Sunday, November 27, 2005

Your Next Set-Top Box, Part 2

In Part 1 of this topic, I introduced the concept of the "One Box," a set-top box (STB) that can serve as a digital cable box, DVR, DVD/blue laser player, game console and media center. I proposed that One Boxes will most likely be based on Microsoft's XBOX 360 and Sony' Playstation 3. In the second and final part, I'll examine the challenges and opportunities that the One Box brings to major industry players.

Cable MSOs

In my opinion, the cable operators never really wanted to get into the set-top box business, but they were forced to do so, first for technical reasons and then for security and value-added services. In the early days, when TVs only had screw-type antenna terminals, cable operators could get by with cheap baluns that converted coaxial cable signals to television antenna inputs. Eventually, virtually all televisions included coaxial cable inputs, which eliminated the need for a balun. However, in these simple systems, it was very easy to steal cable signals, and almost impossible for cable operators to track thieves down. To combat theft, cable operators switched to addressable set-top boxes, which enabled them to turn service on or off at a central location, as well as identify people who were getting cable service but not paying for it.

When cable systems went digital, there were a vast number of digital channels that a television set couldn't tune to. The FCC requires cable operators to provide a low-cost analog service for those customers who don't want or can't afford digital cable, but any viewer who wants more than the limited analog channel lineup has to upgrade to a digital STB. With digital boxes, cable operators can provide interactive programs guides (IPGs,) enhanced pay-per-view and video-on-demand (VOD) services. The latest digital STBs have integrated DVRs which permit local storage and replay of programs.

Each improvement makes STBs more complex and expensive. At present, MSOs purchase set-top boxes for $100 to $300 each. They have to stock, maintain and refurbish boxes. As boxes are lost, stolen or destroyed, they have to replace them. And, the IRS requires cable operators to write off their investment in STBs over seven years. The result is that MSOs take a lot of time deciding on whether, when and with what to replace their existing STBs. The upfront cost can range into the billions of dollars for the largest MSOs.

Now comes the One Box. Unlike cable STBs, the One Box will be updated on consumer electronics timelines. For example, the original Microsoft XBOX started shipping in the U.S. before Christmas, 2001. Four years later, it's been superseded by the XBOX 360. (The Playstation 2 will be about six years old when it's superseded by the Playstation 3.) While neither the XBOX 360 nor the PS3 are "open," they're both expandable. In about the time that an MSO can upgrade its entire installed base to a new generation of STBs, consumer electronics companies can ship two generations of their products.

If third-party STBs take off, cable operators will get stuck with thousands or even millions of boxes that they no longer need. The MSOs can't require their customers to rent STBs from them because of an FCC ruling that requires cable operators to support third-party "navigation devices" (set-top boxes, DVRs, television receivers, etc.) by July 1, 2007, starting with the six largest MSOs. Cable operators must provide customers using such devices with a CableCARD (TM), which performs the same security and service support as their digital STBs. Today's CableCARD 1.0 standard doesn't support electronic program guides, video-on-demand or interactive applications, and only includes a single tuner (which makes recording one program while watching another impossible.) CableCARDs conforming to the 2.0 specification will support VOD and interactive applications, and will include two tuners for more DVR functionality; these cards are expected to ship by the end of 2006. However, existing CableCARD slots won't support the 2.0 standard; they have to be redesigned in order to be compatible.

Cable operators rent out CableCARDs, of course, but they generate much less income for them (CableCARDs typically rent for 1/3rd or less of the monthly cost of a digital STB.) CableCARDs are also much easier to steal or lose, and they can't be repaired or refurbished; if they're damaged, they have to be replaced. So, they're stuck with two inventories: One of STBs, the other of CableCARDs. The can't drop the STBs because most of their customers still can't use CableCARDs, and they have to supply CableCARDs and thus make much less money from rentals. Over time, there will be more and more CableCARDs and fewer and fewer standalone STBs.

Consumer Electronics Manufacturers

Consumer electronics companies have wanted to get into the set-top box market for years, but for all practical purposes, they're locked out of the U.S. cable business due to the MSOs' massive investments in Motorola and Scientific-Atlanta (soon to be Cisco) equipment. The limitations of CableCARD 1.0 (one-way communications only) make it an unacceptable substitute for integrated STBs. The formal launch of CableCARD 2.0 and related software will for the first time put the CE manufacturers (including Microsoft and Sony) on an even footing with the legacy STB vendors.

While Microsoft and Sony are uniquely positioned to deliver One Box hardware, there are other vendors who are very close. For example, TiVo announced last year its intention to offer a combination HD DVR/STB as soon as 2.0 CableCARDs ship. Humax, a TiVo licensee, already combines DVR functionality with a built-in DVD recorder, thus providing three of the four elements of the One Box. LG, Panasonic, Philips, Samsung, Sharp and Toshiba (among others) all sell DVR/DVD recorder combos that can incorporate full digital STB capabilities with CableCARD 2.0.

There's no particular magic involved in building a STB/DVR/DVD recorder; all the hardware is readily available. The challenge is integration: Getting all the pieces to work together seamlessly and transparently to the user. The key is software--both the user interface and the "behind-the-scenes" services and system management software. In this area, Microsoft and TiVo are well ahead of Sony and the other CE manufacturers. TiVo's true "value-adds" are its intuitive user interface, powerful features and online program guide, all implemented in software on a generic Linux platform. Microsoft licenses the Microsoft Program Guide, a software and services package that gives Windows XP Media Center Edition-equipped PCs TiVo-like functionality, to CE manufacturers (the first being LG Electronics.) No matter who manufactures the hardware, the "arms merchants" that make everything work will be software and services experts like Microsoft and TiVo.

Content Aggregators

The One Box could well become a godsend for content aggregators, placing them for the first time on an even playing field with the cable and satellite operators. The cost, time and effort required to launch a new cable network are enormous. The vast majority of proposed cable networks never get off the ground because of a lack of funding, a lack of available channels (even on digital tiers), or both. The fastest way to get a new network on a large number of cable systems is to buy an existing one. For example, Al Gore and Joel Hyatt led an investment team that acquired Newsworld International from NBC Universal for $70 million, and transformed Newsworld into Current, a current events network targeting the 18-to-34 audience. By buying NWI, Current got into 19 million households, most of which came from DIRECTV, but the network has no chance of being successful until it gets into most U.S. households through cable. To do so, Current will have to pay cable operators to carry the network, at least until its advertising revenues and audiences are large enough that MSOs will start paying carriage fees to Current. Several hundred million dollars will be sunk into the network before it becomes available to the majority of television households. The One Box could eventually make it practical for future networks like Current to launch directly into consumers' homes via the Internet, dramatically decreasing the amounts of time and money needed to reach "critical mass."

Startups Akimbo and DAVE Networks are examples of IPTV distributors that license video content from a variety of sources and then make it available to consumers through proprietary set-top boxes and software. To date, the "take rate" for their STBs and services has been low, in part because most consumers don't want to add yet another set-top box to their living rooms. The One Box will enable these companies to offer content and services without requiring consumers to purchase their STBs. They can get out of the STB business and focus on their content and services.

The One Box is also attractive to content aggregators such as Google, MSN and Yahoo, which can provide their own friendly user interfaces and "electronic program guides" for the content that they host on their own systems and promote for others. For example, one can readily envision a Yahoo! program guide running on the One Box that enables viewers to stream and download news, sports and entertainment. Content on the Internet will be almost as convenient to find and watch as content on cable, so long as the Internet powerhouses are willing and able to develop a look and feel for their services that's comparable or superior to what consumers already get with their cable set-top boxes.

Integrated Set-Top Box Manufacturers

In the One Box era, the incumbent STB manufacturers will have their work cut out for them. One the one hand, FCC rules require the MSOs to replace their existing integrated STBs with STBs with CableCARD slots, which will open up an enormous replacement market years ahead of time. On the other hand, there's absolutely no reason why MSOs have to buy their open STBs from Motorola, Scientific-Atlanta, Pioneer, Pace, etc. The incumbents will manufacture and ship millions of CableCARDs to the MSOs, but the cards sell for a fraction of the price of integrated STBs. As a result, their revenues will drop dramatically unless they can convince MSOs and consumers that their STBs are preferable to those from consumer electronics companies. STB manufacturers have always had no more than a handful of serious competitors for sales to cable operators, but that era is coming to an end.
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