It was meant to be a passport to a lucrative, hi-tech future. Instead, ITV Digital looks increasingly like an expensive liability for its corporate parents, Granada and Carlton. Perhaps, says Kate Bulkley, the time has come for them to cut their losses...

The sad truth is that if ITV Digital was closed tomorrow, the share prices of its owners would probably double. This is the message equity analysts and institutional shareholders have been sending out as they have watched the stock prices of Carlton and Granada plummet. This year, Carlton's share price has gone from around 600p to a low of 129p. It closed yesterday at 177p. Its market value has nose-dived from £5bn earlier this year to a low of less than £1bn. The fall from grace has been severe and humbling: Carlton faced the ignominy of being kicked out of the FTSE 100 three weeks ago. And Granada closed at 121 yesterday. Its year high was 223p but it has fallen as low as 91.5p.

To be fair, the capitalisation hemorrhage of its two corporate parents is not largely the fault of ITV Digital. The share-price falls of Carlton and Granada have to do with a rapidly declining advertising market which fuels the companies' commercial TV businesses. But the future of the loss- making pay TV platform could be a big part of the solution to the ITV companies' problems. At present, ITV Digital looks much like Carlton and Granada's corporate version of the BBC hit show The Weakest Link. Investors and analysts who want action that will prop up the stock prices see revamping or even closing ITV Digital as a relatively easy fix. The possible future of ITV Digital is capturing a lot of attention. One analyst calls the dilemma of the ITV Digital shareholders a "triple whammy" of falling ad revenues, and two big ongoing costs: a further £300m (in addition to the £800m already spent) to bring ITV Digital to breakeven and the funding for a new ITV Sport, which has so far cost £150m.

The rapid deterioration in the advertising market has hit Granada and Carlton hard. ITV's advertising revenues are expected to be cut by some 16 per cent this year, equivalent to about £300m of lost revenue. This fall has put more pressure on ITV Digital, now seen by many analysts as a discretionary spend. And it's a risky expense as well. ITV has pushed forward its breakeven date from 2002 with two million subscribers, to a rather vague "2003 or 2004" with 1.7 million subscribers. Today ITV Digital counts 1.1 million subscribers and most analysts are expecting pretty strong new subscriber figures for the most recent quarter. Last quarter, ITV Digital added 48,000 new subscribers and is expected by Merrill Lynch to add 55,000 this quarter. ITV Digital is outselling Sky 2-to-1 at retail although is should be remembered that 40 per cent of Sky's sales are now done direct.

The finances of Carlton and Granada are being closely scrutinised. Last week several analysts questioned Carlton's rising debt level, which will end the year at £600m. The company has also halved its dividend, so, says one analyst: "There are clearly constraints on its ability to keep investing into ITV Digital and most importantly into the ITV Sports channel." That was launched in August and features Nationwide and Champions League games.

A Carlton spokesman says the company is fully funded and "nothing has changed" in the business plan for ITV Digital. But the pressure is on. Late last month the media-buying firm Zenith joined the equity analysts and came down hard on ITV Digital, saying it would take "divine intervention" to make ITV Digital profitable, and urging its owners Carlton and Granada to get out of it.

Although executives at ITV Digital claim "breakeven is within sight", certainly ITV Digital has suffered from a litany of mis-steps, by the company and the Government, which granted the original frequencies for the service. The licence provided only limited signal coverage of the UK, which has hampered growth. Many viewers get fuzzy or no reception, so they disconnect. And the boxes tend to freeze and must be re-booted like a computer.

The 23 per cent rate of disconnection, or churn, of ITV Digital's customer base is more than twice as high as its biggest rival British Sky Broadcasting and it has said churn could peak at 30 per cent this year. There have been and continue to be mistakes over what channels ITV Digital should offer. The new ITV Sports channel was launched, to sighs of "about time" by some and "too little, too late" from others. The ITV Digital lineup is weak compared to Sky and cable. Part of the problem has been the not- invented here arrogance of the ITV parents. For example, The Discovery Channel was originally turned down by the digital terrestrial pay platform for an ITV-grown documentary channel that failed to inspire. The Carlton Food Network, re-christened Taste, closed this summer due to lack of audience. Granada's Well Being Channel has faced similar challenges.

The re-branding and integration of ITV Digital into ITV righted a lot of old wrongs - not leveraging the ITV brand from the outset - as well as cutting £20m out of the cost structure, but it only papers over fundamental questions. One of those is the rampant piracy of ITV Digital's subscription cards readily available on the internet and reportedly costing ITV Digital millions of pounds a month in revenues. An ITV Digital spokesman admits: "It's more of a problem than it used to be [but] we believe some of the figures quoted are much too high."

Another basic question is how to compete with Sky, which has dozens more channels, many of them more interesting than ITV Digital, or with cable, which offers two-way, high-speed broadband services as well as TV and cheap telephone lines. ITV and ITV Digital's CEO Stuart Prebble says: "There are 15 million people out there who aren't waiting for broadband. They just want a little more telly." Perhaps. The more important point is that as broadcast audiences fragment, ITV needs a digital strategy. The question is: is this one, the right one?

The one decision most observers say has really cost over the years was when the ITC barred BSkyB on competition grounds from joining the original OnDigital consortium. Sky agreed to supply programming to the new over- the-air digital service, but the European Commission nixed that too. So OnDigital launched without Sky's pay-TV expertise and had to learn the hard way about things not part of the broadcaster's natural lexicon,including subscriber management, customer service and multi-channel marketing.

The competitive situation has changed a lot over the past three years and the regulatory winds may be shifting, which could open up new possibilities. The decision-making criteria that stopped BSkyB from joining the ITV Digital party three years ago may no longer apply. The ITC, at least, seems to be changing its tune. The director general, Patricia Hodgson, said recently that the focus of regulation shouldn't be around creating competing platforms but rather on whether there is open and fair access by programmers to these platforms.

"We have to look at the access conditions themselves rather than the old-style competition rules that focused on not owning too much of the landscape," says Ms Hodgson. But any rapprochement between Sky and ITV will be difficult. There has not been a lot of love lost between the two since they have been pay-TV competitors. Carlton and Granada complain that Sky has abused its dominant position of running the biggest pay-TV platform in the UK. The recent tussle has been over getting satellite carriage for ITV's channels. So far the two have disagreed, most vociferously, about the fees Sky wants to charge for the use of its subscription system.

A recent headline in The Sunday Times, which like BSkyB is part of Rupert Murdoch's News Corp empire, blared: "ITV chiefs want to make digital peace with BSkyB." The article spoke of some kind of co-operation brewing between Sky and ITV Digital, including a possible investment by Sky into the loss- making platform. Merrill Lynch analyst Neil Blackley says merging the billing and other back office operations with Sky would cut ITV Digital's costs and "give it a chance".

Certainly, Sky executives see possibilities in an alliance. Richard Freudenstein, Sky's chief operating officer, told a TV audience in Cambridge that the solution to ITV Digital's problems is to restructure it and "make it a complementary service to Sky and cable". Sky and cable would benefit because ITV Digital would be a sort of digital starter pack, a platform to advertise the benefits of upgrading to the more fully-loaded packages of services offered by Sky and cable. But many observers believe ITV Digital and Sky working together is politically unpalatable to those worried about a Murdoch juggernaut over the UK's digital future. BT and the BBC and UK cable companies are possibilities.

Sources close to ITV, Granada and Carlton have also had discussions with Microsoft and utility company Centrica. One problem is how to value an investment in ITV Digital. Last year there were indications that the company would be floated after it reached one million subscribers at a mooted value of £1.5bn to £2bn. With the collapse of stock prices a public float is no longer on the table. One analyst says a more realistic figure for ITV Digital's value once it reaches the 1.7 million subscriber level (ie breakeven) is about £400m.

Some of the most likely partners for ITV Digital have their own problems. Cable company NTL is working under an £11bn debt load, and Telewest also has to watch its cash although its debt is smaller.

The future of ITV Digital also concerns the Government which is wants its plans for a digital Britain to stay on track.

A leaked letter reportedly written by Charles Allen to Prime Minister Tony Blair this year, complained that stringent cross-media ownership rules and the advertising downturn was making the UK's independent TV companies vulnerable to foreign takeover. The letter also highlighted problems at ITV Digital, saying it was chewing up cash and was nowhere near its targets. It was a thinly veiled plea for help. Whether the letter was the right approach to take is debatable. Mr Allen has suffered much criticism for it, and Carlton's chief executive Gerry Murphy called the letter "scaremongering". But Mr Allen has repeated the message in subsequent public comments . He believes the Government, as a matter of urgency, must lead a "digital action plan" to help encourage people to switch to digital services.

Of course, ITV Digital would be particularly well-served if as part of its plan the Government mandated the sale of integrated digital TVs. IdTVs get all free-to-air digital terrestrial channels and purchasers of the integrated sets can receive ITV Digital simply by slipping a credit-card- sized subscriber card into the set. IdTV's would cut ITV Digital's hefty subscriber acquisition costs by up to 70 per cent, lowering the cost per subscriber from about £200 to about £60. But idTVs cost a lot more than regular analogue TV sets. Until the Government sets an analogue switch- off date - the Secretary for Culture, Tessa Jowell, says the Government is committed to a 2006-to-2010 switchoff timeframe, and as more free-to- air digital channels such as the three recently approved BBC ones are launched, reasons to trade your TV for a digital one may not be big enough.

Stewart Prebble says if ITV Digital is abandoned now "it would mean the Government could say goodbye to this country's world lead in digital rollout, and watch most other advanced countries move towards digital switchover while we remain an analogue-only economy". But the Government cannot be seen to be bailing out ITV Digital at the expense of the rival platforms, cable and Sky. And Mr Prebble seems to be ignoring another point. Digital terrestrial TV is not just about the pay-TV offer of ITV Digital. There are already half a dozen free-to-air digital channels, including BBC News 24, BBC Parliament, the ITN News channel, ITV 2, a shopping and a travel service. These require no on-going subscription to ITV Digital.

One suggestion being floated around the City and TV circles is the possibility of a three-way alliance, BT, the BBC and ITV centred around a low-cost, BBC-branded digital terrestrial set-top box or adapter. The BBC would benefit from promoting its free-to-air digital channels and using its strong programming budgets to make the offer appealing.

BT might be interested in incorporating a DSL (digital subscriber line) modem into the box to provide the broadband connection as interactive services are launched. ITV might be able to cut its costs by piggy-backing on to a BT billing system. But the main benefit for ITV would be that it could limit its digital set-top box costs. Hopefully, the BBC box would be taken up widely and like integrated digital TV sets, there could be a slot for the ITV Digital subscription card so consumers could choose to subscribe. Interestingly, last week the BBC director general Greg Dyke is said to have told told questioners at a private function sponsored by Harvard Business School that a BBC-branded box was a possibility. He also said a BBC box should retail for between £100 and £150 but "it's up to the Government to promote digital TV". A BBC spokeswoman said the BBC is researching a free-to-air digital terrestrial TV box, but there are "questions over cost and who would undertake the financing".

On top of the advertising crunch, ITV is facing an increasingly competitive landscape. It may still be the dominant player, able to attract the biggest audiences to commercial TV. But last week ITV suffered its worst peak- time audience share, dropping well below 30 per cent. An ITV spokeswoman agreed the channel had a "bad week" but says the average peak time share in all homes is still 35.5 per cent.

The growth of satellite and cable, not to mention Channel 5, is increasingly giving audiences and advertisers an alternative. Given the pressures on its main ITV business is it little wonder that ITV Digital's shareholders are looking very seriously at their options. Stay tuned.

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