By PETER GRIFFIN
The New Zealand branch of Rupert Murdoch's pay TV empire is run from a large, ageing shed set back from a suburban Auckland road.
But the building's shabby exterior belies its place at the the heart of a $2 billion listed company that beams the All Blacks, TV soaps and blockbuster movies to just under 600,000 households, about 40 per cent of New Zealand's total.
It is a company, which in the year to June, generated $187 million in underlying profits and a bottom line profit of $35.3 million.
The building is a rabbit warren of well-worn, multi-coloured corridors and windowless offices.
The broadcaster's modest studios say it all - a collection of flimsy sets designed to come to life with lighting and editing.
"It's smoke and mirrors," Sky communications director Tony O'Brien says.
This is Sky - all of it. As the frugal company points out in its annual report, if the building was lost in some disaster, there would be no Sky for six months, a fact that is pushing it to build a back-up.
Sky's affable American chief executive, John Fellet, arrived on an 18-month contract. He's been there 13 years.
"It's funny, my career has all been in turn-arounds, but I got here early in Sky's evolution," Fellet says.
Senior managers were out in the early days selling pay TV to pubs or working in the call centre.
Sky has spent hundreds of millions of dollars on building its subscriber base and is now in a solid position.
It has 84 channels and a growing share of the TV viewing market - up to just under 20 per cent of TV viewing, says the Neilsen TV ratings company.
The network last week secured exclusive rights to New Zealand cricket cover for five years and has a near monopoly on top live sports events.
And its share price has risen from $3.50 a year ago to around $5.40.
But Fellet is not complacent.
Growth in subscriber numbers is expected to slow to an average of about 3 per cent in the next few years, so Sky will have to work much harder to keep revenue growing.
It is also in the middle of negotiating a merger with its listed majority-owner, INL, due to take place early next year.
What does Sky have in its favour?
Choice and sport, says Bob Wallace, executive director of the Television Broadcasters' Council which represents the free-to-air channels - Sky's competitors.
"It's why Sky is so determined to get the major sporting events, it's what subscriber television is all about."
Wallace says New Zealand is virtually alone in letting a pay TV operator have such a hold on live sport.
And Sky has plenty of choice, these days, even if it's mainly overseas programmes.
"Trying to find something [to watch] on those 84 channels can be a pretty thankless task," Wallace snipes
Fellet rejects the criticism.
"What you learn in this job is that there's no such thing as bad programming," says Fellet who in the past year has introduced UKTV, the History Channel and the Disney channel.
"I can't stand the reality TV revolution. If it was up to me, we'd just show John Wayne movies and baseball games."
Sky's satellite service offers a cost-effective method of distributing content such as TV programming.
But the company knows that advancements such as those in high-speed internet technology could erode its advantage.
That is why it last month accepted an approach from the owners of DVD Unlimited and bought their small Nelson business, which mails DVDs to customers for a monthly fee.
It will give Sky a customer base that could eventually swap postal delivery for a high-speed internet connection.
"It's terribly ironic in this day and age that the most economical way to get a movie to your home is with a first class stamp," says Fellet.
"We know it will cannibalise some of our business, but not unlike pay-per-view movies cannibalised our movie channel.
"When you look at both of them, revenue per subscriber is much bigger."
Pay TV operators worldwide are doing the same.
Telstra owns 50 per cent of Australia's dominant pay TV operator Foxtel and has set up its own DVD rental operation, Fetchmemovies. Media mogul Kerry Packer has a rival service in Homescreen. Both are understood to be losing money.
Fellet doesn't rule out one day offering high-speed internet services to customers via satellite, by Sky. It has a contract allowing it to send programming through Telecom's phone lines, when the technology enables it.
Technology will continue to change Sky's game.
"I remember them saying, 'Sky is screwed, they're a three-channel UHF operation'," says Fellet of the pre-satellite period.
"It was the most effective way of delivering pay TV at the time. Satellite's the most effective way of delivering pay TV now."
But there are also alternatives to keep the business humming.
In a cluttered room in the bowels of Sky, a wall is stacked with various models of Sky decoders.
In pride of place is a shiny new box, a PVR or personal video recorder which includes a decoder - the box that sits on top of the TV and unscrambles Sky's signal.
It carries the Foxtel badge but, by the end of next year, Sky will have its own box.
It will feature a 160 gigabyte computer hard drive and will integrate with Sky's electronic programming guide.
Viewers will be able to "time-shift" through programmes - watching recordings not when they are broadcast but when they have the time.
But Fellet isn't expecting the PVR to trigger an explosion in subscriber numbers. It's more aimed at keeping subscribers, cutting down on churn - the annual turnover of customers. Churn is down for Sky but still at a sizeable 17 per cent.
He says the changes required to support the PVRs will cost "a couple of million dollars at the head end no matter what".
And for subscribers, he says a PVR will cost "$200 to $250 above whatever your normal Sky installation is."
Another project is to increase viewer interaction. Sky will deliver online voting via the Sky remote for the People Choice Sports Awards.
There is always more programming. Sky has a reservation on the Optus D1 satellite which will be launched next year and will give Sky more capacity.
Subscribers paying an average of $55 each a month are Sky's bread and butter, but advertising on 18 Sky channels has grown 3.75 per cent to around $26.6 million.
It's a small but growing part of the TV advertising pie which hit a record $592 million last year.
As Sky's audience grows, advertisers are spending more to reach them.
"Each digital subscriber spends 50 per cent of their time watching Sky channels," says Fellet.
"For every additional subscriber we pick up there's more eyeballs watching CNN or the movie channel."
But he is realistic about pay TV's place in the advertising market.
"TVNZ is the price maker. Advertisers queue up there if they want to go long. If you want to increase your spend you go to Sky."
Martin Gillman, head of Total Media, which buys advertising time and space, says the free-to-air channels face little substantial threat from Sky.
"Free-to-air will dominate the advertising market for a long time. Sky's revenue will always be driven by subscriptions, advertising's just the cream."
Gillman believes his clients would spend more on advertising with Sky "if we could get more supporting evidence to help sell it".
Much of the advertising was placed around big sports events, but Sky was trying to lessen its reliance on the big games to bring in ad revenue.
Says Gillman: "And Sky are doing well. They're starting to get slightly better ratings on non-sport channels."
Wallace and Gillman agree that the attractiveness of good, locally produced programmes will always sideline Sky in the TV advertising market.
The bulk of Sky's locally produced content consists of live sport studio sport shows. Fellet would like to do more, but it is expensive.
Sky doesn't seek any of the New Zealand On Air money which props up most of TVNZ's and CanWest's locally produced programmes.
"It comes with strings attached," says Fellet "And it's more about support of the local television industry as opposed to what the consumer wants. We're just about what the consumers want."
Fellet believes that in a small market, it makes better sense to partner with a free-to-air network and run programmes that an independent producer may have won public money to make.
Sky has a number of regulatory and legal hoops to jump through before the INL merger can take place, but the deal makes sense.
INL holds about 78 per cent of Sky and has $310 million in cash sitting on its books.
The merger will boost Sky's equity, allowing it to pay out a larger share of its cashflow.
Says Fellet: "INL is widely publicly traded but all its assets are in Sky. Sky has the assets but it's not widely publicly traded."
"There's an awkward situation where you get into arbitrage."
Fellet will not be involved in the merger negotiations.
"I'll be conflicted out because INL directly determines my salary."
He says he has never discussed with News Corp what its shareholding goals for Sky are. It holds about 43.6 per cent of INL, but there is potential for it to be diluted.
"My only guide is Direct TV and BSkyB, something in that 40 per cent to 45 per cent range. Rupert could stop it from going to 35 per cent, he wouldn't have to call me."
As far as the merger is concerned, Fellet believes it will be good for Sky, as the investment index is reweighted in favour of the merged organisation.
"Some of our biggest fans of Sky were sellers. Their mandate was that they couldn't have more than twice the weighting index."
Sky in numbers
Market capitalisation: $2 billion.
Customers: nearly 600,000 households.
Subscribers pay: an average of $55 a month.
Bottom line profit: $35.3 million last year.
Share of TV viewership: nearly 20 per cent.
Channels: 84.
Major shareholder: INL, 78 per cent.
Smoke, mirrors, success
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