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Cable companies are now cash machines
It may be time to snap up shares in cable providers Comcast, Time Warner and Liberty Media. With most infrastructure investment behind them, the green is about to roll in.
By Michael Brush
If you get the feeling each month, as you pay your bills, that your cable company has a license to print money, you might just be right.
Cable providers such as Comcast and Time Warner are, in fact, at a turning point in their businesses that means they'll be rolling in cash.
The big change: The cable companies have finished the major work on building multi-billion-dollar digital infrastructures. With the big spending behind them, they'll have smaller expenses going forward. And they are taking full advantage of that infrastructure by selling new products like inexpensive voice-over-Internet-protocol (VoIP) phone service, fast Internet access, digital TV and video on demand.
Cable companies are now cash machines because they are leveraging the digital platform, says Robert Routh, a Jefferies & Co. media and entertainment analyst who has made several astute calls in these sectors over the past few years.
But because of some doubts about the competitive landscape, cable stocks are at their cheapest valuations in five years. That makes this exactly the right time to snap up shares of Comcast (CMCSA, news, msgs), Time Warner (TWX, news, msgs) and Liberty Media International (LBTYA, news, msgs).
The threats: Phone and satellite
As the cable skeptics are happy to point out, a big potential headache for the cable guys is that phone companies like SBC Communications (SBC, news, msgs) and Verizon Communications (VZ, news, msgs) are going into the TV business. They need to make up for dwindling margins in their core phone business.
In a hint of what may unfold in the coming battle for your TV set, the phone companies are now offering aggressive introductory discounts on DSL Internet connections -- in hopes of stealing business from cable companies.
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We feel that it is going to be a nasty fight, says Michael Church of Church Capital Management, a Yardley, Pa.-based money-management firm that has $1.8 billion under management. We think you are going to see cable margins collapsing. The phone companies are not scared to throw their margins out the window because they have their backs to the wall. Their core franchise is under attack.
Further down the road, wireless offerings and broadband delivered over power lines may also erode the cable providers' Internet access business.
Satellite companies are another worry. Satellite continues to beat cable in consumer satisfaction polls. And while cable dominates emerging high-definition TV, Lehman Brothers analyst Vijay Jayant predicts new satellite launches will allow satellite companies to beam HDTV into at least 80% of U.S. homes by the end of 2006.
In the meantime, satellite companies continue to win business. Echostar Communications (DISH, news, msgs) and DirecTV Group (DTV, news, msgs) had 25.6 million customers at the end of the first quarter, according to Standard & Poors analyst Tuna Amobi. Competition like this will put more pressure on cable-company margins, Amobi says. Thats one reason he has neutral ratings on cable stocks.
The case for cable
As compelling as all these arguments seem, Ill take the other side of the trade, for several reasons.
While the challengers look formidable, they face problems of their own -- especially further down the road as the convenience of a buying a bundled package of voice, Internet and digital TV products sets in.
Satellite companies may have a hard time providing a comparable bundle, since their systems are basically one way -- meaning they can only beam you programs. Right now, they offer the bundled "triple play of TV, voice and data by teaming up with phone companies. Once phone companies get into TV themselves and compete with satellites, the phone companies may not like those alliances as much.
Cables two-way system will also give it a greater advantage with the spread of interactive TV, such as online games, says Routh.
The phone companies face challenges of their own in their play to get into TV. First, they will be the third or fourth provider, which could make it tough to win business, says Roth. Next, they wont have the same reach at first, so theyll pay more for content on a per-user basis.
Theres also a basic mismatch in the battle between phone companies and the cable guys. The cable companies are entering telephony, which is much easier and more profitable to enter than video, says Robert Bartolo, co-manager of the T. Rowe Price Media & Telecom Fund (PRMTX). The cable companies also have an edge in that their infrastructure is already in place.
Cable companies also have some advantages on the regulatory front. The Supreme Court recently ruled in FCC v. Brand X that cable companies dont have to provide access to their lines to independent operators like EarthLink (ELNK, news, msgs). That gives the cable guys a big advantage, says Andy Lipman, a telecom regulation expert at the law firm Swidler Berlin Shereff Friedman in Washington, D.C.
Meanwhile, phone companies face a long haul getting approval from municipalities across the country to offer TV -- just like cable had to do years ago.
Comcast turns on the cash flow
But maybe the biggest thing going for the cable companies is that the digital build-out is draining fewer dollars. Now they can get down to making money from their new systems, says Value Line analyst Nils Van Liew, who is bullish on cable stocks.
In 2002, for example, the various cable companies that now make up Comcast spent $5.2 billion on infrastructure upgrades and other capital expenditures. Last year, that number was down to $3.6 billion, says John Alchin, co-chief of finance at Comcast. And this years guidance is for between $3.2 billion and $3.3 billion. So in three years, we have come down by about $2 billion, he says.
At the same time, cash flow is increasing because the company is selling new products, a trend that will continue. In 2002, Comcast had $4.9 billion in operating cash flow. This year it expects operating cash flow in the mid-$8 billion range, an increase of about 15% over last year, says Alchin. The products that we are deploying really dont require any significant investment in the plant infrastructure, because all the plant has now been rebuilt. There is effectively no more ditch-digging to do.
Now it's mostly about product -- whether that's high-speed Internet access, VoIP, digital TV, HDTV, digital video recorders and video on demand. Comcast currently has about 3,000 video-on-demand programs. And that number is going to explode to about 10,000 in six to 12 months, says Alchin. Purchases of pay-per-view programs, driven by VOD usage, increased more than 20% in 2004. Orders for VOD programs offered free as part of a Comcast package deal rose fivefold last year, to 100 million orders.
Comcast expects free cash flow to increase 20% to 30% this year from last years $1.9 billion. T. Rowe Prices Bartolo expects free cash flow to continue growing at 20% to 30% over the next several years.
More cable: Time Warner and Liberty Media
Steve Neimeth, a portfolio manager at AIG SunAmerica Mutual Funds, holds Time Warner shares because he believes investors are overlooking the huge potential cash-flow gains from cable, while at the same time worrying too much about declines in subscribers at the company's America Online dial-up Internet service. Morgan Stanley analyst Richard Bilotti last week said Time Warner should trade at up to $23 a share in a year from recent levels of $16.60.
Routh, at Jefferies, likes Liberty Media because it is expanding its cable distribution reach in Europe, Eastern Europe, Japan and Latin America. They are becoming a worldwide provider of cable. They are predominately in areas where they have no competition, says Routh.
Buyout mania
If you have any doubt that cable companies are a good buy, pay attention to this. In the ultimate form of insider buying, the founding families and managers of three cable companies have thrown in the towel and moved to take their companies private.
In June, for example, the Dolan family made a bid to buy out Cablevision Systems (CVC, news, msgs). In March, Insight Communications (ICCI, news, msgs) announced that it was going private through a buyout group led by Insight founders Sid Knafel and Michael Willner. Last year, Cox Communications went private. After these deals, only about 55% of the industry will be public, estimates Morgan Stanleys Bilotti.
The key point is the owners know more than we do, says Routh. If this was a bad business, they wouldnt be taking them private. They would be selling them. If anyone knows what these businesses are worth, it is the founders.
Stock picks
With this column, I'll add Comcast, Time Warner and Liberty Media to my Company Focus portfolio for tracking, and we'll see how they do from here.
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