The Cable Fable
Elizabeth MacDonald
Forbes
08.12.02
The industry is overvalued, says James Chanos, the short-selling sleuth who uncovered the Enron scandal. Why? The never-ending treadmill of capital spending.
James Chanos, the first to spotlight Enron's accounting scams, is someone to be reckoned with on Wall Street. The lanky short-seller has delivered a spate of other prescient calls, targeting high-flying stocks, from Amazon to Yahoo, that later crashed. So when he trains his sights for his investment clients on the cable industry, it pays to listen.
Everyone knows cable stocks aren't doing well, so what's the big whoop? Cablevision is down 84% from its 52-week high, Comcast is down 42%, etc. Adelphia has declared Chapter 11 amid a self-dealing scandal involving founder John Rigas.
Adelphia's shenanigans aside, the industry argues its current travails are temporary. Subscriber growth has flattened, so the cablers are adding new services like digital programming and telephone hookups. What's more, they say, cable has won the broadband race over the phone companies, making it the primary pump into homes for the Internet, video-on-demand and the like. Sure, the cable crowd admits, it has to spend heavily to build out systems, but this is almost done. Prosperity--free cash flow--is just around the corner.
Chanos, 44, has been around long enough to be unimpressed. For one, cable today is eerily reminiscent of the railroads in the 1880s: overleveraged companies going bust, having laid the track that someone else later takes advantage of, with the emphasis on "later." His stronger argument is based not on history but on capital expenditures. He says that capex will continue remorselessly, that operators will have to spend lavishly just to stand in place.
Chanos (pronounced "CHAIN-os") and his firm, Kynikos Associates, looked back 18 years (11 years for Cox Communications, the earliest data available) and concluded cable's story was a fairy tale. Upgrades and new technology always seem to require more, not less, capital spending over the long pull, making the sector heavily reliant on continued financing from investment banks. Chanos says the projections look dismal as far out as 2007, when the industry's capital spending for the current round of new technology is supposed to be done.
Cable analysts customarily ignore net income and look instead at operating income (in the sense of earnings before interest, taxes, depreciation and amortization). While Chanos looks at both, he also focuses on return on capital. The industry's average 5% pretax return on capital over 18 years is paltry, far short of the cost of borrowed money. More consolidation won't help because cable outfits lack the financial oomph for mergers: Comcast's acquisition of AT&T's cable assets is the last big merger we'll see in a while.
Here's one more way of looking at the value of cable assets: Take the enterprise value of a public cable company (interest-bearing debt plus market value of stock, minus cash on hand), then divide that figure by the number of subscribers. While that number currently is $3,500, Chanos would pay no more than an average $2,000 per subscriber.
Stick with $2,000 for now. At first blush that doesn't look terribly expensive, since a subscriber will shell out $800 a year on average and may already have his new set-top box. Subtract a $480 average annual cost to serve the subscriber with repair visits and so on. You get $320, or 16% of the purchase price--pretty good for a cash-on-cash operating return. A strip mall would do only half as well.
But drilling deeper into the numbers offers a less pleasing picture, says Chanos. He factors in the annual maintenance spending to keep the system up and running, particularly as customers upgrade their service. Chanos says the bulls believe that maintenance-level capital spending figure is $100 a year per subscriber, while the bears put it at $150 a year. Chanos charitably takes that bullish $100 and subtracts it from the $320 cash return.
The resulting $220 per subscriber translates into a tiny pot of real cash to service cable's sometimes monstrous debt. Cox stands the best chance of handling its $1,100 debt per subscriber, but then there's $1,352 for Comcast, $2,404 for Cablevision and $2,497 for Charter. (Bankrupt Adelphia's debt was $2,508 per sub; the number can't be broken out for AT&T's and AOL Time Warner's cable operations). While the other companies didn't comment, Cablevision took strong exception to this debt figure, arguing that since it is a diversified company, the calculation includes debt for Madison Square Garden and Rainbow Media, among other things.
Despite Cablevision's complaint, Chanos says if you must buy into cable, skip the stocks and buy the bonds, which have prior claim on the $220 of loose cash.
A July 12 report from Credit Suisse First Boston gives Chanos more ammunition. The report provides a detailed look at "churn," which is essentially cable's costs for labor and advertising. Credit Suisse says that cable companies have been hiding the impact of their churn by capitalizing labor costs. In other words, if they spend $50 to install cable in a home, the cable guys only subtract $20 from revenues to calculate the current period's earnings. Then they spread the rest over a dozen years. The worst offender, Credit Suisse says, is Charter Communications, which capitalizes $29 per customer.
So what are cable stocks really worth? Chanos takes his $2,000 per subscriber and subtracts net debt, preferred stock and minority interests. The results aren't pretty. Chanos says Cox is really worth just $8 a diluted share, not the $27 it's currently trading at. Comcast is worth $5 for its cable assets ($18 if you factor in all its assets, including its stake in QVC), not the $22 it trades at now. As for Charter, at $3? Chanos says its equity is worthless.
What do the cable companies say to all this? Eileen Connolly, vice president of AT&T's financial communications, says all of its upfront expenses will bear fruit--in due course. Revenue is exceeding costs in two new services, high-speed data and local and long-distance telephone services over cable, she insists.
Cox will only say that it expects to turn free cash flow positive by year-end 2003, declining further comment. John Alchin, Comcast's treasurer, says Chanos' estimate that cable assets at Comcast are worth just $5 a share "borders on ludicrous," as it grossly underestimates the value of cable subscribers and Comcast's ability to generate free cash flow. Charter says it will meet its earnings estimates and insists its quality of earnings is just fine. AOL Time Warner officials were unavailable for comment. |
