When Will Cable Start Shifting Bandwidth Away from Video and to Internet Access?

If an ISP’s highest-margin product is projected to have demand growth of an order of magnitude growth, or more, while other products with lower profit margins are declining, should we not expect more bandwidth to allocated to the fast-growing, highest-margin service?

Internet bandwidth, despite all worries about the “dumb pipe” implications, is the highest-margin product most ISPs can sell. And while the strategic implications are different for telcos, cable operators, satellite, mobile and other ISPs, at least for cable operators, it will make sense to shift network bandwidth to Internet access, while allocating less for video entertainment.

Among other things, that could in the future conceivably mean a bigger shift to “switched” or “on demand” video, more fiber, closer to the customer and significant changes in the volume of channels offered to end users.

One issue is precisely how high profit margins might be, for various providers.

Smaller ISPs, as you would guess, tend to have lower margins than some tier-one ISPs. One study of smaller Australian and New Zealand ISPs estimates gross profit margin between 26 percent and 39 percent, for example, before adding in overhead and other costs not directly related to access, transit costs or backhaul.

Some might claim cable’s broadband gross margins are about 95 percent, versus 60 percent for video, according to Craig Moffett, Sanford C. Bernstein & Co. analyst. That is not so. That figure by Moffett applies only “cost of goods sold” against revenue.

Moffett’s cost of goods sold takes into account only the day-to-day costs of running the network, as opposed to building it. In other words, COGS includes only out of pocket operating and marketing expenses, for example, not amortization of the network construction.

This produces gross profit margins that make cable companies’ profits look artificially high.

Net margins are another matter, since gross margin does not include all other overall and allocated costs.

Many estimates now suggest that net profit margin for video entertainment services now routinely are as low as 20 percent, where once net margins were about 40 percent. The same is true for broadband access, which estimates now suggest are about 40 percent, not the 97 percent “gross margin” figure.

Whatever you think the relevant percentages are, there is no question but that, for cable operators, Internet access bandwidth increasingly is more valuable than video entertainment bandwidth, as the profit margins are roughly double those of video entertainment service.

That is reflected in the growing recognition that it is broadband access which is becoming the foundation service for cable operators, gradually replacing television revenues. “Eventually, as linear TV is viewed less, the spectrum it now uses on cable and fiber will be reallocated to expanding data transmission,” says Reed Hastings, Netflix CEO.

Netflix and other streaming video services now are driving bandwidth consumption in the U.S. ISP business. Since at least 2011, real time entertainment content has represented at least 49 percent of peak hour traffic  in North America.

By 2012, video had grown to represent as much as 75 percent of peak hour traffic. With gradual attrition of video revenues, it will at some point make sense to allocate more cable bandwidth for Internet access, and less for linear TV.

That process has forerunners. Cable operators in past decades had prioritized analog signal delivery over digital. As the need to support Internet access grew, operators gradually shifted to “more digital” in the mix, and finally to “all digital,” as doing so frees up additional bandwidth for use for Internet access.

And that process will continue. Of course, that also means, absent dramatic new changes in video compression (we can assume progress, but not orders of magnitude), it will make financial sense to allocate more bandwidth for Internet access, and less for linear TV.