CABLE VALUES
How high's the sky?
By John M. Higgins
With a deal frenzy gripping the cable industry, investors and some operators seem to be taking their eye off the most important element of creating long-term value: executing on all the promises MSOs have made. Core operations are sagging, with AT&T Corp. and MediaOne Group Inc.'s systems posting negligible cash-flow growth and other operators slowing. Outside of AT&T, only a few hundred thousand digital subscribers can be found. All operators are having trouble filling orders for high-speed Internet service.
Can operators pull it together? BROADCASTING & CABLE gathered three industry securities analysts to assess the takeover wave and whether operators can actually deliver. Morgan Stanley Dean Witter's Richard Bilotti, Deutsch Bank Securities' Doug Shapiro and Nationsbank Montgomery Securities' John Tinker (who is leaving to start his own hedge fund) sat down with BROADCASTING & CABLE Deputy Editor John M. Higgins. An edited transcript follows:
The deal frenzy these days is incredible. Cox has cracked the $5,000-per-subscriber barrier in buying Media General. Can buyers make any money on these properties at these prices?
Tinker: Basically there's a land grab, and everyone's panicking.
Bilotti: The problem is everybody's panicking and buying. Not everybody's getting Rodeo Drive. Some people are getting South Central.
Shapiro: Why is Cox panicking? Why do they need to panic?
Bilotti: I'm not sure Cox is the one panicking.
Tinker: Everyone wants scale. They think if you're not big, you're not in the party. If you go back to the good old days, you had to have a million subs. Then it went to kind of 2 or 3 million. Now probably 10 million is right. If you don't have scale, you're not playing in the deals.
Shapiro: It's a land grab, but not necessarily because everyone's panicking.
Tinker: Oh, I don't know what else you'd call it! The very size of the deal volume is panic.
Shapiro: If you're rational and you're looking at what's going on, you do decide you need scale. It's not a panic; it's either buy or be bought.
Bilotti: Panic is not a phrase we want to use. It is a land grab, but you want to make it simple, and it's not simple. They're not all buying the same systems. The one with the price of $5,500 may be a cheaper investment than the one that's $3,500. It doesn't reflect two things. It doesn't reflect demographics, which do influence growth rates, and it doesn't reflect the state of readiness of the actual physical plant. It's easier for Cox to make the money on the Media General deal than the TCA deal, despite the fact that Media General is a higher cash-flow multiple. Media General--the demographics of the marketplace are unique.
Can you make money buying at these prices?
Bilotti: You want to boil it down to one simple number? If it's an upgraded system, you can make money at $5,000 a sub--if and only if you can sustain 13% cash-flow growth for seven years. If it's not an upgraded sub, you're going to need to sustain 15% growth. That's a long time. Half of that growth comes from new services, half from the existing business.
Shapiro: There's another factor in this $5,000. Dan Somers [AT&T CFO] looks at valuation much differently than we do. AT&T has related, or tangential, businesses coming in and they're building in synergies with the phone business. The financial buyer can't extract that value. What's it worth to AT&T to shave a couple of points off your customer churn? What's it worth to be able to bundle cable and phone?
Bilotti: We don't know how AT&T sees cable affecting their decline in long distance. That could be a huge differential. If bundling cable, local phone with long distance holds the decline to 10% of long-distance customer base with cable and 20% without, that's a difference of 6 million customers.
Today a lot of operators are growing cash flow less than 10%. Doug, you say it's buy or be bought. Why?
Shapiro: If you believe scale's a necessity, then everyone's faced with a decision. You either say, "I want to play in that game and there's economic value that I can extract beyond getting scale," or you say, "These guys are crazy for paying this much to get scale and I'm selling."
Bilotti: This is no different than what happened with the big entertainment conglomerates seven years ago. They said from scale you would get economies, operating cost economies, which would translate to a competitive advantage, which would translate to proprietary earnings. It didn't work then. There is not one acquisition, with the exception of Time Warner buying Turner, that didn't create at least short-term earnings and value dilution, and in the worst case, created persistent dilution.
Shapiro: We're touching on two different issues here. Panic implies that there's no choice. Everyone who's buying cable systems today has a choice. Your ultimate question is, "Are they making the right choice if they buy?"
I can see the benefits of having local concentration. Why does Cox, which is wonderfully clustered, has great local economies of scale, why do they need to go out and buy another 2 million subscribers that have nothing to do with their existing operation? What's the sense in Adelphia buying FrontierVision, which is spread out all over?
Tinker: The perception in the cable business is size does matter, when in fact it may not.
Bilotti: The fact of the matter is size has mattered historically because the TCI model was to use sheer size to demand ownership interest in programming and other ventures.
You noticed that Leo Hindery [ex-TCI president] shed one-third of his subscribers before he sold to AT&T. TCI got too big to manage.
Tinker: That was a very subtle move. But AT&T is back getting bigger than ever now.
Bilotti: That was financial necessity more than the strategic necessity. You have an industry that's attempting to push consolidation to a new level. At the very time they're engaged in an M&A cycle, the world around them is shifting to an execution cycle. Whether they want to admit it or not, as we sit here today, DirectTV just reported 142,000 subs and Bell Atlantic is making real rumblings that "DSL Lite" is going to be a product in the fourth quarter of this year--and compete with high-speed cable Internet. They should be focusing on execution, and they're focusing on acquisition.
Shapiro: They're not mutually exclusive, though. There're two drivers. One is ego, if you like. They want to have more leverage in the industry. The other is they think that they can extract value at the price that they're paying. With Cox can you argue that egogetting in the way? No. They're saying they can extract value.
There's a point at which cable operators use acquisitions to cover up bad financial performance. Nobody's looking at that weakness. Investors are all excited about the deals.
Shapiro: Acquisitions are distracting. But with a lot, their chief concern is they're going about as fast as they can. The gating factor on upgrades isn't capital, the problem is labor, getting installs done. What they're looking at is if we're going to maximize our operating efficiency, we're going to need that scale.
Bilotti: It's not that they're diluting their rollouts this year, Doug. They'll slow them next year, because in a lot of cases, the companies are buying properties from highly leveraged operators whose systems aren't ready. Remember when operators promised they would start generating free cash flow? We all now know what they're doing with it. It's being used to buy out other companies and in the reconstruction of systems of those that couldn't rebuild on their own.
Tinker: Obviously you can make money if enough of these new services kick in. The gamble is, what are the new services and when do they kick in?
Bilotti: And also the cost of capital. Because all you need is one good sharp interest-rate hike and you could have the same cash flows, but they're worth less.
Tinker: Oh, that's a whole new ball game.
Is anybody impressed by the performance so far of any of the new products?
Shapiro: Digital cable sales have been pretty impressive. The question is, is it impressive on the demand side or is it impressive on the execution side?
I'm big on execution. Demand means nothing if you can't satisfy it.
Bilotti: You've got a digital cable product that has been wildly successful beyond any of these guys' expectations. The only question now is how fast can they roll it out so they can stop DirectTV.
I actually read your reports and you say that AT&T's got 890,000 digital homes and every other operator has only 30,000 each. That's not very impressive.
Bilotti: Yeah, but Comcast was adding 5,700 digital subs a week, and they just increased the size of their footprint by another 50%. So they're going to be close to 10,000 a week. That's a damn good number for a company their size.
Tinker: Look, the changes in technology are staggering. If you're a cable guy, everyone knows the price of the box is coming down and no one knows what the box is really going to be. Why would you take the risk of massive capital spending when you know that Gates is going to come out with a new box in two years, which will make your box redundant? The last thing cable guys want to do is sell this in the stores. What they really want is the old models they had--a box that had a 10-year life or something. They're scared, as they should be.
Bilotti: Telephone is in the middle. The ability to hook it up and get penetration where it's available has been great. The ability to turn on plant, to actually support it, has been slower. Everyone underestimated how much work it is to maintain a reverse path to the kind of reliability necessary to support telephony. And if Cox underestimated it with their engineering prowess, God only knows how far everybody else missed it by.
What about high-speed Internet?
Bilotti: The one that's disappointing is data. That should be rolling off the shelves.
Shapiro: That's all in execution. The demand is definitely there. The install times are still too long and expensive.
Bilotti: The demand's definitely there. AOL has proven it. People keep signing up for the damn thing and it's an inferior product. Do you think the problem is installation or customer service?
Shapiro: It's the install.
Bilotti: It's customer service.
Shapiro: If it were customer service you'd see subscriber churn. You don't see the churn.
Bilotti: These guys are finding out that with the customer service requirement for data subs, holding subscribers' hands, the sub loses money for six or eight months. In the first month that a cable customer has a cable modem, they are apt to be on the phone with the cable company's customer service rep as much as 60 minutes. By the time the cable company's done paying for the CSRs, paying @Home its slice of the revenue, and paying the marketing and everything else, it's vastly negative.
That's worse than expected?
Bilotti: I agree with Doug. It's partially provisioning, but it's partially the fact that the business takes longer to gain scale and turn profitable.
Shapiro: Don't forget, they're keeping the pricing artificially high so there's not too much demand. They are keeping the price high and they are not marketing it nearly as much as they could.
Tinker: They are not marketing it at all.
Bilotti: The installation problem will be somewhat solved when standardized modems let subscribers buy and install on their own. But I only see a gradual acceleration, not a big jump. The average data customer uses up so many support resources that by the time they [the operators] look at the customer, it takes six months before it's profitable. You cut the number of install hours down, but now you triple the hours on the phone walking people through it.
Does this change your valuation model of operators? This was supposed to be the most important new business.
Tinker: This was always a perception game. At what point do people really start expecting results? Right now it's still sort of tomorrow, tomorrow, tomorrow. And now the deal cycle is sort of near the end. People are going to want to see numbers.
Bilotti: Their cash-flow growth rates are way behind what people were predicting last year. They're three-quarters of the growth rate that had been expected.
Tinker: But the interesting question is when does it change to a reality game. There was enough execution to show Wall Street that there was a business and the cable guys had enough of a skill set to make it happen.
Shapiro: There's a fundamental financial reason why investors are always so forgiving on execution, and that's because execution, per se, financially this year means nothing. What is important is execution directionally. Are they getting better? If AT&T/TCI isn't putting up the numbers but is showing the right trends directionally the Street will forgive it. As long as that continues to happen, you could have perpetual forgiveness.
Bilotti: At the time of the AT&T deal, didn't they basically say that the TCI cable properties were going to produce $2.75 billion of cash flow? They were flat in the first quarter. Think that's going to happen?
Tinker: But why would you ever believe the number?
Shapiro: I didn't believe it. I got pilloried for not believing it. I was the most hated man in cable.
You got pilloried because you downgraded TCI at $18 a share and it went to $60. So Leo Hindery [now AT&T Broadband president] had a just-in-time strategy, he sold TCI just in time before the wheels came off?
Tinker: Absolutely. Now you've got the reality of actually having to build these systems. But the Street's in love with this area. Take At Home. That stock should have collapsed. They never hit a number in their life--period.
Shapiro: There was one quarter.
Bilotti: But they revised it downward three times.
Tinker: We've now got competitors like High Speed Access Corp., which is trying to come public. The Bells are finally getting their act together in data. People are realizing that there is a soft underbelly here, some competition.
Bilotti: High-Speed Access? Talk about plugging your own deals. (Montgomery is taking HSA public.) By my calculation, there are 65 million cable subs in the United States, and all operators added somewhere around 150,000 subs in the first quarter. Direct TV did that all by itself.
Tinker: The call-to-arms is being trumpeted by the competitors, so they better get the execution right now.
Shapiro: There's no question they have to get the execution right. But I think the question is how does The Street respond.
Tinker: Let me ask these guys a question. Let's assume that the AT&T-Media One deal goes through, but one of the costs is that AOL might begin to win some kind of common carrier status. So what does that do to the economics of your model, if suddenly At Home and Road Runner don't control the content in data?
Shapiro: If you start to see it moving in that direction fast, the stocks come under a huge price shock immediately. That could be the end of the entire economic model.
Is controlling content that important?
Shapiro: No. Once you start unbundling the pipe, how do you regulate what the content is? It could be Internet data. But why couldn't it be video, why couldn't it be voice? Other people can use your pipe to compete with you. So the most punitive result is that you destroy the entire economic model.
What about video on demand? Is it going to be widely deployed?
Bilotti: Yes. They do it, it works, and everybody two years from now says, gee, that was the killer app. I have more skepticism that they can get telephone right as an industry than that they can get VOD.
Tinker: I thought At Home couldn't hit a number. Now operators deliver video on demand next year? VOD is going to be a killer app, but not for a long, long, long time. We're still talking three, four, five years. The studios are going to focus on DVD first. They can resell the whole library. It's a far more exciting product for them in the near-term. VOD will be at a disadvantage because Blockbuster will get the movies first.
Bilotti: I'll say there's a million homes with VOD by the end of next year.
If the economics supporting a $5,000 basic cable subscriber valuation are legit, does it suddenly make financial sense for an overbuilder?
Bilotti: Yes, but with one caveat. An overbuild only makes sense where you think not only can you attack the cable company, you really do have to believe that you have a three- to four-year jump on the RBOC [regional phone company] being able to respond. RCN makes more than half of its gross profits from modems and telephony.
Tinker: I love RCN. They do a great job. That's a very good question now. They never really made sense before. But then this is part of the whole wider question of wider services. Suddenly the game has changed and my working assumption is that there will be competition.
Shapiro: Overbuild competition doesn't materialize overnight.
Bilotti: Jerry Kent [Charter Communications chairman] has the best argument on avoiding competitive threats. He says, "Look, I want to do two things over the next three years. I want to accelerate my rebuild so no one can send data any faster than I can." That's one way to blunt an overbuilder. And the other thing is, he says, "I want to overhaul my customer service so I look like Cox and I have sterling reputations in every market." Because if you have a really strong customer service reputation and a really modern network, somebody can go overbuild you, and you know what's going to happen? They're going to take a lot of share from the local phone company, and they're not going to dent the cable company.
How hard can it be to dent a cable company?
Shapiro: Ameritech is running into real difficulties against different players. You have enormous differentials in the penetration they've gotten into the markets. Against TCI systems, they get 30%-40% of the market.
Bilotti: And then they run into Comcast and they just get annihilated. You'll see overbuilds, but they're going to look more like overbuilds of the phone companies, where telephone is the primary business and video supplementing those revenues.
So what about cable stocks?
Tinker: There aren't many left. And there's very little float. At some point the market focus is going to shift over to reality. What are you guys really doing? Then it's going to get a little harder. The gamble really is at what point does the market shift. If you go back to the early 1990s, basic subscriber growth started sliding and somebody realized that there was going to be a peak. That's why the whole idea of the full service network was dreamed up to reinvigorate Wall Street.
Shapiro: Figuring out when that psychology shifts, that's the extremely challenging thing.
Tinker: It may not be until another couple of years' time, but it is going to change.
Bilotti: AT&T is the one that's sitting on the inflection point, because they ponied up $106 billion total and they have to prove that their vision of an integrated phone and video pipe not only works, but it can be deployed quickly.
Adelphia has to prove that you can buy large-scale companies that haven't been upgraded and rebuild them in a fast enough period to work. Those bets could go either way.
The one that seems to me to be a sure bet is Comcast. Their strategy has been brilliantly executed. They bought a lot of their scale before the prices got too far out of hand. Steve Burke [president of Comcast cable] has done a wonderful job of turning that company's focus 100% on driving those boxes into the home.
Tinker: Execution, execution, execution.
Bilotti: But Comcast is not comparable to AT&T. The best counterpoint to AT&T is Time Warner. The question is, do you want a big cable system that is attempting to leverage itself using telephony, ownership of telephony assets, or do you want a big cable system that's attempting to integrate with content. And I'd rather go with Time Warner.
Tinker: This is like the old story of "Are we in the railway business or are we in the transportation business?" If you're in the railway business, you got killed when the airline business came in because you didn't define it correctly. This is the old cable debate from way back, "Are you in the distribution business or the entertainment business?"
Bilotti: AT&T, Time Warner, and AOL more and more get looked at as rumbling along, basically with variations on the same theme. AOL has the most unusual valuation, right? AT&T has what definitely is the most intriguing business plan, because if it works, there's a massive economic turn.
With the stocks, do you see more huge gains, a limited upside or is it time to short?
Tinker: If a Britisher can use a baseball analogy, I think we're probably about in the seventh inning.
Shapiro: I remember the day after the Microsoft investment in Comcast, Comcast was at $21, and there were a lot of people who thought it's finished, the cable run is finished. We're done here. People thought it was the seventh inning every inning. It's always looked like it was about to run out, and the question is, is it going to run out?
I would say it's pretty safe to say that the stocks take into account success in the high-speed data, success in telephony, success in digital video, a benign regulatory environment, and a favorable interest rate climate. What else is there to come? What about VOD? What about your interactive work? Look at e-commerce.
Bilotti: Everybody predicted the end of the long distance business a couple of years ago. And you know what, the pie just kept growing. You're biased because the last time was such a train wreck during the hype over the convergence wave of the early '90s.
I'm not biased. I'm skeptical.
Shapiro: Do we get to make fun of you for that "Are Cable Stocks Too High?" cover story a year ago?
Yes, you do. So you don't short any cable stocks?
Tinker: You wouldn't short it now because there's no data telling you they're not going to hit numbers. All I'm saying is that that's an issue that you've got to become increasingly aware of.
Shapiro: You can only short a balance sheet. You can't short a concept.
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