BSkyB gears up for the second phase of the digital war

It lost its multi-channel monopoly when the BBC and ITV entered the field. But this autumn, the broadcaster is launching a powerful new weapon: 'freesat'. Tim Webb and Clayton Hirst report

At a recent party to celebrate the broadcaster's 15th anniversary, Sky News anchorwoman Kay Burley recalled that at the launch of Sky in 1989, the running joke was that more people had seen the Loch Ness monster than watched its programmes. "No one says that now," she told the assembled heads of Sky News, to much amusement.

But some 15 years on, BSkyB's phenomenal growth is stuttering and the City is getting nervous. "BSkyB is at a crossroads," says media analyst Graham Lovelace of Lovelacemedia.

On Wednesday, the City will have its first real chance to grill BSkyB's new chief executive, James Murdoch, about his future strategy when the company reports its annual results. The rise in subscriber numbers, which has been the main driver for growth for the past decade, is tailing off. Most analysts reckon it will still reach its target of eight million subscribers spending on average £400 per year by the end of 2005, but say that it is not far from its ceiling. Within BSkyB there are many who worry about slowing subscriber growth. No one quite knows what the broadcaster will do next.

One thing is certain: doing nothing is not an option. A resurgent ITV and the hugely popular free-to-air digital terrestrial service Freeview are snapping at the heels of BSkyB. BSkyB's dominance of multi-channel television, which has taken years to establish at a cost of billions of pounds, and which has seen off the twin threats of ITV Digital and cable, would be wasted.

On a personal level too, James Murdoch, whose appointment attracted so many accusations of nepotism from shareholders, is under great pressure to prove the critics wrong. So where does BSkyB go from here?

BSkyB's broadcasting platform is no longer the only player in town for multi-channel television. As Matt Blackborn, executive buying director at media buying agency Starcom Mediavest, observes: "There is a land grab going on for platforms." Within 18 months of launching, Freeview, run by a consortium of BSkyB, the BBC and Crown Castle, is now broadcasting into four million homes, over half the number of Sky. ITV is a newly regenerated force after the long-awaited merger of Carlton and Granada was completed in February. On Tuesday, it will announce the 1 November launch of its new drama channel, ITV3, into its family of channels, called ITV World. The fight for viewers in multi-channel homes is hotting up.

BSkyB has not been sitting on its hands. In June it announced a free-to-air digital satellite service to deal with the threat of Freeview. Dubbed "freesat" because BSkyB has yet to give it a proper name, it will launch this autumn. Offering 200 digital terrestrial and Sky channels, but excluding its premium content, notably films and sport, BSkyB hopes it can attract those viewers who do not want the full Sky package. Because freesat viewers need a Sky dish, BSkyB is hoping to use aggressive marketing to upgrade as many homes as possible to its full subscription package. It is understood that BSkyB will also boost revenues by offering premium content on a pay-as-you-go basis. Ben McOwen Wilson, a partner at Spectrum Strategy, the technology consultancy, says: "You could see Sky offering a kids' half-term TV package, say, or a movie package at Christmas."

BSkyB, which generates less than a tenth of its revenues from advertising, insists it is not abandoning its pay-TV business model. But by offering channels on Freeview and freesat, the broadcaster is experimenting with a "mixed economy" business model, says Mr Lovelace. "It is trying to increase the number of viewers at the lower end of the market. Previously, its focus has been on driving subscription and ARPU [average revenue per user] numbers, but in the future advertising will make up a higher proportion of Sky's income," he adds.

Analysts expect more details about freesat this week, although no one knows if James Murdoch will use the opportunity to deliver his much-anticipated "state of the nation" address to outline BSkyB's medium-term strategy. Some BSkyB insiders were surprised at the timing of the freesat announcement, which came soon after the BBC and ITV declared that free-to-air digital satellite would be the only way to achieve analogue switch-off. BSkyB's freesat announcement was designed to pre-empt the BBC, which is also developing its own free-to-air digital satellite service. One senior BSkyB source said the announcement was made on the hoof and had originally been pencilled in this week. But opportunistic "guerrilla" marketing has always been BSkyB's forte.

The BBC says it is still in talks with broadcasters, including BSkyB, about launching a rival service. The corporation could yet join BSkyB's enterprise, or BSkyB could be involved in a "freesat 2". Either way, BSkyB knows it must be involved. With the BBC's huge marketing department behind it, any new service is bound to be a success.

Of more immediate concern for James Murdoch is Sky One. The flagship entertainment channel is important to advertisers because it is Sky's biggest non-sport or movie offering. But it has had a difficult year, despite highly acclaimed programmes such as Nip/Tuck and 24. Star-com Mediavest's Mr Blackborn says it is losing ground to other commercial multi-channel entertainment channels, such as Bravo, and finding it hard to justify charging advertisers a 20 to 30 per cent premium.

Advertisers start negotiations with media buying agencies this autumn for next year's contracts. Chris Hayward, head of television at ZenithOptimedia, says: "There is still plenty for Sky to do to restore confidence, like revamping Sky One. ITV is catching up in terms of revenue. Sky will be looking to restore gap."

There are no alarm bells ringing just yet at Isleworth, BSkyB's unglamorous home off the A4 to the west of London. Analysts at Numis Securities expect the company to announce pre-tax profits of £510m, against £259m last year. This year it started paying a dividend for the first time since it went digital in 1999.

The current situation doesn't constitute a crisis. But having fought off first British Satellite Broadcasting (BSB), then ITV Digital and the cable companies, BSkyB must do it all over again. But this time, it might not be so easy.

THE NEW THREAT - VIDEO OVER BROADBAND?

Cable television was always seen as the main threat to BSkyB's dominance of the digital television market. The so-called "triple play" - bundling telephone, broadband and television services together - was supposed to be enough to draw consumers to cable rather than satellite.

But it didn't happen. The two main UK cable companies, NTL and Telewest, ran out of money. Growth in cable television subscribers was reduced to a trickle.

However, the emergence of new technology could shake up the market. Video over broadband will allow people to watch programmes over an internet connection. BT and Wanadoo, which is owned by France Telecom, are planning launches next year. And NTL and Telewest are said to be working on similar proposals.

In the long term, this promises to change television viewing and could force BSkyB into a strategy rethink.

BT and Wanadoo maintain their planned services won't rival Sky's. "If you have a Sky box, then you will want our offering as well - not instead of," insists Pierre Danon, chief executive of BT Retail. Privately Wanadoo, which is headed in the UK by Eric Abensur, spins a similar line.

To make their video over broadband services a success, both companies need BSkyB's content, and not just its home- grown programmes. Trevor Brignall, business development director at Cap Gemini, says: "BSkyB has a lot of buying power and is well connected with the film studios. There is now a real opportunity for Sky to act as a wholesaler."

Video over broadband has advantages over satellite. Programmes can be watched on-demand, with more interactivity between the viewer and, importantly, the advertiser. Rebecca Jennings, senior analyst at Forrester Research, says advertisers may be prepared to pay a premium of up to 15 per cent for an interactive advert.

If BSkyB judges that this technology could one day become mass market, it will have to develop its own broadband plans. Speculation is rife over its next move. Adam Daum, chief analyst at technology research company Gartner, says: "I suspect BSkyB will sit back and watch other companies lose a lot of money. It will then magically announce a deal with BT for video over broadband."