Sony Enters U.S. Cable
Business
The Motley Fool - January 07, 1998 19:32
SNE
Sony Corp. NLV NextLevel Microsoft MSFT Intel INTC SNE SEM CTV TCOMA DIGI V%MFOOL P%TMF
Sony Corp. (NYSE: SNE) entered the U.S. cable business on
Monday by forming a "strategic alliance" with NextLevel Systems (NYSE:
NLV), 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),
Intel (Nasdaq: INTC), 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), and CommScope (NYSE: CTV)
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). 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), 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) 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. |
