spent as much money on fiber, but they are a big company, serious about what they are doing, and spending a lot of money."

Verizon has one of the biggest capital spending programs in the world. The company plans to spend $23 billion between 2004 and 2010 to run high-speed fiber-optic lines directly into customers' homes to deliver television and speedy Internet service. Verizon says it will recoup about $5 billion of the costs in operating savings, because its fiber system is less expensive to maintain than traditional copper lines. "I feel very good about what we have done, relative to what people said we could do," says Marilyn O'Connell, senior vice-president of video solutions at Verizon. "I think we have proved that we can execute our business plan, that it is a good plan, although it will take another couple of years to achieve a return on investment," she says.

Verizon is following the same aggressive capital spending plan that it used in the wireless market, where it has seen strong financial returns. Its capital spending budget for 2007 is $14.62 billion, or 19.6% of its forecasted revenues of $93.8 billion, according to Goldman Sachs (adjusting for the 45% stake in Verizon Wireless held by Britain's Vodafone (VOD)). About $10 billion of that spending is focused on the wireline business, including the television effort. In comparison, AT&T's capital spending budget for 2007 is $18.5 billion, or 14% of its $119 billion in forecasted revenues for the year.

Reversal of Fortune

Over the years, Seidenberg has pushed the approach of big capital investments, even at the expense of short-term support among investors. AT&T, especially under Whitacre, relied a bit less on capital spending and a bit more on the big acquisitions that appealed to investors for their quick returns. AT&T's stock surged ahead for years, rising nearly 40% during 2005-06, even as Verizon's shares lost ground. But in recent months, their fortunes in the stock market have reversed, with Verizon outdistancing its telecom rival.

Now, Verizon has the potential to force Comcast and other cable operators into another round of capital spending. Goldman has a buy rating on Comcast, with a price target of $34. But it says risks to its investment thesis include the threat of the phone companies' ongoing video rollouts and the need to boost capital expenditures to address bandwidth constraints. Verizon's fiber network currently allows it to offer customers connections of 15Mbps to 50Mbps downstream and 5Mbps upstream. It can boost those speeds any time it chooses. The cable companies offer speeds closer to 5Mbps to 10Mbps downstream and 1Mbps upstream. That may be sufficient for now, but as consumers watch more video on Web sites such Google's (GOOG) YouTube and even upload their own clips, that may become insufficient.

There's some risk that AT&T could feel similar bandwidth constraints, although it says it's fine for now. "Right now, we believe we have the right architecture and that it meets our longer-term strategic needs," says Brian Buffington, marketing director for AT&T's TV service, known as U-Verse. He says the company is adding 7,000 to 8,000 video customers a week and that it can use compression technology and other techniques to free up more room on its network. AT&T also is ahead in the move to IPTV, which uses Internet Protocol technology to carry TV signals to TV sets. Verizon's fiber system uses a more traditional standard. IPTV allows AT&T to deliver television service using less bandwidth, according to Buffington, although there have been technological challenges to AT&T's approach (BusinessWeek, 2/12/07).

Video Customers Generate More Revenues

The phone companies have plenty of challenges ahead. Comcast and other rivals are biting into their traditional phone business. Verizon alone lost 579,000 residential phone lines during the second quarter. It's much easier for cable companies to enter the phone business than it is for phone companies to enter the TV business. They also are attacking the phone companies in other key markets, such as wireless phone service and communications for small and midsize businesses. Video customers, however, generate about three times as much revenue as phone customers do, which means that phone companies don't need to steal as many customers to stay even in terms of revenue.

At the very least, TV is helping phone companies hold onto customers. At Verizon, O'Connell says that the loss of customers to cable is falling in markets where Verizon has offered FiOS TV for at least six months. She wouldn't provide details on retention rates, but her comments are consistent with research that shows the overall rate of decline has slowed. The results are certainly good enough that rivals like Comcast are taking notice.

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