Motley Fool on NextLevel..................
FOOL ON THE HILL
An Investment Opinion by Louis Corrigan
Sony Connects with NextLevel
Sony Corp. (NYSE:SNE - news) entered the U.S. cable business on Monday by forming a "strategic alliance" with
NextLevel Systems (NYSE:NLV - news) , sending shares of the cable-box manufacturer up 9% to $19 11/16. The broad
terms of the alliance point to some exciting developments finally taking hold in the cable industry, where multimedia hype has
often run years ahead of actual products and even consumer demand. The deal also reinforces the growing impression that
NextLevel is the best-positioned player in a marketplace where Microsoft (Nasdaq:MSFT - news) , Intel (Nasdaq:INTC -
news) , and other technology giants are vying for a piece of the action. Yet what the Sony deal suggests that the other recent
activity in the industry really had not is that the old abused cable box could be on the way to becoming a consumer product, a
multitasking entertainment and communications device for the digital living room.
Sony is expected to pay $25 apiece for 7.5 million newly issued shares of NextLevel, which had 147.9 million shares
outstanding as of November. That price represents a 38% premium over last Friday's closing price of $18 1/8 and over
NextLevel's 1997 high of $21 1/2. (On July 28, NextLevel, General Semiconductor (NYSE:SEM - news) , and
CommScope (NYSE:CTV - news) emerged from the former General Instrument Corp.) The press release indicated that the
companies are "discussing future generations of digital cable TV devices and high definition television (HDTV) products, as
well as incorporating new features like Sony's Home Network architecture into NextLevel's advanced digital set-top boxes."
In effect, Sony is paying for the chance to use new generations of digital cable boxes only now rolling out as a kind of Trojan
horse for its own consumer electronics products. These products may be embedded within a more or less conventional box,
or they might accompany that box in an entirely new, consumer-friendly configuration. Digital cable boxes should redefine the
market since they allow broadband, high-speed, two-way signaling. Cable companies will be able to expand their channel
offerings and provide interactive services that simultaneously combine the functionality of cable television with that of a
modem-enabled personal computer. Fast Internet access, Internet telephony, video-on-demand, and push-button electronic
commerce are some possibilities. Now imagine Sony cable boxes that also include new Digital Video Disks (DVD) or the
functionality of a Sony PlayStation.
Meanwhile, NextLevel will pocket $187.5 million in cash while repositioning itself as more than just an important but
low-profile equipment supplier for cable companies such as Tele-Communications Inc. (Nasdaq:TCOMA - news) .
Concerned about brand recognition, NextLevel announced last month that it would change its name back to General
Instrument, with its ticker symbol becoming GIC around February 2. Yet even General Instrument has little cachet with
consumers. Sony, however, is one of the most widely recognized and respected brands in the world. NextLevel reportedly
joined up with Sony rather than rival Thomson Electronics for exactly that reason.
Under the new deal, every NextLevel box will carry the Sony name. Moreover, NextLevel gains an entirely new distribution
system that includes essentially every major consumer electronics outlet. The details remain sketchy, but it's suddenly possible
to imagine a world where Americans shop for souped up cable boxes sporting variable options with the same interest they
currently bring to the purchase of a PC and perhaps even the enthusiasm once shown for VCRs and Sony's own Walkman.
The Sony agreement is just the latest piece of good news for NextLevel after a rocky fourth quarter. On October 16, The
Wall Street Journal ran a story discussing Microsoft's burgeoning interest in television, including its $1 billion investment in
cable operator Comcast (Nasdaq:CMCSA - news) , its $425 million acquisition of WebTV Networks, and its desire to
invest $1 billion in Tele-Communications Inc., in part to help speed the rollout of advanced cable services. Microsoft sees TV
as the next software frontier and the source of lucrative recurring revenues for interactive services, like downloading movies.
The giant has been pushing its Windows CE software as the standard operating system for digital cable boxes. But NextLevel
reportedly possesses encryption technology crucial for pay-TV services. That has put the firm in continued discussions with
Microsoft, with some speculating that Microsoft might buy the company outright.
The day after the Journal article, NextLevel stunned Wall Street with a third quarter revenue shortfall. It also said that fourth
quarter results would miss the $0.24 per share estimates, coming in between $0.09 and $0.11 per share before restructuring
charges. Moreover, FY98 earnings would be $0.45 to $0.50 per share versus estimates of $0.75 per share. Chair/CEO
Richard S. Friedland resigned. The Board announced that the acting CEO would be Edward D. Breen, president of the
company's broadband unit, which includes the cable box business and accounts for 70% of the firm's revenues and all of its
profits. The stock plunged $5.44 to $13.44. Within weeks, the company was hit with class action lawsuits. Around the same
time, a court determined that NextLevel had to fork over $141 million to DSC Communications (Nasdaq:DIGI - news) to
settle a lawsuit.
On December 17, however, new Chair/CEO Breen came back with good news. The company had cut 1,325 positions in its
satellite TV operations, leaving it with annual savings of $0.05 to $0.07 per share per year beginning in 1998. The struggling
satellite unit, which makes receivers for PrimeStar, had been generating around $500 million in revenues but operating at a
slight loss. Next, Breen said the company will likely spin off the NextLevel Communications telephony unit, which recorded its
first $3 million in revenues in the third quarter but is expected to record a $30 million after-tax loss for FY97 ($0.20 per share)
and an after-tax loss of $23 to $28 million ($0.15 to $0.18 per share) for FY98. Assuming this spin-off occurs, NextLevel
now expects to report FY98 earnings of $0.65 to $0.75 per share, after also excluding an after-tax charge of $65 to $100
million ($0.42 to $0.64 per share) to be spread over the fourth quarter of '97 and the first quarter of '98.
Breen also announced a blockbuster deal with nine of the nation's cable TV system operators, including Tele-Communications
Inc., to provide up to 15 million digital boxes over the next 3 to 5 years. The agreement is worth at least $4.5 billion. Despite
the aggressive $300 per unit price, Breen said the huge deal provides NextLevel with high profit margins due to manufacturing
economies. Moreover, some industry watchers have suggested that NextLevel could sell up to 25 million boxes worth $7.5
billion over the next five years. As with the Sony deal, this agreement aligns the parties' economic interests because the cable
companies will receive warrants allowing them to buy about 16% of the NextLevel's shares at $15 apiece. The warrants
become exercisable as the set-top boxes are delivered between now and 2000. NextLevel also agreed to give
Tele-Communications Inc. another 10% equity stake in itself in exchange for that firm's digital transport and authorization
technology, which should help provide a secure platform for the cable industry's digital future.
Despite this flurry of activity, is NextLevel a good investment? Hard to say. Priced around $19 a share, the company trades at
25.8 times best case FY98 earnings estimates. Yet that doesn't account for shares to be issued to Sony or potential future
dilution from the warrants. Whether profits can really grow fast enough to justify that multiple is an open question. Digital
product sales were nearly nonexistent a year ago, but they made up 31% of the firm's broadband sales in the third quarter.
Even so, NextLevel has shipped only 700,000 digital set-top boxes so far.
On the other hand, NextLevel has helped deploy the infrastructure making it possible to provide 24 million households with
digital cable services. With Microsoft and Intel pressing for rapid digitization of entertainment, the delays that have so often
plagued the introduction of new cable services might just be over -- assuming that the fight over standards doesn't go on and
on. Still, the more advanced digital boxes reportedly won't be out for at least two years, and demand for digital boxes will
probably cannibalize analog sales. Conservatively, NextLevel could see just $900 million a year over the next five years from
the cable deal. Yet the broadband unit responsible for 70% of the firm's sales recorded $953 million in revenues for the first
nine months of 1997. While the Sony agreement seems to add significant new spice to cable's future, investors should channel
any interest in NextLevel into some serious homework lest they get boxed in. |
