Interactive TV: It's Baaack!!!
Years ago, the big boys like Time Warner, Bell Atlantic, and TCI failed to deliver video-on-demand. A few startups are turning that bad dream into real business.

By Marc Gunther,
Fortune, July 20, 1998
For Ted Maguire, a 52-year-old truck driver who lives near Philadelphia, the future of television is now. He and his wife, Linda, no longer drive to the video store when they want to rent a movie; instead, they turn on TV, choose from 150 titles on their cable system, and settle back to watch - pausing, rewinding, or fast-forwarding at will. "It's very convenient," says Maguire, who subscribes to a video-on-demand service called OnSet, "We love it."

That reaction won't surprise executives at companies like Time Warner, Bell Atlantic, and Tele-Communications, Inc. that spent hundreds of millions of dollars testing video-on-demand in the mid 1990s. (For the lowdown on TCI and AT & T, see First.) Viewers, they found, enjoy watching whatever movie or TV show they want, whenever they want. Unhappily, delivering video-on-demand with VCR-like features was prohibitively expensive; video-server systems could cost $5 million, high-powered set-top boxes $6,000 apiece, and digitizing a movie another $4,000; writing software to make it all work was a nightmare. Then came the explosive growth of the Internet, which pushed interactive TV into the background.

Now - with hardware and software costs tumbling and technical issues becoming manageable - video-on-demand is turning into a real business. As cable operators deploy digital set-top boxes and upgrade systems for two-way data, their enthusiasm is mounting. Says TCI chief technology officer Tony Werner: "Three years ago, was it a business? No. Today it's getting interesting. If you go out two or three years from now, it looks great."

What's surprising is that the resurgence of video-on-demand is being led not by a media, cable or telephone giant but by a little-known Silicon Valley startup called DIVA Systems Corp. With none of the hype associated with the prior launches of interactive TV, DIVA has signed up 1,250 customers for its OnSet service in Pennsylvania, New Jersey, and Georgia. So far it is working with three mid-size cable operators and a big one, Cablevision. Four more rollouts are planned this year.

DIVA's biggest challenge is getting its service distributed by the cable industry's powerful gatekeepers. Big operators like TCI, Time Warner, and Comcast are taking a wait-and-see stance. They want to be sure the product works on a broad scale. They want to see how much money viewers will spend. Most of all, they don't want to share what could be a lucrative new revenue stream with DIVA, which owns and operates OnSet even after it's rolled out by cable systems. "If you're a small operator and you don't have much capital, DIVA might look like a wonderful deal," says Tom Feigy, a Time Warner executive who ran the company's flashy interactive experiment in Orlando. "But if you're a large company like TCI or Time Warner, the DIVA model doesn't make a lot of sense." Or as another industry insider puts it, "Our guys always prefer to deal with people in the family. Cable is one big incestuous clan."

The outsider leading DIVA is 73-year-old Paul Cook, a World War II veteran, an MIT-trained chemist, and the founder of Raychem, which he built into a $1.5-billion-a-year company before retiring in 1990. Later, as chairman of nonprofit SRI International, a Silicon Valley research center, Cook came upon a powerful computer called the Sarnoff server that was built for RCA in the 1980s to stream video into color-TV sets. Figuring the server could be rejiggered for video-on-demand, he County, started DIVA in 1995. "The challenge of going after this huge market was more than I could resist." says Cook. Video rentals generated $8 billion last year.

Cook and DIVA president Alan Bushell assembled a team of 250 engineers, software programmers, and cable alumni to develop OnSet, at a cost of about $80 million. With-out a press release, a Web page, or even a listed phone number, DIVA began trials in September 1996 in a Delaware county, PA cable system owned by the Len-fest Group. "We didn't want to be part of the hype" Bushell says. "We wanted to let results speak for themselves." DIVA raised $75 million in equity and $250 million in high-yield debt on Wall Street from such investors as Merrill Lynch and Putnam.

Cable customers who subscribe to OnSet pay an additional $5.95 a month, all of which goes back to DIVA. New movies cost $3.99 each, so-called adult titles $7 or $8, older movies $2.99, and how-to and kids' shows as little as 99 cents. The fees are shared by DIVA, the cable operator, and Hollywood. All the major studios except Viacom's Para-mount (Viacom owns Blockbuster, remember?) supply content to DIVA, and cable networks such as HBO are eager to join in. As costs drop for real-time encoding of live sports or news events, they too could be made available.

"We believe it's economically viable on movies alone," Bushell says. "But the upside is sports, TV shows, music videos, infomercials to help a consumer buy a car or plan a trip." DIVA says its typical customer buys more than four movies a month.

Others will soon enter the arena. Sea Change International of May-nard, Mass., is developing a video-on-demand system that, unlike DIVA, it will sell outright to cable operators. Intertainer, a startup in Santa Monica, Calif., has developed a service to run over cable modems and souped-up phone lines; it will offer movies, TV shows, music, and travel and fashion videos, with links to promote home shopping. Formed in 1996 by Hollywood hotshots Jonathan Taplin and Richard Baskin, Intertainer begins trials this summer. Backers include Sony, Intel, Comcast and US West, soon to be joined by NBC.

DIVA execs say rivals will be surprised at how difficult it is to build a video-on-demand service that can be scaled up to handle millions of subscribers. In the meantime, Cook says, "our costs are going down rapidly, and our capabilities are going up sharply." DIVA executives also told FORTUNE that they're now willing to give equity to major cable operators in exchange for carriage; that's a model the industry knows and likes. But the strongest force that will drive cable to offer video-on-demand is competition from satellite-TV providers and phone companies. This summer US West will roll out a service called Tele-Choice in Phoenix, combining Intertainer's on-demand programming with Net access and telephony. DirecTV already offers more than 200 channels of programming. The longer cable waits to go interactive, the sooner its customers will look elsewhere.