[click image to enlarge] VOD Milestones

The new economics of video-on-demand (VOD) are piquing the interest of a growing number of multiple system operators (MSOs) who, in the past, have considered VOD's multiple components too costly and the revenues too skimpy to venture into the business.

However, since Time Warner Cable convened the Full Service Network's $300 million VOD pathfinding trial in Orlando in the early 1990s, the costs of hardware, software and other vital VOD components have plummeted to a point where cable operators can now make a valid business case to launch VOD service. Mix in the ongoing digital video roll-outs by MSOs such as Cox Communications, MediaOne, TCI and others, along with the economies of scale they bring, and VOD finally begins to look economically viable.

"In the early 1990s, there wasn't a single business model in existence. Now, it's a very realistic business, and you can figure on two-year paybacks for initial capital investment," says Yvette Gordon, director of interactive technology for SeaChange International, a supplier of digital video delivery systems. Despite her built-in bias, Gordon ought to know about VOD economics: She's one of the many Time Warner pioneers who worked in Orlando. Compared to 1994, capital costs related to VOD have practically free-fallen. Back then, a "gold-plated" digital set-top cost about $5,000, and a single stream of video was about $2,000. Today, those costs have dropped dramatically and are projected to go lower, say most industry analysts. By year's end, they believe the total cost per stream will drop to $700.

Capital costs, which include five key areas, are estimated to be: $350 per stream for video servers (DIVA recently lowered its cost to $150); $300 per stream for encryption, modulation and upconversion; $200 per stream for network transport equipment; and $300 of varied costs for VOD set-top applications, some of which are now included in advanced set-top boxes. The initial capital investment also includes an approximate $350,000 one-time investment in management, hardware and software.

Adding to the VOD component price drop is the cost of computer memory. In 1992, for instance, the cost per megabyte was $1. Today, it's between four and seven cents.

"The costs have dropped so significantly (during) the past few years, that the economics are much more advantageous," says Doug Ike, director of digital video services for MediaOne Labs. As a result, MediaOne is "heavily investigating VOD," says Ike. Heavily enough, Ike adds, to have begun working with VOD vendors in lab trials. "We want to scale large systems. We view VOD as a key extension to our digital suite of services, and in the next 18 months you'll see some market activity."

According to Paul Kagan Associates, 70 percent of digital homes in the U.S. will have VOD capability by the year 2008, and more than 31 million homes will have access to VOD movies. Those numbers, Kagan projects, will represent $4.8 billion in movie revenues.

Yet questions remain about the actual business of VOD, and the on-going operating expenses inherent with a new business such as VOD.

"The lower capital costs have been interesting, but the real interest is in operational costs," says Gordon. "How many people will it take to run a trial? How much automation is needed? What are the costs? You have to create a whole business of creating content and databases, and it takes lots of people to run it." And those people, Gordon adds, are not traditional cable employees. "Cable systems must add software engineers, test environments, network engineers … They are part of the operational costs, and most MSOs have concerns about them."

Despite MediaOne's acknowledged interest in VOD, it too has questions about the operational costs of the business. Says Ike: "Operational costs are the biggest unknown. Past trials have been on a limited basis, except (the) Full Service Network, where operational costs were necessarily bloated. The technology has been proven, but when you crest above tens of thousands of streams, it becomes a much different management and system integration issue, and a large-scale VOD stream hasn't been built or tested yet."

Tested or not, some insist that the huge drop in VOD component costs alone is reason enough to take the VOD business to market. "Last year, the capital cost per stream was about $1,000; now, it's much less. For instance, about half of the per-stream cost is storage, so server costs will probably be less than $100 (per-stream) because of competition," says Ray McDevitt, senior vice president of marketing and program management for DIVA, an end-to-end on-demand TV service.

As for operational costs, which have averaged about $4/month per subscriber, according to a report from CableLabs' conference held in Vail, Colo., McDevitt insists those will fall as well. "Operating costs are now averaging about $1.20 a month per subscriber," McDevitt says.

One reason for the drop in operational costs, he suggests, is because equipment health can be monitored remotely at multiple sites. McDevitt adds that better-controlled encoding costs, and lower transportation and distribution costs, combined with efficiently maintained headends, should cause operational costs to fall even further.

A year ago, those costs may have been considered an obstacle to building a true VOD business model, but no more, according to Raj Amin, manager of business development for Scientific-Atlanta. "VOD is really not a lot different than pay-per-view. It includes some CSR training, but there's a lot more technology available to manage the network than there was a year ago."

Amin cites satellite delivery systems as one example. "Through satellite delivery of encoded content, you can automatically update servers with content, buy-rates, etc., so content providers can now focus on that." And that, Amin says, translates to a lower operational cost.

Those lower costs, however, may be a few years away, argues Scott Wilcox, another FSN veteran who today is senior vice president of technology for Prasara Technologies, a provider of Internet applications. "Satellite delivery could be very powerful, but that's down the road. VOD is here today, so how do you manage the customer service interface? How do I deal with royalties? You need a network management tool because all these components have to come together."

For VOD to come together as a business, Wilcox adds, it must be managed differently than traditional services such as pay-per-view. "VOD is an E-commerce application. If you treat it as such, you should be able to manage all E-commerce applications after VOD. The cable industry must look at analyzing their selections based on software, not hardware." The shift to lower VOD component costs, says McDevitt of DIVA, is not over, and will be led by even less expensive set-tops. "The biggest cost reduction will probably be with set-tops," he says. DIVA has also dropped its cost to $150 per stream for its video server, which includes all hardware, software and storage.

Set-top box manufacturers such as General Instrument (GI) have also felt the impact of VOD cost cuts. "With set-top boxes under $300, the business model makes sense now," says Denton Kanouff, vice president of digital network systems for GI. "So, we have to provide a lot more support to third-party applications."

Kanouff adds that, "From day one, operators want to have new applications. They need horsepower, two-way capabilities, telco return, and more. We've seen so much interest that we've built in real-time RF return." GI plans to slash its prices for set-tops as well. GI will drop the price of its DCT-5000 to under $300, and its DCT-2000 to under $200, Kanouff concludes.

Yet, for the rejuvenated on-demand service to truly become a revenue winner, industry executives still believe that a realistic business model based on real-life marketing data, along with on-going operating costs, are crucial to VOD's long-term success.