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Giant cable companies are consolidating and seeing their revenues and profits expand, but customer satisfaction is low leading to those bent on disruption making headway in the video distribution business, especially in the younger demographic.

The Time Warner and Comcast Combination

Time Warner (TWC) and Comcast (CMCSA) are combining, with the deal expected to close by the end of this year. Comcast will buy Time Warner for about $45 billion in stock, provided that federal regulatory bodies approve the combination. Time Warner has about 11 million residential video subscribers and is clustered in key geographies such as the New York metro area, Texas, and southern California. Comcast has 23 million video customers and is itself valued by the market at about $140 billion. Comcast provides services in places such as Florida, northern California, Washington D.C., and the Pacific Northwest, which don’t materially overlap with Time Warner’s served areas.

The merger would create a dominant force in the cable world. The newly combined company would be an option for much of the U.S. population with its services, about 30% of pay T.V. subscribers in the U.S. would be customers, and even more broadband Internet subscribers would be, too.

Charter Communications (CHTR), a top-ten cable video provider based in Connecticut, was pursuing the acquisition of Time Warner. Charter might still get a piece of the action as a smaller party in the deal. Charter’s role would have three parts. First, it would acquire 1.4 million Time Warner customers for cash. Next, it would swap equivalent business for 1.6 million Time Warner customers. Finally, Comcast would also spin off a company based on its 2.5 million subscriber strong Midwestern and southern markets; Charter would take a 33% equity stake in the new entity, while the newly combined Comcast/Time Warner would own the balance. After all is said and done, Charter would be the second-biggest cable TV company.

Besides the moves toward horizontal integration, companies like Comcast are vertically integrated, further improving their strategic position. For example, Comcast also owns NBC Universal, a major content provider, after a deal that was put under heavy regulatory scrutiny. Content providers are a major cost for the video distribution business, and, occasionally, a source of feuds. Despite the improved bargaining power that would come from consolidation, Comcast does not suggest to lower prices for the average consumer.

The AT&T and DIRECTV Deal

Meanwhile, AT&T (T - Free AT&T Stock Report), which provides TV services through its fiber-optic distributed U-verse business, is buying DIRECTV (DTV), the biggest satellite TV provider, for almost $50 billion in cash and stock. It says that the move will help it negotiate with content providers and ultimately lower prices for consumers. This combination would serve over 25 million subscribers in total. The deal is expected to close in less than 12 months and, like the Comcast/Time Warner deal, is also pending regulatory review.

Unsatisfied Customers

The cable companies have low consumer satisfaction. Almost three-quarters of recently surveyed clients believe that cable companies engage in predatory behavior. Half were reported saying they would switch if they could. The biggest reason people cite as to why they don’t sign up for pay TV service is that they say it’s too expensive.

One issue among consumer advocates is bundling. The average American pays for 189 channels, but only watches 17, one study suggests. Some have proposed making services à la carte. Canada actually passed a law forcing the unbundling of channels last year. In the United States, Senator John McCain of Arizona has taken up that cause, but his peers seem less enthusiastic.

In this environment, the cable companies are facing client attrition. For example, Comcast lost about 300,000 net video customers in 2013. Time Warner has been faring even worse in this regard, with total relationships down roughly 1% in in the first quarter. Perhaps the consolidation is the reaction of a shrinking market for such services.

Another issue that affects the image of cable companies is net neutrality. Some service providers want to charge websites that use a lot of bandwidth, such as Netflix (NFLX) for their heavy Internet usage. Critics of the policy say it will destroy the even playing field that Internet participants have enjoyed so far. Netflix ended up inking a deal earlier this year with Comcast, where Netflix pays more for a direct connection, likely increasing streaming quality. Netflix signed a similar agreement with Verizon (VZ - Free Verizon Stock Report), but continues to grapple with that Internet service provider over these issues.

Related Parties

Content providers have had disputes with cable providers for some time. Those that are independent from the big companies will lose bargaining power from ongoing consolidation, and some, too, are seeking out alternative outlets for their media. An example of the latter is the popular “House of Cards” series, which can be seen on Netflix. The same bargaining effect will be seen on cable equipment providers such as Arris (ARRS).

Technological Innovators Gaining Market Share

More and more content is moving to the cloud, and a number of Internet technologies are garnering favor for video users. A survey found that almost 50% of the U.S. population has a subscription to either Netflix, Hulu Plus or Amazon Prime. Netflix actually has more video subscribers than Comcast, and saw its U.S. subscriber base grow 11% in the March quarter. (Comcast’s valuation is still considerably bigger thanks to its greater monetization and media empire, among other reasons.) A Netflix subscription and Internet connection is cheaper than video and Internet service from the likes of Comcast. Young people, still mired by the consequences of the 2007-2009 recession, more tech savvy, and likely to use the Internet to save money, seem to be leading the way.

Hulu is a joint venture of Comcast’s NBC Universal and a slew of other major broadcasters. Its paid Hulu Plus service garners about 6 million subscribers, according to recent reports.

Aereo has touted itself as a technological alternative to an antenna and a television to watch local broadcast television. However, content providers have fought this system of transmitting their copyrighted programming to consumers, and the Supreme Court recently ruled that Aereo was illegal.

As a result of both the growth of the diverse Internet platforms and increased channels, audiences are becoming more fragmented. In the 1950s-1970s, there were three major broadcast channels. That number has obviously grown.

With the advent of services such as Google’s (GOOG) YouTube, practically anyone with a camera and an Internet connection can gain millions of viewers. The growing number of platforms affects both the cable business and society at large, which is able to splinter into different interest groups and niches. Even shorter videos are competing effectively for consumers. Now, there is a popular platform for sharing six second clips called Vine, which is owned by Twitter (TWTR).

Conclusion

In conclusion, some tectonic shifts are underway in the cable TV industry. Merger activity is leading to increased consolidation. Regulatory bodies are dealing with legal considerations and the influence of lobbyists, with content and equipment providers too monitoring the situation closely. These issues affect American cable TV consumers, who are hard pressed by an uneven economic recovery, generally unsatisfied by cable TV service, and on average spend a significant amount of monthly income for these services. In this environment, Internet-based services are the single biggest threat to the traditional cable TV business. Indeed, these services have seen their subscribership expand, as the client base for traditional cable TV is slowly degraded.

For more information on the investment merits of the cable TV industry, see our quarterly industry report and related individual company pages. 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.