Why Canadian Cable Companies and Telecoms Are in Trouble

Includes: BCE, RCI, SJR, TU
by: Sean Michael

If the new Conservative majority government in Canada has its way, the telecommunications industry in Canada will be liberalized through some form of relaxation of foreign ownership restrictions in the sector. The existing foreign ownership restrictions in Canada, among the most onerous in the developed world, have up to this point protected Canadian firms from real competition and allowed them to enjoy inflated margins as members of a cozy oligopoly.

Liberalization could prove disastrous for incumbent Canadian telecom and media conglomerates, including Bell, Rogers (NYSE:RCI), Telus (NYSE:TU) and Shaw (NYSE:SJR). While new developments in internet video technology have already threatened the existing telecoms business model in Canada, further liberalization of this market could accelerate the erosion of incumbentsmarket share, pricing power, and industry control.

Major competitive threat from web-based firms

Even without liberalization, Canadian firmsofferings are already being out-classed by web-based companies. For example, Rogers charges $7.99 for a single viewing of an HD movie through its Rogers On Demand service. For the same $7.99 Netflix (NASDAQ:NFLX) offers unlimited viewing of a large catalog of HD movies for a month. Unsurprisingly, Netflix subscriber growth in Canada has been robust since it entered the Canadian market, even without any prior brand presence from a legacy DVD delivery service. Indeed, Netflix growth in Canada has been far quicker than it was in the United States, and subscriptions are expected to soon exceed 1 million, or 7.5% of Canadian households.

Meanwhile, Blockbuster (OTC:BLOAQ) Canada has filed for bankruptcy just over six months after its parent company in the US. The trend toward low-cost subscription movie services and away from high-cost per-movie rental services appears unlikely to reverse any time soon in Canada.

Yet, no Canadian firm has announced any plans to introduce a low-cost subscription viewing model to become competitive with Netflix. Instead, the response of incumbent cable companies has been to lower caps on internet usage (typically around 25 GB per month, or one tenth of Comcasts (NASDAQ:CMCSA) 250 GB usage cap), and to enforce per-gigabyte charges on internet use above the cap of $2 to $5 per gigabyte in an apparent attempt to inflate costs for Netflix customers.

The incumbents have made their own far more expensive internet video offerings exempt from the bandwidth usage caps and overage charges. Netflix has responded by adding a “low quality” option which uses less bandwidth, out of consideration for Canadian customers who are trapped inside restrictive usage caps and face punitive overage charges. The company has also apparently stepped up its lobbying efforts in Ottawa.

In addition, incumbent ISPs have banded together and formally appealed to the CRTC to force Netflix to submit to regulation as a broadcaster, which would hobble the low-cost entrant with cumbersome red tape and Canadian content requirements. In Canada, broadcasters are subject to onerous and costly regulation of the content they show, but so far web-based video groups such as YouTube and Netflix have been exempt from this.

These attempts to stifle competition and protect their own market share have alienated many of incumbentsown customers, prompting them to switch to competitors who offer unlimited internet packages. Incumbents have tried to convince the regulator to eliminate the ability of any firm in Canada to offer unlimited internet packages for residential customers, but this was met with a powerful wave of public and political opposition including a petition that went viral earlier this year, and culminated in a rare intervention by the Minister of Industry to stop the CRTC from allowing Bell to effectively impose usage based billing on the entire country.

Charging $2 to $5 per gigabyte to Canadian consumers for internet use inusage based billingschemes has been very profitable for major Canadian firms, and in some cases has been the main driver of revenue growth in the internet service business. But this has only been possible because of laws which prevent competitors from abroad from entering the Canadian market and eating the incumbent firmslunch. Shaw and Telus have indicated within hours of each other that they too will be introducing the hugely unpopular practice of capping and charging per gigabyte, following the lead of Bell and Rogers which have been doing this for years.

The Conservative government, now with a majority in Parliament, has indicated that they are preparing to allow more foreign players into the telecommunications market, and Globalive was just the tip of the iceberg.

Adding to the risks faced by incumbents is growing discussion of functional separation, or breaking up these vertically integrated behemoths to reduce conflicts of interest inherent in having companies that sell content also maintaining regional monopolies or duopolies on network access. And perhaps even more problematic is the growing proportion of adults under 35 who do not have a cable subscription and do not intend to get one, since they obtain virtually all their video entertainment, including TV shows, sports and movies through the internet.

Compounding this revenue-killing dynamic for Canadian broadcasters is the fact that young people in Canada are increasingly tech-savvy. Many, it is reported by senior executives at Shaw, already bypass the Canadian broadcasting system entirely by using one-click proxies, DNS spoofing services, or other methods to watch video content from lower-cost and/or higher quality content providers outside Canada, confounding any attempts togeo-blockCanadian internet users. Growing numbers of Canadians now watch the Daily Show, Mad Men and House directly on US websites, cutting out Bell, Rogers, Shaw, and other Canadian middle men.

As Apple TV (NASDAQ:AAPL), Google TV (NASDAQ:GOOG), Amazon Prime (NASDAQ:AMZN) and Hulu proceed with plans to aggressively expand into Canada, the future for Canadian broadcasters looks bleak. The situation is particularly bad for Shaw and Bell, who are still saddled with debt from their relatively recent acquisitions of major broadcasting corporations.

Foreign wireless companies will eat incumbentslunch

The same companies who control the mobile communications market have been able to realize huge margins from exorbitant prices on wireless voice and data plans. However, since the Conservative government allowed Globalive (controlled by Egyptian firm Orascom) to enter the wireless market, pricing has come under significant downward pressure. The incumbents' unions, rather than attempting to out-innovate the new entrant, have simply resorted to legal action, arguing that it is unlawful for Globalive to offer mobile phone services in Canada. Why innovate when you can litigate? Senior management at the major Canadian carriers claim to have no involvement or knowledge of the legal action being taken by their workers' unions against Globalive.

Reducing foreign ownership restrictions is also likely to change the game in the oligopolistic Canadian wireless industry. Even with the recent entry of Globalive, Canadian wireless plans (including mandatory fees and charges) are still so expensive that Canadas mobile phone penetration rate was recently measured by the OECD at 67% - dead last among the group of 28 rich nations. There are millions of people in Canada who might consider getting a cell phone if only the cost of doing so was comparable to costs in the US, Europe or Asia. Mobile data costs in Canada are even further out of line with the rest of the world than per-minute voice rates.

Broadcasters and telecoms in many countries have been facing pressure from web-based competitors. But in Canadas traditionally uncompetitive telecommunications and broadcasting industry, the impact of this latest technology shock may be particularly severe. Largely due to decades of telecom protectionism and some of the most draconian foreign ownership restrictions in the industrialized world, Canadian telecoms firms have enjoyed outsized margins, generous valuations and attractive dividend growth for more than two generations.

With a perfect storm of disruptive technology rendering traditional broadcasting all but obsolete, foreign entrants with superior services and lower costs, unfavorable demographics, a powerful pro-competition government, entrenched inflexible business models, lack of competitive and innovative edge due to decades of insulation from the rest of the telecom world, bloated balance sheets due to costly acquisitions of old-media companies, and regulatory uncertainty relating to usage based billing and functional separation, large telecommunications firms in Canada do not look well-positioned. Adding to this concern is the fact that none of them has any product - current or planned - which can credibly compete on cost and quality with web-based media services.

While Canadas economy overall is likely to prosper under the Conservative majority government, any significant growth in Canadian telecoms is likely to come from smaller, more innovative firms who are able to keep up with new technologies, not bloated old-media companies whose business models depend on trying to artificially inflate the cost of internet service for the whole country and lobbying for legislation that kneecaps superior foreign competitors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.