Cable Stocks Swoon

Accounting scandals, heavy subscriber losses at two major cable operators — and the striking image of one of the industry's pioneers being led off in handcuffs — helped make 2002 one of the cable sector's worst in recent memory, as shares in the nine publicly traded MSOs fell about 55 percent last year.

This is the third straight year that cable stocks have declined. The sector was down 15 percent in 2001 and lost 26 percent of its value in 2000.

And though some stocks saw a late rebound as 2002 came to a close, most analysts aren't looking for a big change in the sector for 2003.

"It was a pretty bad year," said SunTrust Robinson Humphrey cable analyst Gary Farber. "Even putting the stock performance aside, just all of the issues that came up, it was a pretty bad year."

Accounting scandals

Chief among the issues that helped drag down the sector were the accounting scandals at Adelphia Communications Corp., Charter Communications Inc. and AOL Time Warner Inc.

Adelphia's situation was by far the most egregious. Federal prosecutors accused five top executives — former chairman John Rigas, his sons former chief financial officer Timothy Rigas, former executive vice president of operations Michael Rigas, former vice president of finance James Brown and former treasurer Michael Mulcahey — of bilking the company out of $1 billion for their own purposes.

The Rigases were arrested by U.S. Postal Inspectors on July 24, in a high-profile media event that culminated in the image of 78-year-old John Rigas being led out of his daughter's Manhattan apartment in handcuffs.

Adelphia filed for Chapter 11 bankruptcy protection in June, and its stock lost nearly all of its value. Its shares were down 99.7 percent for the year, from $31.71 each on Jan. 2, 2002 to just 9 cents per share on Dec. 31.

The accounting problems faced by Charter and AOL Time Warner were less serious, but also had devastating effects on their stocks.

In August, Charter revealed it was the subject of a federal grand jury investigation into some of its accounting practices, including its method for counting subscribers. By December, the company had fired its chief operating officer, Dave Barford, and CFO Kent Kalkwarf over a series of issues, including the grand jury investigation. Barford was replaced by longtime cable executive Margaret Bellville, whose appointment was expected to repair some of Charter's lost credibility.

Charter stock was No. 2 on the list of 2002's biggest losers, dropping 92.9 percent from $16.60 to $1.18 per share.

At AOL Time Warner, questionable accounting practices were brought to light in a series of Washington Post
articles in July. The press accounts led to the company's revelation in August that it had improperly accounted for about $49 million in revenue at its America Online Internet unit.

Those problems helped accelerate the ouster of former co-chief operating officer Bob Pittman, who was installed to turn around the failing AOL. Pittman resigned, part of a major management restructuring in July.

AOL Time Warner stock was down 58.5 percent for the year.

Rounding out the sector: Cablevision Systems Corp. (down 65.1 percent); Mediacom Communications Corp. (down 50.9 percent); Insight Communications Co. (down 48 percent); Comcast Corp. (down 37.3 percent); AT&T Corp. (down 31.9 percent); and Cox Communications Inc. (down 31.2 percent).

"It [2002] was a tough year for cable stocks," said Stifel, Nicolaus & Co. cable analyst Ted Henderson. "It was a tough year for investors to get over the hump of the high debt and complex structure of cable and the taint from Adelphia, Charter and even AOL."

Bright spots

But for all the bad news, the year did yield some bright spots. In October, the National Cable & Telecommunications Association and 11 CEOs from publicly traded MSOs banded together to formulate standard rules for reporting subscribers and expenditures on customer premises equipment.

Also in October, the cable industry dodged a bullet when EchoStar Communications Corp.'s pending merger with DirecTV Inc. parent Hughes Electronics Corp. — which would have created a single direct-broadcast satellite competitor with 18 million subscribers — was rejected by federal regulators. The parties officially scotched the deal in December.

And in November, Comcast Corp. completed its $54 billion merger with AT&T Corp.'s AT&T Broadband unit, creating the largest MSO in the country, with 22 million subscribers.

Comcast also managed to unwind the long and complicated Time Warner Entertainment partnership with AOL Time Warner, receiving $3.6 billion in cash and AOL TW stock, as well as a 21 percent interest in a future Time Warner Cable initial public stock offering. That IPO is slated for the first half of 2003.

Cable operators also attempted to ease investor fears by focusing on generating free cash flow, or earnings after capital expenditures and interest payments are made. AOL Time Warner and Comcast were the only major MSOs on track to achieve free cash flow this year, although Comcast said it would miss the target in 2003 because of the AT&T Broadband acquisition. However, the rest of the sector expects to reach the free-cash-flow metric in late 2003 and 2004.

Eye on operations

Investors will be looking closely at operational performance in 2003, said Henderson, as well as the ability to achieve free cash flow, reduce capital expenditures and the continued successful rollout of new services.

But investors should not expect a dramatic rebound in their cable holdings, he cautioned.

"I don't see someone taking the position and seeing these cable stocks turn around and run for the hills," Henderson said. "They've already hit their bottoms, now it's a question of how high up the market is going to take them. That's going to be predicated on how well they execute."

Many eyes will be on Comcast. Analysts will no doubt scrutinize whether the Philadelphia-based MSO can reverse subscriber losses at the former AT&T Broadband systems — Ma Bell's cable unit lost nearly 500,000 subscribers in 2002 — and boost cash-flow margins at those properties, currently in the mid-20 percent range, to the industry standard of about 40 percent.

Although Henderson said he'd be surprised if Comcast showed significant improvement at the Broadband systems in the first quarter, he expects to see signs of a turnaround before year-end.

Programmers showed a little more resilience, as the advertising market began to show signs of recovery. As a whole, that sector was down about 28 percent for the year.

Leading the pack were E.W. Scripps & Co. and Fox Entertainment Group, which actually posted gains for the year. Scripps stock was up 13.5 percent during the period (from $67.80 per share to $76.95 each), while Fox rose nearly one percent from $25.69 to $25.93 per share.

Equipment losses

In the equipment sector, though, losses were heavy, as declining MSO capital-expenditure budgets began to hit vendors' bottom line.

For the year, equipment vendor stocks declined 55.7 percent, led by Com21 with an 84.2 percent drop. The two largest cable set-top box vendors, Motorola Inc. and Scientific-Atlanta Inc., also posted declines — 52.7 percent and 44.3 percent, respectively.

H.C. Wainwright & Co. senior vice president Lawrence Harris said the declines were expected as cable operators were successful in slashing their capital budgets in 2002. And since the focus for 2003 will be on continued reductions, things are not expected to get much better.

"One company's capital expenditure is another company 's revenue," Harris said.

While equipment vendors saw less demand for set-top boxes, Harris said that many have lessened the blow by reducing their own costs and focusing on other product lines.

S-A, Arris Corp., Corp. and Harmonic Inc. all made substantial layoffs in the past 18 months. And on the mergers and acquisitions front, Arris sold its Interactive division to S-A in November for $37.5 million, focusing more on telephony and data equipment and away from transmission.

Both S-A and Motorola were hit hard by the Adelphia bankruptcy, which curtailed its set-top box purchases. However, S-A gained some of that back when Cablevision — previously a Sony Corp. customer — rejiggered that pact and agreed to buy Explorer 4200 set-top boxes from S-A for its digital rollout.

Motorola, which sustained heavy losses in its other businesses, appeared to turn its sights away from the cable industry and toward its larger wireless-telephony business. In July, chief operating officer Ed Breen — who came to the company in the merger with cable box maker General Instrument Corp. in 2000 — resigned to take the top spot at Tyco International Ltd.

"The sense I have is that the key focus now is upon its larger businesses, wireless headsets and semiconductors," Harris said. "There will likely be less emphasis over time on the broadband business."

But Motorola stands to make substantial set-top box sales to Comcast, as that MSO moves to upgrade the former AT&T Broadband systems, Harris added. AT&T Broadband has been a major Motorola customer in the past, and Harris said he sees no indication that relationship will change.