VERY interesting article on cable business $$$$$$$$$
World's greatest business
Market Sleuth 05/11/00 5:30 PM
By Tom Kerr
It's been called the world's greatest business. It has 40%-plus cash flow margins, you bill the customers in advance, you don't have to carry inventory, and there is no single significant customer to lose and ruin your business. In addition, it's not economically sensitive, it currently has no exposure to Asia and Latin America, and there is very little competition.
It's the cable business, and now players in this industry, if they execute according to plan, are poised to become even greater. The incremental revenue and cash flow opportunities that have been talked about for years are finally here. This is because cable companies are nearing the end of massive upgrades where old analog cables are being turned into digital high-speed two-way systems. It is estimated that approximately 80% of all cable homes are now upgraded to at least 550 Mhz, the range necessary to provide advanced digital services.
What are the incremental revenue opportunities? The first is high-speed data transmission, which means Internet access at transmission rates many times faster than a 56k dial-up modem. Speed is significant not only in terms of customer satisfaction, but in terms of efficient use of ancillary services such as streaming video and large file transfers. ExciteAtHome (ATHM), the leading broadband Internet provider over cable systems, said recently that its 1.5 million subscribers generate bit traffic roughly equal to America Online's (AOL) 22 million subscribers.
A second opportunity is digital cable television, a higher quality version of cable television with twice the channel selection and a much clearer picture. For example, Time Warner (TWX) can go from offering 79 analog channels to 170 digital channels for an additional monthly charge of about ten dollars. Watch out for DirecTV and Echostar (DISH).
And the third source of revenue is telephony over cable. This is, of course, one of the key reasons for AT&Ts (T) acquisition of Telecommunications Inc. in 1997, now called AT&T Broadband Services. Yet there is still some doubt as to whether it's a feasible business model, or if the technology even works on a massive scale. It's a difficult question to answer; however, it's been working successfully in Europe with cable companies like United Pan Europe Communications (UPCOY), as well as here in the United States with Cox Communications (COX), which has over 134,000 residential telephony subscribers as of March 2000. And at a monthly charge approximately 30% less than the local phone company, this could still pose problems for regional telephone companies.
The significance of these incremental cash flow streams can be demonstrated financially. If these revenue opportunities come to fruition, a cable company's EBITDA (earnings before interest, taxes, depreciation, and amortization) growth rate could increase from the high single digits to mid-teens, yet at the same time, capital expenditures will decrease as the upgrade of the systems is completed, which means most cable companies will start to generate significant free cash flow at an increasing rate. This can be used to reduce debt, buy back stock, or invest in new ventures.
Furthermore, a company that consistently grows 13-15% and generates free cash flow is now considered a steady blue chip growth stock, and consequently deserves and will be awarded a higher multiple.
Yet these stocks have traded down this year, largely due to rising interest rates. Cable companies are traditionally highly leveraged and affected by short-term rate fluctuations, and much of a cable company's growth is back-end loaded so the higher discount rate when applied to valuation calculations provides a much lower intrinsic value. The data prospects alone should offset any interest rate concerns, as this is probably the best near-term opportunity for cable providers right now.
The majority of them are tied into exclusive arrangements with ExciteAtHome. (Time Warner has its own system called Road Runner). ExciteAtHome provides the network, the backbone, and the data centers, and each cable company provides marketing and installation and basic cable plant over which the data flies. For a $35 monthly fee, roughly $15 more than the average 56k dial-up service, the consumer gets some of the fastest Internet access in the world. The cable company gets 65% of the monthly fee, and ExciteAtHome keeps the remaining 35%. With customer churn almost non-existent so far (ATHM reported 1.5 million subscribers as of March 31), this could turn into a nice incremental stream of revenues for the cable companies. ExciteAtHome recently committed to an aggressive spending plan in which they hope to garner 3 million subscribers by year-end 2000, ramping up to 10 million subscribers by 2002. Some of the additional marketing costs will be borne by the cable providers, another reason the stocks have been under pressure. But it is far better to pay up and grab subscribers now when acquisition costs are low and there is limited competition.
So will the world's greatest business transform these additional services into better stock market returns? From these discounted levels, and for those with a time horizon longer than one month, the answer is probably yes. Stick with the big five pure play firms outlined below. (I've eliminated the two largest cable companies, AT&T and Time Warner, because they are not pure cable plays anymore). In order of size, they are as follows:
Company YTD return Notes
Charter Communications (CHTR) -41.1% More leverage than most, but controlled by Paul Allen
Cox Communications (COX) -19.5% Well-managed company with low leverage and large outside investments
Comcast (CMCSA) -32.9% Large investment by Microsoft; big supporter of AtHome
Adelphia (ADLAC) -35.2% Highly leveraged, owns one of largest CLECs in the US
Cablevision (CVC) -14.6% Majority of subscribers in New York City market, owns Madison Square Garden
Dick and Dick may be on to something here (VBG)
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