August 11, 2015
Arris/Pace: For Small and Mid-Sized Cable Operators Tied to the Arris
Conditional Access System, Deal Limits Choices from 2 to 1
Update
Although the Arris/Pace merger at first appears to be a 3-to-2 in the US set top box (STB) market, for small and
mid-sized cable operators, the deal is more of a 2-to-1. This is because the vast majority of small and mid-sized
cable operators are wedded to the Arris conditional access system, and only Arris and Pace boxes are compatible
with Arris’ system. Cisco boxes do not work on the Arris system, meaning small operators can only use Pace for
leverage in price negotiations with Arris.
TiVo collaborates with Pace - and recently began collaborating with Arris - to put its software on their boxes
rather than acting as a robust third competitor. TiVo’s collaboration with Pace has posed a formidable threat to
Arris regarding mid-sized cable operators, and the deal will eliminate that competition. For other manufacturers
to profitably enter the STB market for small and mid-sized cable operators, they need to first win a contract from
a large operator, according to an industry insider.
In future reports, we will explore whether merger conditions that require low-cost licensing of Arris’ conditional
access network could promote entry into the STB market for small and mid-sized cable operators, or whether
divestiture could create an additional STB competitor. Because of this possibility of a remedy, as well as the fact
1.) The deal does not reduce innovation, 2.) The TV industry is in a slow transition away from set top boxes, and
3.) FCC regulation could potentially create open standards for set top boxes, we view the market implied
probability of 40% as too bearish.
Recent Developments regarding STBs
Technicolor to acquire Cisco’s STB business. On July 22, Cisco announced Technicolor was acquiring its
STB division. Because the deal will not affect the current concentration of the US STB market, but will simply
swap Technicolor for Cisco, we do not expect it to have a significant effect on the Arris/Pace merger. It does,
however, eliminate Technicolor as a potential entrant into the US STB market.
Political pressure regarding STB rental fees. On July 30, Senators Edward Markey (D-Mass.) and Richard
Blumenthal (D-Conn.) released findings that the average household spends more than $231 per year on STB
rental fees. Their statement declared: “We need a new, national consumer-friendly standard that will allow
consumers to choose their own video box irrespective from their pay-TV provider. Consumers should not be
forced to rent video boxes from their pay-TV provider in perpetuity."
Although the findings increase political pressure for greater STB competition, they are unlikely to substantially
affect DOJ’s analysis of potential competitive effects in Arris/Pace. The findings largely center on the issue that
consumers rent their STBs from operators at a cost that exceeds that of purchasing them outright, and on the
absence of a competitive retail STB marketplace. Accordingly, they are more likely to apply pressure to the FCC
as it considers a successor to the CableCARD, the main goal of which was to foster a competitive retail STB
marketplace. This task is currently assigned to the Downloadable Security Technology Advisory Committee
(DSTAC), which has a report due on September 4.
1
You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.
Apart from Arris, Pace is the only set top box that currently works on the Arris conditional access system.
Conditional access systems encrypt the television signal at the cable headend. The STB at the consumer’s home
decrypts it. In the late 1990s, cable operators had to choose to use either the Motorola (now Arris) or the
Scientific-Atlanta (now Cisco) conditional access systems. “The overwhelming majority chose Motorola,”
explained a cable industry insider. The first report of DSTAC working group 2 notes that the Arris system “was
tailored primarily for the more rural and less clustered systems,” while the “Scientific-Atlanta (now Cisco) design
was tailored primarily for the more urban and clustered systems primarily owned by Time Warner Cable…”
Still today, small and mid-sized cable operators are largely dependent on the Motorola/Arris conditional access
system. Thus, they can only use STBs that are compatible with that system. For a long time, the only supplier
was Motorola, explained the insider. Large cable operators eventually pressured Motorola to license its
conditional access system. Pace was the only STB manufacturer that got a license to build a box that would work
on the Motorola system, he said. As a result, cable operators utilizing the Motorla/Arris conditional access
system had two options for purchasing STBs, Arris and Pace.
Changing conditional access systems does not appear to be a viable option for small and mid-sized cable
operators, however, as it costs several hundred thousand dollars to do so. The amount of money that the operator
would save on having more STB options hence does not justify the cost of changing conditional access systems.
In addition, for other STB manufacturers to reposition their products as compatible with the Arris conditional
access system would require both Arris's permission, as well as a significant investment in the form of licensing
fees. Even in the event of a post-merger price increase to small and mid-sized cable operators (large operators are
likely immune to such a price increase), the potential sales volume may not be great enough to motivate such repositioning, however.
Despite Pace’s seemingly low market share among small and mid-sized cable operators, operators utilize
Pace to obtain lower prices from Arris in price negotiations. We previously reported that our survey of 40
small and mid-sized cable operators did not indicate Pace has a large share of that market, with only 3 operators
using Pace. However, we noted that one cable operator told us he used Pace as a stalking horse to obtain lower
prices from Arris. We recently spoke to another insider who also believed that the existence of Pace as an option
has caused STB prices to go down for small and mid-sized cable operators. Operators have been able to “say to
Arris we’re going to look elsewhere,” and, “there’s somewhere else to look,” said the insider. This has led to a
“check on Arris’ ability to gouge,” he added.
One reason Pace has nonetheless gained only weak market share among small and mid-sized operators, however,
is that switching STBs is a sizable effort. Operators need to train their customer service representatives and
technicians to support each type of STB used. This makes cable operators more inclined to continue to use the
same types of STBs than to switch.
TiVo/Pace partnership poses a formidable challenge to Arris; Merger will eliminate that competition. Midsized cable operators that were seeking an additional choice beyond Arris for set top boxes looked to TiVo. TiVo
built boxes that work on the Arris system using CableCARDs, which do not require permission from Arris or the
payment of licensing fees for Arris’ conditional access system. The TiVo integration was expensive for cable
operators, so it was not an option for smaller operators. Although CableCARDs allow for decryption, TiVo still
had to make a large investment to build work-arounds that would allow its STBs to fully function on the Arris
system.
2
You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.
Because TiVo is predominantly a software company, it began putting its software onto Pace STBs, which could
be manufactured for a lower price. Largely at the behest of TiVo cable operator customers who were seeking a
second STB option, TiVo recently announced a partnership to also put its software on Arris boxes. For TiVo’s
current cable customers, which includes RCN, Grande Communications, Suddenlink and Armstrong, the
Arris/Pace merger will limit their STB options at 1 instead of 2. Also, since Pace is viewed as the lower cost
option in the market, there is concern among TiVo customers that prices could go up, said an industry insider.
Because Pace has been willing to work with TiVo for several years, many also view Pace as more innovative than
Arris. According to the first report of DSTAC working group 2,“TiVo demonstrated a single user experience that
integrated Cable Service, Netflix Service, Amazon Service, and other OTT video services. The user has a choice
of launching the OTT Application separately, or watching content from within the TiVo user experience instead.”
The TiVo/Pace combination thus was a formidable, lower-priced and more innovative competitor to Arris.
Potential entrants likely require a large cable operator contract to enter the small and mid-sized operator
market. Small cable operators told The Capitol Forum that manufacturers make STBs for the large operators,
and then the small operators largely buy the boxes off the shelf. Pace has been available to small operators
primarily because Pace gained a large contract with Comcast. STB manufacturers are not interested in entering
only the small and mid-sized cable operator market, according to industry sources, as the costs of integrating with
or licensing the Arris conditional access system make entry costly and the potential sales volume is not
sufficiently great.
Oddly, if Comcast were to award a large STB contract to a different manufacturer, like Samsung or Humax, that
manufacturer potentially could then enter the small and mid-sized cable markets. To date, large cable operators
like Comcast have not done so, however. As we have reported previously, large cable operators have the option
to utilize contract manufacturers because they are getting STBs made to their specifications. DOJ however
cannot rely on such entry in its analysis, nor is it possible to know whether a new entrant would undercut Arris on
pricing the way that Pace has done.
Next Steps
In future reports we will explore:
1. Whether merger conditions could create a competitive option for small and mid-sized cable operators,
such as divestitures or mandatory licensing of the Arris conditional access system at a sufficiently low
rate.
2. Whether changes in the TV industry such as over-the-top TV, the IPTV transition, and the DSTAC
recommendation due on September 4 could affect DOJ’s analysis of the deal.
Issue Snapshot
Outlook: Current Consensus of 40% is Too Bearish
Reasons for Challenge/Collapse
Most Compelling Narrative
The deal would eliminate an aggressive competitor
that has shaken up the historic duopoly of the US
Reasons for Merger Clearance
Most Compelling Narrative
Large cable companies have significant buyer power
and options for direct manufacturing that could
3
You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.
set top box market. Cable operators report that
STB prices have decreased as a result of Pace’s
entry into the market and that they have used Pace
to obtain lower prices in negotiations the
incumbents. Smaller cable operators are
particularly vulnerable to a post-merger price
increase. TiVo’s collaboration with Pace has
challenged Arris regarding mid-sized cable
operators, and the deal will eliminate that
competition.
prevent a post-merger price increase to them. To the
extent large cable companies rather than STB
manufacturers control the level of competition and
innovation in the STB market, the Arris/Pace merger
may have little competitive consequence. Limited
penetration among small and mid-sized cable
operators decreases the odds of strong customer
opposition.
Competitive Analysis
-The relevant product market likely will include
STBs only, not third party streaming devices that
are currently incompatible with cable systems.
Competitive Analysis
-Buyer power likely will prevent a post-merger price
increase to large cable operators.
-DOJ will take a close look at pricing data. If
Pace’s entry into the US market has had significant
price effects for small and mid-sized cable
operators, DOJ will view the loss of that
competition as problematic.
Political and Other Factors
-Political pressure for greater STB competition
focuses on rental fees and the absence of a retail
marketplace. Although not directly related to the
Arris/Pace merger, greater consolidation generally
runs counter to pressure for greater STB
competition.
-Large MSOs that provide STB manufacturers with
detailed product specifications potentially could utilize
contract manufacturers as an alternative in the event of
a post-merger price increase.
-Because Arris and Pace manufacture STBs according
to large cable operators’ specifications, the merger is
unlikely to reduce innovation.
Political and Other Factors
-Current FCC reform efforts may promote standards to
create a more open playing field for set top boxes, but
it is unlikely such reforms will be timely enough to
affect the antitrust analysis of the Arris/Pace merger.
-The OTT transition, which may eventually moot set
top boxes, similarly is not likely imminent enough to
alter DOJ’s analysis of the deal’s price effects.
-The merger is unlikely to hamper the transition to
OTT video, as Arris and Pace are relatively small
players in cloud and network infrastructure.
Timeline
-The parties announced the acquisition on April 22, 2015. On June 29, the parties announced they had
received a second request from DOJ. Next steps for DOJ are speaking to industry participants about
potential competitive effects, reviewing documentary evidence the parties they produce, and studying price
effects with economic models.
4
You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.