Good morning,

Today’s Daily Update Interview is with Craig Moffett. Craig Moffett is the founder and Senior Managing Director of MoffettNathanson, where he primarily covers the telecommunications, cable, and satellite broadcasting industries. Moffett first started working with the telecoms industry as a consultant with BCG, where he was VP and Partner, before becoming an analyst at Sanford C. Bernstein, and then founding MoffettNathanson.

Moffett has been consistently ranked as the number one cable and satellite analyst on Wall Street, and I can attest to the fact he, more than almost anyone else, foresaw the current upheaval in the TV market, including the recent dispute between Charter and Disney. In this interview we discussed the late 1990s telecom bubble, the path dependency that created the U.S. TV and broadband markets, and how Disney and other companies traded an “incredibly advantageous” industry structure for one that was “incredibly pedestrian”, and why that puts Google in the driver’s seat going forward.

To listen to this interview as a podcast, click the link at the top of this email to add Stratechery to your podcast player.

On to the interview:

An Interview with Craig Moffett About Charter vs. Disney and the Path Dependency of the Communications Industry

This interview is lightly edited for clarity.

The Telecom Bubble

Craig Moffett, welcome to Stratechery.

Craig Moffett: I’m really delighted to be here, Ben. Thank you for having me. I’m a huge fan of yours, so this is exciting for me.

Well, the feeling is mutual, and it’s hard to think of a better occasion to have the Grand Poobah of telecoms and cable on for an interview. I was actually originally wishing I could have you on last week as the Disney-Charter fight went down, but in retrospect, it was probably best that we waited to see what the deal looked like.

But that’s a teaser; before we get to that, I’d love to hear more about your background, how you got into covering this space. We got a little bit of history of MoffettNathanson when I talked to Michael Nathanson last year, but I’d love to hear the Craig Moffett story.

CM: Well, the Craig Moffett story is that I started as an artist, oddly enough. I was a painter and sculptor and was running an art gallery after I went to Brown, and decided I would get my MBA thinking that I would eventually go into museum administration and stay in the arts.

When I got to business school, the story gets less interesting, because I became a mercenary. I figured out that you could actually make some money, which seemed like a good idea at the time, and I was really enamored with strategy consulting, I was fascinated by business strategy, that’s why I’m such a fan of yours. I was fascinated by business strategy and was fortunate enough to join BCG right out of business school and I got sucked into telecom very early in my BCG career.

I stayed for eleven years and was running the telecom practice through the late 1990s during the Telecom Bubble and the long-distance rise and collapse, and then took a detour to be the CEO of the Internet business at Sotheby’s, the auction house, back in the very early 2000s, and then went back to the telecom business again after that and joined Bernstein, which is where I met Michael. We worked together for almost 10 years at Bernstein and then started MoffettNathanson, so I’ve been in telecom collectively, boy, thirty-some odd years.

So do you take any responsibility for the rise and fall that you referred to in the late ’90s?

CM: No. In fact, just the opposite. It was funny, I had written all of these things about the marginal cost structure of telecom and why the long-distance bubble was a bubble and was going to collapse, and it made me a pariah in the industry back in the late 1990s when everything was very go-go and I was predicting doom-and-gloom. I gave a speech at a telecom show in New Orleans in 1998, I think it was, where I predicted that all the long-distance companies in America were going to go bankrupt, and I was just about booed off stage.

(laughing) I can imagine!

CM: But a lot of the lessons that shaped my thinking about cable and about telecom come from having been a front-row witness to the insanity of the late 1990s into the early 2000s in telecom and watching that bubble pop, and you can make a strong argument that the collapse of the telecom bubble in the 1990s was actually a much bigger issue than the popping of the Internet Bubble, and that there was a lot more actual capital involved.

There’s a lot more money involved.

CM: That’s right, there was real money involved. And in fact, if you really want to stretch the narrative, you could argue that the Housing Crisis of 2008 and the Great Recession was actually a consequence, really, of the Fed trying to avoid what otherwise would have been a deep recession when the Telecom Bubble popped.

Interesting.

CM: That lowering interest rates to where they did created an enormous bubble in the housing market that finally burst and almost collapsed the banking system and all of it was a series of dominoes that were created by this massive over-investment in long-distance capacity in the late 1990s.

So you talked about looking at the marginal cost. What was the key thing that you seized on?

CM: It was the build-outs, it was the capacity. So remember in the mid-1990s, we were watching the rise of the Internet and the massive increase in data consumption, and the market rightly understood that we were going to be short of capacity, particularly in the backbone of the network, long-distance and unfortunately for the industry, there were three approaches to solve the problem, and all of them worked.

The capital markets tried to solve the problem by throwing more money at it and building new networks so you had all of these new companies like Global Crossing and IXC and you name it, and Qwest and what-have-you, creating long-distance networks. You also had the traditional telecom suppliers, then Lucent and Alcatel and people like that, create more and more efficient transport-modulation schemes. So you went from, in industry parlance, OC-3 to OC-12, to OC-48, to OC-96, to OC-192 and so on. Then you also had a company called Ciena create dense-wave division multiplexing and create what they called windows, or really you can think of them as different colors over a laser, and that worked too.

I was working with WorldCom at the time. I’d always wanted to get WorldCom as a client because we wanted to try to figure out, what is it they’re doing? Their stock price was going bananas, and they were perceived to be winning the war, and so I got a small engagement with WorldCom as a consultant to try to figure out — actually, the question they were trying to solve was — are the next-generation networks, Qwest and Global Crossing and Level 3, are those companies actually “orders of magnitude lower cost”, which was the narrative in the market at the time?

I was in a meeting with the management team of WorldCom and started to work on the whiteboard and we were doing exactly the math that I was just describing of, “Let’s talk about the increase in capacity that’s created by having added 9 new long-distance networks to the market”. So start with 9. The number of strands per network had gone from 2 to 4 to 8 to you were having 16-strand sheaths, and so I can’t remember what the number was, but it was maybe the average of 4.2 or something strands per network at the time. You had the network going from DS-3 to OC-3 to OC-12 to what-have-you, and that was times 6 times 6 times 6 times 6 times 6 and then you had dense-wave division multiplexing, which was you’d gone from two windows to four windows, so it was times 2 times 2 times 2 times 2, we just did math.

And all these were multiplied by each other.

CM: Right. And we did the math, and it turned out that the industry had increased capacity over the span of the prior seven years by 186,000 times.

(laughing) That’s a lot.

CM: And remember, there was a guy named John Sidgmore at WorldCom who was in the room at the time, who was famous for having said that demand was doubling on the Internet every six months. In fact, that wasn’t true. What he was really measuring was purchased capacity was doubling every six months, it wasn’t remotely true that that capacity was a hundred percent utilized all the time. So if someone bought a T1 from their carrier, it wasn’t continuously carrying 1.544 megabits per second 24 hours a day. But even if you believed the doubling every six months, it was going to be a thousandfold increase in usage for a 186,000-fold increase in capacity.

It turned out that the answer was yes, the marginal cost of the new players is about an order of magnitude lower than the marginal cost of the old players, but the revelation was, “But who cares?” Because the marginal cost of the new players is one-1000th of a cent per minute, the marginal cost of the old players is one-100th of a cent per minute, but the price in the market is still about 5 cents a minute. I don’t really care whether it’s at one-100,000th of a cent or one-10th of a cent or one-100th of a cent, if the basis of pricing becomes marginal cost, you’re all going to hell in a hand-basket.

That was the revelation, and it was a very clear and simple observation that says — this industry is doomed because you can’t have an industry with high debt loads, 186,000-fold increase in capacity, and essentially zero marginal cost and expect that it’s not going to end up with everybody in bankruptcy. Sure enough, everybody pretty much ended up in bankruptcy.

So the narrative around the dot-com buildup, at least in tech is, “Hey, you know what? That’s what needs to happen in a bubble”. We get all this build-out, there’s all this dark fiber everywhere, Google famously buys up a whole bunch of it and that was necessary for the Internet to flourish, and I think it’s a very neat narrative that ignores the problem of these massive amount of debt that, to your point, arguably contributed to the housing recession. But is there still some validity to that narrative, from your perspective?

CM: Yeah, I suppose there is. The fact that there was a massive amount of cheap capacity ended up being a good thing for lots of applications that emerged, because the cost of transport was essentially free. And by the way, it shaped a lot, in that even today, the view that transport almost has to be free is a function of what happened in the late 1990s, where effectively it was free for competitive reasons, and it never really changed.

Path Dependency in the U.S. Market

So basically, what you’re saying is you have to go back to the dot-com bubble to fully understand everything that’s happening with TV and all the stuff that we’re here to talk about.

CM: In fact, even earlier than that. I think that to really understand the way this industry looks today, the path-dependency issue is tremendously important, and you really have to understand how the telecom industry evolved in the United States going back all the way to the Kingsbury Commitment between AT&T and the US government back in 1913, and then the regulatory regime that followed for the next 75 years.

All right, give me the five-minute overview.

CM: Well, the five-minute overview is AT&T actually, arguably as an act of patriotism — this is in the early part of the 20th Century — AT&T was going around and buying up small telephone companies, effectively at gunpoint, by saying, “We won’t interconnect with you, and therefore, we will put you out of business unless you sell to us for pennies on the dollar.”

Is that the patriotic part or are we going to still get to that?

CM: No, this is before the patriotic part.

(laughing) Got it, okay.

CM: They were effectively monopolizing the industry anyway, and they agreed, in the Kingsbury Commitment, to becoming a regulated monopoly because they thought it was the right thing to do for the country, and it gave up a lot of that monopoly pricing power in return for becoming a regulated entity. That regime lasted for 75 years. Part of the regulatory regime that it created, it prohibited the phone companies from having any financial interest in what they carried. That is, they could not have interest in content in any way.

Right.

CM: They couldn’t carry video.

Because they got Title II and all that stuff.

CM: That’s right. All that dates back to the 1934 Communications Act, and they were prohibited from being in the video business. So when you wrote your brilliant piece about cable a while back and you talked about the history of cable, one of the really important things to remember is the phone companies weren’t allowed to be in the cable business, and if they had been allowed to, they would have been in the cable business.

They would have just run it over their existing wires.

CM: That’s right. Or it would have created wires big enough to carry it.

Right, exactly. They weren’t big enough. Everyone complains about the broadband monopoly issue, but at least we have two wires to every house, it could have just been one.

CM: And in fact, it’s a really fascinating set of policy questions that emerge from what you just said, because there are good arguments to say this is a natural monopoly business. Years ago, I wrote a piece about the subway systems in New York, and said: imagine that someone came to you and said, “We’re going to build an alternative to the S Train to connect Grand Central Station and Times Square between the East and West sides, and we’re going to compete with the existing S Train on the basis of which one is safer and faster and lit better and more comfortable and what-have-you.” Almost any sane person would say that would be an insanely poor use of capital.

And Craig is like, “Well, let me tell you about the dot-com bubble of the ’90s.”

CM: That’s exactly right. But also, it raises a question. So we ended up building a network where you try to put two pipes into every home, and then you only turn one of the two of them on. By definition, that is creating an enormous amount of stranded capacity, and therefore, excess cost in the system, and you’d have to believe that monopolies are wildly inefficient in order for that to be a better answer than a well-run monopoly, and a well-run monopoly for the 75 years after the Kingsbury Commitment was actually what we had.

But let me go back to what I said before about the capacity for a second, because it was really interesting. When the 1996 Act was passed and deregulated the telecom business, almost as an afterthought, it said that cable companies could get into the voice business and phone companies could get in the video business. The capital markets immediately assumed that the phone companies would win, because the phone companies had strong brand names, they had strong balance sheets. In those days, the brand names were NYNEX and Bell Atlantic and Pacific Telesis and the local exchange companies that today rolled up into Verizon and AT&T, but those companies had strong brand names and strong balance sheets.

The cable companies were, by contrast, these fly-by-night family operations that had lousy balance sheets, lousy customer service. You hated them, I hated them, we all hated them. But at the end of the day, the cable companies had 4,000 times more capacity than the phone companies did, because the phone network was built in order to carry voice calls that traveled at 9.6 kilobits per second, and the cable companies were built to carry video, and so had a massive amount of capacity, because video was this enormously bandwidth-intensive application.

So you put these two networks into competition, and I remember when I started in the capital markets in the early 2000s, after leaving my consulting career, thinking, “I can’t believe the market still hasn’t figured out that cable is going to win this war.” This is in 2002, I have to tell this story because the market will figure it out in the next year or so, and then I’ll have nothing left to talk about.

Here we are.

CM: As it turned out, it took the market another ten years to figure out that cable was going to win and the phone companies were going to lose.

This ties into the Disney stuff. Actually, you raised like 47 things that I want to follow up on, but we are driving towards Disney, that is the destination here. Famously, cable, their big business now is broadband. Was this the same dynamic where they just had excess capacity from cable? Obviously they’ve had to upgrade their connections over time and there’s been new standards, but was broadband just the exact same story replayed? Then is the only reason we have telecom just because they had nothing else to compete for, so they were forced to upgrade? What’s the sequence there?

CM: Yeah, so interestingly, the phone companies were actually first into the broadband market.

With DSL.

CM: With DSL. And at the time, the cable plant wasn’t expected to be very effective at delivering broadband. It wasn’t until 1998, I think it was, when famously Brian Roberts of Comcast was on the stage at the National Cable Show, the NCTA show as it was called, with, I think it was Jerry Levin of Time Warner Cable and a couple of others, and Bill Gates was on the stage with them, and Bill Gates made the comment that he thought eventually cable would win the broadband wars and that cable’s infrastructure would ultimately prove to be better than the telecoms and it kicked off the broadband revolution for cable.

To be clear, they were already in the business to some degree, but it really started the cable’s story and the pivot toward broadband as their core business. The cable stocks went wild because the endorsement from Bill Gates was everything and Microsoft actually made an investment in Comcast at the time, and it was off to the races for the broadband business, and ultimately it turned out to be a much more effective technology than DSL. DSL is effectively just taking an analog waveform, and think about it as the peaks as ones and the troughs at zeros, and if you want to pack in more data density in that, you just have to run higher and higher frequencies. But if you remember Maxwell’s physics from high school, the higher the frequency, the steeper the attenuation with distance, it just didn’t work very well over distance. Cable worked really well over distance, and so cable ended up winning the war going away.

To tie back to the bit about having two cables into every house and, “Is that really an efficient use of capital?”, I think the classic argument about a better way to do Internet service is that just like there was with the phone company, there should be one cord to the houses, and on top of that cord there should sit different ISPs, different ways to access and that sort of thing. The question and pushback that I would usually have to that is — well, this is stealing, I think, I don’t know if Marc Andreessen stole from someone else, but I’m stealing from him — is that a comparison to pipes doesn’t work because we don’t shit 10x more every year. We need to increase broadband capacity. To that end, is there a world where the monopoly structure could have scaled to Internet, or did we actually luck out by having the two cords, which seemed super inefficient but actually ended up spurring more investment because there was competition?

CM: It’s a really interesting question, the policy issues are never ending. I think ultimately there certainly could have been policy solutions to a regulated monopoly approach to broadband. Remember, that’s essentially what the highway system is. Highways, in not just the United States, but almost everywhere in the world, are a government-owned enterprise, and they are essentially the same thing. At the end of the day, they’re just infrastructure and that’s arguably all the cable system is. In some countries like South Korea, you have a quasi-government owned network, and in other places you have competition. It’s not entirely clear which is actually a better solution in terms of creating consumer welfare.

For the US probably the competition one is probably the better solution.

CM: Yeah. Look, that’s probably right and certainly it’s heretical to even entertain the idea that —

We actually got it right?

CM: Well, no, it’s heretical to entertain the idea that this could have been a regulated business, or still everyone fundamentally rejects the idea of regulated businesses.

It’s funny, we were thinking about very different audiences. You’re like, “On Wall Street, it’s heretical to think this could’ve been a regulated business”, I’m thinking about on Tech Twitter online, it’s heretical to think that competition actually worked out. That was a funny juxtaposition there.

Anyway, I think we’ve explored a lot of path dependencies. We get to broadband, this becoming their core business, cable ended up being better. All of this discussion that we’ve had about Disney and Charter and why the leverage is different, it’s all big structural discussions, who actually has power in these negotiations?So part of this is that for cable companies their business moving to being primarily broadband. Video is more of an add-on, which is an inverse of the way it was before. But part and parcel of that is a question of “What’s going to drive consumers to switch”? I talked about that in my ESPN Leverage piece, you’ve written about this, when the competition was satellite versus the competition was DSL versus the competition today — what is that competition today? I already got pushback from my Article today, Winners and Losers, that I’m not properly accounting for the monopoly of broadband that’s out there and there is no competition. Is that the case, or what threats do these cable companies face?

CM: Yeah, it’s certainly not a monopoly, but I think you have to think about the broadband market with a bit of geographic nuance.

In fact, about a third of the country by population has been overbuilt by fiber by somebody, usually it’s the phone company. You have a competing fiber to the home network from one player competing against an equally capable broadband network from the cable operator. In fact, some would argue that fiber is actually advantaged over cable infrastructure, although the reality is that’s probably not terribly material. In fact, the architectures are a lot more alike than they are different, and most of a cable plant is fiber anyway, but you have that in about 35% of the country.

The cable operator is competing against a DSL connection in most of the rest of the country, and for all intents and purposes, that is very close to a monopoly. The debate among cable investors today is, “What role will wireless play in that narrative?”. It’s, “Will fixed wireless broadband emerge as an everywhere competitor that brings very low marginal cost capacity to the market and therefore ends up dramatically disrupting the broadband market?” or, “Is fixed wireless broadband an asterisk to the industry because it has limited capacity and so it will make sense in certain places, but not many and ultimately it will be remembered as something of an afterthought?” That right now is the critical debate.

What’s your view on that debate?

CM: That the capacity-constrained asterisk argument is closer to the truth.

I agree.

CM: At least for now. It is a very interesting application, particularly in relatively rural markets where the mobile network is not overly taxed, but it’s probably not a major threat to terrestrial broadband.

The other big question is what happens to that 35% of the country that is overbuilt by fiber? Does that become 45 or 50% of the country, or does it become 75 or 80% of the country? I think a year and a half or two years ago, the view was 75 or 80% of the country is going to be ultimately overbuilt by fiber and you’ll have two networks, and the pricing power of broadband will collapse because the marginal cost of running these networks is very low.

The more I would argue reasoned argument was that, “No, the economics of fiber overbuilding aren’t going to support anything like 70 or 80% of the country being overbuilt and that overbuilding will turn out to be a pretty bad investment in anything too far beyond 45 or 50% of the country.” In part because the US is such a low density country, and you get to very, very high cost per home passed because if the cost per mile stays constant and the number of homes per mile starts to fall, it doesn’t take a math genius to figure out that you end up with very, very high cost per home passed and I think that’s where we’re headed in the fiber builds, and as the cost of capital has risen with rising interest rates, the returns on these investments have gotten worse and worse.

Charter vs. Disney

Well, let’s get to Disney-Charter then. What was so striking is the fact that Charter’s like, “Fine, if we don’t have video, it’s okay, we’ll still have broadband.” Is that actually then ultimately downstream of the effective monopoly status that they have, or is that because they knew customers could go to YouTube TV or they could go to Fubo or whatever it is?

CM: I think it’s a little different than either of those, Ben. I think it certainly helps that cable had found a new business that as it turns out, was a better business than video.

You don’t have to pay for content.

CM: That’s right. So the fact that they had a business to fall back on that had over the course of the last really twenty years, become not just a good business, but their primary business, obviously made it much easier for them to pivot.

But the real driving force of the change in leverage was more interesting than that, and it is ironically that the structure of the media business in the United States gave so much leverage to the media companies. After twenty years of them using it, they had effectively used it all up to the point that they had sucked all the profit out of the video business from their distributors. There was this actually very ironic argument that by going direct-to-consumer with their streaming apps, the media companies would be able to capture the transport margin that the cable companies were collecting. They didn’t call it transport margin, they just called it the margin that their distributors were making. The irony was they weren’t making any margin anymore because they’d already taken it.

By the way, the competitive dynamics of the media industry were fairly simple. Media, at least good media, is something like a monopoly, particularly sports.

Yeah, a self-contained monopoly.

CM: Yeah, especially sports is a monopoly. You can tell as a Jets fan, who by the way, I am waking up this morning with the shock and sadness of the Aaron Rogers injury last night.

Hey, as a Packers fan who was cheering for him, I share your pain. It’s quite sad actually.

CM: Really brutal. But telling a Jets fan that you should just go watch the Cleveland Browns instead is a complete non-sequitur, this is a pure monopoly, and so the broadcast rights to the Jets or the broadcast rights to the Packers or the Eagles or whatever team are monopolies, and they’re sanctioned by the government, and they give the programmer enormous leverage, and you had this industry structure that was set up with the bundles that existed in the old days of television, and the old days — meaning until a week or so ago — and those bundles protected the media companies from having any price signals transmitted to the end user.

I think that this part is so important. They could raise prices again and again and again, and who got blamed? Comcast got blamed, Charter got blamed.

CM: That’s right. And Ben, you and I were talking about the analogy, the closest analogy I’ve ever been able to find is the US healthcare system, where because of the insurance-payer system, the end consumer of medical services in the United States typically has no idea whatsoever what those services cost, they simply submit it to their insurance company and their insurance company negotiates for the price, and that led to healthcare costs rising in the United States at three times the rate of inflation for thirty years.

Exactly the same thing happened in media, where the media companies were able to raise prices to end users at three times the rate of inflation for thirty years, to the point that the media companies were all massively over-earning, and then looked at this idea that you rightly called double-dipping this morning, where the media company said, “Well, we’ve got this goose that laid the golden egg, but let’s also see if we can charge customers for our streaming content, and we’ll take our best content and move it off of the old platform where we’ve got a guaranteed contractual fee that we are going to get from the distributors. We’ll take the best content and put it on our streaming platforms and we’ll charge consumers for it again and get paid twice.”

The real change in leverage wasn’t that the content wasn’t as good, the real change in leverage was that Charter wasn’t making any money anymore, so they became a very dangerous negotiator because when you have nothing to lose, you can negotiate very, very hard.

I think that’s the point that has to be made again and again, because it gets at why the bundle wasn’t probably going to blow up last week, and why Disney was going to fold. This wasn’t a situation where Charter was extracting some great deal for themselves, they were just having a willingness to abandon a deal that was not bringing them anything other than mad customers.

CM: Right. I mean, imagine that you were getting a subscription to any service and in the not so fine print it said, “We reserve the right to take all the things that you’re paying for off of the subscription and still charge you for the subscription, and you are obligated to keep this subscription for the next few years regardless of what content we decide to take off.” That would be an insane deal to sign and all they were saying is, “We can’t commit our customers to those kinds of costs without having some assurance that the content that they’re paying for, the sports content for ESPN, will still be made available for them even if you decide to put it on an alternative platform instead.”

Ultimately we said, “That has to be where this ends up.” It’s just common sense that says this deal will end up with an agreement where Disney does decide that they have no leg to stand on for double-dipping on the ESPN side. You can make an argument that double-dipping on the entertainment side wasn’t quite as bad, the content they were creating for Disney+, like The Mandalorian for example, really was created for Disney+ and was never on cable, and so there was a better argument to be made that those should be kept separate. But the ESPN content, it was a no-brainer that had to be given to consumers if Charter was going to continue to carry ESPN, and in fact that’s exactly where we ended up, where Charter will carry ESPN, the customers will get access to ESPN+ when it goes direct-to-consumer with the best sports, but Charter will have to pay Disney for Disney+. So it seems like a logical and reasonable outcome.

Well, in this process, they’re not going to pay for all these other channels that are just running Disney+ content, so I’m guessing that’s probably a bit of a wash.

CM: Yeah, well, those channels were nonsense channels anyway.

Media Companies and the Golden Goose

To me, those channels were the true articulation of ESPN’s power. It wasn’t sufficient to look at the affiliate fee. I remember I told this story on another episode — oh, I told it with Bill Simmons earlier — it blew my mind when Sling TV launched the first virtual cable bundle and it only included big name channels and Maker TV. Why is Maker TV on there? Oh, that’s right, because Disney bought a Maker TV YouTube channel and they’re like, “You want ESPN? Guess what you’re paying for? You’re paying for Maker TV.” And those are now going the way of the Dodo bird, rightly so.

CM: Well, in fact, that whole history of the leverage of cable companies versus media companies, that was one of the chapters in that story, right? It started with the cable companies having all the leverage because there was one big distributor in the United States, TCI, owned by John Malone, and all the media companies had to fight for the right to be carried by TCI. And interestingly, TCI only had the capacity to carry a certain number of channels. So in fact, John Malone built Liberty [Media] today out of extracting, not just that you have to pay me for carrying your channel, but you have to give me some equity in your channel for me to consider carrying it as well. That collection of equity slices that he collected along the way as a toll for being on TCI eventually became Liberty.

Then when satellite came along and suddenly there were alternative platforms for distribution, the leverage swung in the other direction because then you had this monopoly content, and now you could play one distributor off the other. Suddenly the programmers got all the power and that led to that thirty year rise in affiliate fees, and one of the ways they extracted it was to demand carriage of all these ridiculous channels.

I remember once Josh Sapan, who in addition to being the CEO of AMC, is also a brilliant observer of the industry, and he once observed that the optimal number of good shows on a network is one, and that if you had two — and there was a time when AMC had three, they had Walking Dead and Mad Men and can’t even remember what the other one was — but the optimal number was if you had three good shows, you would move it off and create a new network and force the distributor to carry three networks instead of two networks instead of one network. That ultimately they would be stuck with the legacy baggage problem of having to carry those networks in perpetuity long after the show that you held them hostage over was long gone, and it’s a kind of bizarre chapter.

It tells you as a way that I think you and I would probably agree as much as any two humans on the planet, that industry structure is destiny, and that it was the industry structure of the business that led this business to evolve the way it did. You could imagine there could have been lots of other industry structures that, again, back to our conversation about path dependency, some of this was written in 1913 with the Kingsbury Commitment and in the 1934 Communications Act. All those kind of moments in time shaped the way the industry was going to evolve for generations to come.

It’s interesting to talk to you versus Michael, because Michael is looking at the media companies. The whole thing in this category is TMT. What is it? Telecoms, Media, Technology, I might have the order wrong, but you can understand how they go together because they’re all zero marginal cost businesses, that’s kind of the distinguishing characteristic. You do something once and then you can use it again and again, and that creates different dynamics.

But I’m curious, because I’ve talked to Michael a few times, and I’ve mostly looked at the media side, it’s adjacent to tech. I’ve always been very interested in — obviously I’m in the media business to a certain extent myself — what’s it been like from your position being on the cable side, on the telecom side, watching these streaming services coming along? Were you from day one, “These people are insane,” or did it take a while to dawn on you that this is going to completely change the structure that we’ve been talking about?

CM: Well, first I would say, so Michael and I have been doing this together for at least twenty years, and so riffing off each other’s insights has been a huge part of both of our careers, and it’s made us both better analysts to really understand the economics and the strategies of the other side through the insights of someone who is as smart as Michael is, at least for my benefit. And unfortunately for me, Michael gets cooler stuff, but being a media analyst —

Well, this is why this week is so fun. It’s your big triumph!

CM: He would get cool plush animals and videos and tickets to things, and I would get a piece of cable that would sit at my desk just so that I could see what the inside of a piece of coax looked like. I used to always wonder, “How did I choose this side of the business? What was I thinking?”

But I think that conversation we were having before about the pricing structure and pricing behind the opaque wall of the distributor was something that I always thought was profoundly important. It always struck me as the media companies didn’t know how good they had it, and they were making an incredible strategic blunder, that going direct-to-consumer sounds good and that trying to capture the distribution margin, and I want to come back to this issue of distribution margin in just a second, but trying to capture that margin sounded good on paper, but it struck me that they were trading an industry structure that was incredibly advantageous for one that, at the end of the day, was incredibly pedestrian. They were selecting an industry structure where the way you did business was to say to a consumer, “Here’s my product, do you want to buy it or not?” That’s the same as every other business in the world, there’s nothing beautiful about it, and I don’t think they realized that the industry structure ultimately was a much bigger deal than whether or not they could capture a little bit of extra margin in a year or so.

By the way, this margin point, I want to come back to that. I had written something, I guess now 15 years ago, that I was just thinking about the other day, that the cable companies would have been well-advised twenty years ago to change the way they account for the video business and to almost treat video content as if it was a pass-through like say sales tax, and that what they were really doing was passing through video content — don’t even show it as part of your revenue and then call the margin on video, not margin, but call it the transport function.

The reason that’s so important is think about the evolution of Netflix. Netflix early on arbitraged the distribution business even more than they arbitraged the content business, and they arbitraged the distribution business by trying to convince regulators, and consumers for that matter, that the transport function that the cable companies provided was part of the video product, and not part of the infrastructure, and that therefore there was no legitimate reason why the infrastructure companies should charge for the transport of Netflix’s 1’s and 0’s. You could have imagined a completely different evolution of the industry if regulators, and even consumers for that matter, thought about the transport function of video as a truly separate function.

Yeah, that’s a fascinating alternative history, where Netflix comes in and there is the expectation is they have to pay and they don’t get sort of that arbitrage opportunity.

The Video Aggregation Battle

So you see this as a big problem, they’re embracing a pedestrian business model, did you see this particular standoff coming? It’s interesting because on one hand, I wrote about it a year ago, by and large, based on a lot of what you had written, Cable’s Last Laugh, it was becoming clear that streamers were in trouble, they had a churn problem. In many respects, they grew so quickly that they switched from a customer acquisition to a churn problem very early in their evolution as businesses. To keep customers, they needed to create content which costs a ton of money, and now they had to achieve profitability. Bundles are great, bundles save you from that, they solve a lot of problems, and here’s the cable companies sitting there who are the kings of bundling, and they have direct access to customers, it seems like an obvious fit.

Then I wrote that and then I proceeded to watch every cable company stock just fall through the floor, basically from the day I wrote it, for nine months straight. What is it about now that made it different? The other thing is I went back and I read a bunch of these old Charter earnings calls, and all the things they talked about last week, they’ve been complaining about on the earnings calls for years!

CM: For years.

They’ve been saying all this sorts of stuff. Why now? Is this a function of the cable companies, or is it that they saw weakness in Disney and they’re like, “They’re vulnerable now. This is the time to act”?

CM: I think it was more what was going on inside the cable companies. It was this confluence that we talked about before of both having a business where they no longer were making any money, so they were liberated by the fact that you couldn’t really hold them hostage anymore, because they really were pretty close to indifferent. And by the way, they happened to have a really good business to fall back on that, as it turns out, was a better business than video ever was anyway. So they were liberated in a way that they had never been, and they were able to simply say, “If we’re going to continue to sell this to our customers, here’s what we’re going to have to have on our customer’s behalf.”

I think they were on the side of the angels on this one. The fact that Disney happened to also be over a barrel meant that Disney was probably going to have to capitulate and that’s why at the end of the day, this didn’t last all that long, but it was really more about what was happening or what has happened in the cable industry over the last decade and a half that set the stage for this.

You wrote a note this week talking about the fact that it wasn’t just that video — they didn’t make any money on it — but also video takes up a huge amount of capacity. These are companies, Charter I think is set to spend $5.5 billion over the next three years to upgrade their equipment to DOCSIS 4.0 so they can actually offer decent upload speeds — as a Charter customer, I can’t wait for that — and could they have gotten a shortcut by just cutting video and actually, “Hey, we can get much more competitive much more quickly at much lower cost.” Was that a factor too?

CM: Absolutely. It was one of the pieces that, I think I titled our note, “Oh, And One More Thing”, because I had made a mental note to talk about that in one of the prior notes I’d written the day before, and then I had forgotten.

(laughing) You forgot about it, I’ve been there.

CM: “Oh yeah, that’s right, I forgot to do that.” I was reminded by one of the real grandfathers of the cable broadband business, as it turns out, who had sent me a note saying the same thing. And I said, “Oh shit, I forgot to put that in. I need to just quickly mention that.” I had to rush it out because I figured that we’d probably have a deal by Monday night in time for the football game, so I had to rush it out Monday morning and make sure I got it out there while it was still relevant, because it was a really important part of the negotiating leverage here was Charter didn’t just have nothing to lose, they actually had something to gain by dropping video.

At the end of the day, the reason they wanted to keep video, and I know that most people roll their eyes at this concept and think, “Well, that’s ridiculous,” but the reason they wanted to keep video was because certain number of their customers like it, and so even if they don’t make any money on it, they would still like to be able to give it to their customers if that’s what their customers want. I know that most people kind of find it almost unimaginable that a cable company could care about what their customers want, but they actually might, in this case, care about what their customers want, not because it necessarily lowers churn or that sort of thing, because you could argue that getting more capacity and having a better broadband service would lower churn even more than bundling it with video would. But they did it because it’s actually a product that some of their customers like and care about and so we’d rather do it than not do it if we have the choice.

So are they the winners then? Or does this actually paint a scenario where maybe they’re actually kind of losers because they didn’t dump this product once and for all?

CM: I think they’re still probably winners because look, at the end of the day, this product is going away. I think one of the really interesting questions though, and I think you make the point in this morning’s note very eloquently, about the re-aggregation function and re-bundling of video. I think the real war over the next couple of years for the media companies is going to be over who gets to own that function.

Yeah.

CM: One of the things that we wrote about last week, and it was a topic that had been sort of swirling around in my head for the last year or so, was that it looks to me like Google is walking away with the video distribution industry. People from the linear video world underestimate just how powerful YouTube is, not YouTube TV, but how powerful YouTube is.

They have a monopoly on an entire class of content that consumes a massive share of screen time.

CM: That’s right, and still growing very rapidly as a share of screen time. If you look at the virtual MVPDs, the collections of linear cable channels, most of them are now in, if not free fall mode, at least in steady contraction mode. That model never really caught on at anywhere near the level that some people thought it would, and the only one that’s growing is YouTube. YouTube TV is walking away with that business too and if they’re not careful, one of the arguments we made in our piece about the negotiating leverage in the Disney-Charter dispute was that if they’re not careful, Disney is going to end up in a world where Google owns video distribution and where you’re back to the TCI model where there’s really only one distributor that you get to negotiate with.

Look, we all are incredibly frustrated that there is not some elegant, integrated platform that disaggregates the shows from their streaming services and lets you have a service that takes all the shows that you want to watch, so I could watch Hard Knocks from Max and then seamlessly shift to something on Netflix and what have you. That’s not just because that’s the way we grew up in the cable world, it’s because that’s a much more consumer-friendly model. The problem is, who are you going to give the rights to to be able to disaggregate that content, to have all the metadata you need in order to make it searchable and what have you? Because the company that right now is trending toward that space is Google and the last thing you would want is to be a content owner and know that Google is about to own me for distribution and fee terms.

What do you mean it’s not great for everybody else?

CM: It’s great for consumers maybe, but boy oh boy does that shift the negotiating leverage and puts the media companies in a tough spot.

This is where the double-dip thing resonates for me so much, because you go back to newspapers and they’re like, “We have this great business model, and wow, the Internet lets us now reach everyone, we can make money in lots of areas.” It turns out if something seems a little too easy and a little too obvious, it’s a little too easy and a little too obvious to everyone, and that’s sort of your problem there. And what happened? That entire industry, the entire text-based industry is completely and utterly consumed by Google and I’ve been banging my head against the wall, saying that “Tech is not your savior.”

CM: Right.

It’s not your savior precisely because it’s almost the lack of intentionality with it. It’s just once you get into a place with these zero distribution costs and just a total abundance of content, you just talked about it, it becomes overwhelming for consumers. They look for a solution, they look for something to help them find their way through this morass of content. And by the way, advertisers are looking for a way to reach consumers. You are going to end up with a company that solves both problems at the same time. And guess what? One company’s already done it, and it happens to have this great position in TV now going forward, which is not great.

CM: It’s not great at all. It is a really, really bleak future for the media companies if Google is allowed to have that much power. And so, the obvious counterparty would be to go back to the cable companies.

That’s right. Yes.

CM: And say, “Re-aggregate, and we would like to give you this function rather than give it to Google.” And it’s not like we have a thousand other choices, and yet nobody is willing to give up right now what they view as customer ownership, because they think that they’re going to be the ones that are going to emerge with that function. So Comcast believes that Peacock is going to inherit the Earth, and David Zaslav at Warner Brothers Discovery believes that Max is going to inherit the Earth, and Disney believes that Disney+ is going to inherit the Earth. Then, you’ve got Amazon and Apple, all of whom have sufficient staying power that they can sort of watch from the sidelines and sort of chuckle about these relatively small companies, in the grand scheme of things, all believing that they’re going to own the customer. You can sort of see where this is going, that Google is willing to play the long game and say, “We’re just going to wait it out because it’s all coming to us.”

Yep. I thought that it was sort of underrated over the weekend, you saw the YouTube TV multi-cast, or four screens for the NFL. Everyone was like, “Why did they buy this package? They way overpaid for it.” I actually had this argument, I think it was an argument with Michael, and my view was, number one, it is a anchor tenant to build up this channel’s marketplace, which for all their forward-thinking, they were way behind relative to Amazon and Apple in building that out. But number two, it ought to terrify everyone in the ecosystem that Google launched on day one with a drastically technically superior experience to anyone else in the industry came up with. This is a company that everyone in tech complains about that they don’t try anymore, but you don’t want to be in a fight with them, you really don’t.

CM: Well, and by the way, to the old timers like me with lots of gray hair, the moment that you can’t escape the parallels, is when Rupert Murdoch way back decided to commit to the NFL on Fox. Fox was not perceived to be a serious broadcast network, there were three broadcast networks, and Fox was a laughing stock. He wildly overpaid for the NFL, because he never made any money on the NFL distribution deal, but that’s not the game he was playing. By getting the NFL, Fox became Fox. It became a world where there were four broadcasters instead of three, and everything else that followed at Fox and News Corp came from the fact that he bought a position in the industry by virtue of his stake in football. It’s hard not to see the YouTube decision to get the NFL Sunday ticket as being almost identical as an analogy.

Is there a world where, number one, the media companies realize that the cable companies are actually their friends? Yes, you’ve had thirty-five years of pulling back and forth on a set pool of money, but now it’s really you against tech, you have to realize that. And then, number two, the cable companies are effective sellers of streaming services, and all their go-to market capabilities actually do come to bear. And then, number three, the media companies actually go back to some sort of rational windowing strategy, where they actually prioritize the model that — because at the end of the day, they’re like, “Oh, we can’t go back now.” Why not? Why can’t you go back? Or is it too many things that need to happen, and in a fragmented market with multiple players, the Nash equilibrium is that Google wins?

CM: There certainly is a lot of water under the bridge and a lot of animosity between some of these, not just companies, but individuals. You can’t forget that a lot of these companies are vanity projects of a single person or a single family, and it really complicates the negotiations. But it is certainly eye-opening, particularly because I spend my time in the capital markets, that the daily volatility in Google or the daily volatility in Apple can be measured in AT&Ts per day, right? The size of these companies has gotten so lopsided that Apple can lose two AT&Ts in the span of a week or gain it back again.

And no one writes about it because it doesn’t really matter.

CM: Yeah, they can gain three AT&Ts and a Verizon on a product announcement, and so even companies that you think of as really large, like these infrastructure companies, are rounding errors compared to the size of Google and Apple and Amazon.

You own the layer that the customer interfaces with, then you basically get all these infrastructure companies to do your bidding. The other analogy that I’ve been drawing on is Apple with the iPhone — once they actually established the ability to move customers, they basically had the world’s telecom industry at their bidding.

CM: It’s a fascinating question, Ben. It’s one of the things that I haven’t written about in a while, but over the years I’ve written about periodically, that you could argue that when Apple launched its credit card, that it was a quiet way of taking just another piece of the customer relationship, the billing function and that the whole idea of iPhone-as-a-Service, that is that you contract with Apple, and we now have the insurance function, which is something that Verizon and AT&T and the phone companies make money on, we have the customer ownership function, the virtual version of sending a bill every month, and suddenly the entire customer relationship is owned by Apple.

It’s a very short step from that point to say, “And by the way, I’m going to contract with each of AT&T, Verizon, and T-Mobile for transport services, and I’m going to decide which network to put my customers on.” The customer may not even know which network they’re being put on and suddenly Apple has essentially taken all of the value out of the telecom industry and kept it for themselves. It’s sort of the doomsday scenario for the telecom industry, I don’t think Apple is particularly likely to do it anytime soon, because I think the regulatory obstacles to that start to be pretty large.

Well, it’s really interesting, because everyone would always say, “MVNOs don’t have any power relative to whoever actually builds the towers.” But it’s kind of like the flip you talked about with that TCI flip, right? It actually can flip if you own that much power.

CM: You know what? Ben, we should come up with a name for that. Let’s call it Aggregation Theory.

(laughing) That’s what it is, right? Everyone has to do your bidding, they have no choice because they need the scale too, and you’re the only one that can deliver them the scale they need. But this whole thing with Disney-Charter is the cautionary tell I would tell Apple, if Apple came to me asking about this, “Your suppliers need a motive to invest”. “If you’re completely abstracted away, you see this with the news ecosystem, the free content ecosystem is trashed these days, and that’s downstream from Google dominance.

CM: Well, I know a really smart guy who has taught a lot of people in tech that there is nothing so powerful as aggregating demand and when you see it in action, it’s an extraordinary thing.

Well, we barely talked about mobile, I actually had a whole bunch of questions about that. I think it’s super interesting what’s happening there, but I think that is a good justification to have you on another time. This has been the most exciting — this has been like the MoffettNathanson, I don’t know, “The Week of MoffettNathanson”. Is there any event that has been more in your sweet spot?

CM: Yeah. Well, it’s really been a pleasure to do this with you, Ben, and I hope we get to do it again. As I said, I’m a huge fan of yours, so thank you for the opportunity to do this with you.

Absolutely, I look forward to doing it again as well.

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MoffettNathanson is a research group owned by Leerink Partners, which makes a market in the stocks discussed in this podcast, including Charter Communications, Inc., Comcast Corporation, AT&T Inc., T-Mobile US, Inc., Verizon Commmunications Inc., The Walt Disney Company, and Alphabet Inc.

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