Cable's Retreat Surprises Analysts

Cable stocks, up by about 3 percent in the first quarter, have retreated in the past few months to an overall increase of less than 1 percent since Jan. 2. Some of that can be attributed to sector rotation: Investors have moved their money out of MSOs and into other stocks. But the sector could be in for another shock if its main competitor — direct-broadcast satellite — becomes considerably more powerful after News Corp. or EchoStar Communications Corp. gain control of No. 1 DBS provider DirecTV Inc. A trio of top cable analysts — Tom Eagan of UBS Warburg, Karim Zia of Deutsche Bank Alex. Brown and Gary Farber of SG Cowen Securities Corp. — recently spoke with Multichannel News finance editor Mike Farrell about these and other issues that face the cable industry. An edited transcript follows:

MCN: What is your take on the cable sector so far this year? Are the stocks performing to your expectations?

Tom Eagan:
I'm actually a little surprised that the cable stocks have pulled back over the past month, after their appreciation in the fourth quarter and the first part of the first quarter this year.

I was expecting a pullback to occur a little bit later in Q2. Whether that was because of capital migration into other sectors or for other reasons, I was a little bit surprised by the pullback early in the second quarter.

Karim Zia:
The stocks seemed to be partly driven by the rotation effects from cyclical areas earlier in the year into cable, now going back into cyclical areas of the market. It seems to be anticipating that a recovery is maybe underway, or that the cycle is bottoming. So we are seeing a little bit of the same rotation that benefited the stocks earlier in the year going the other way.

I think the overriding factors that have generally led the stocks to outperform over the last six months have been a function of an improving outlook, from a fundamental perspective in terms of the prospective acceleration of operating cash flow, that we're almost at the inflection point of. And the impending end of the industry's capital cycle.

Also, it seems as though the ad cycle isn't quite coming back yet, and we were waiting to see what the impact of any return of advertising spending was going to have on the cable stocks.

Again, part of our being a little surprised is that it seems as though the ad cycle hasn't yet come back, but there was a migration out of the cable stocks. The migration seemed to come out before they went into a lot of the tech stocks.

Gary Farber:
My view would be, heading into the quarter, that the risk profile in the sector was very low. What I was looking for in the quarter was for the cable guys to just make the numbers for new products and cash-flow growth. But they came in at the high end, or beat expectations.

I'm a little surprised the stocks haven't done better. If you look at the performance by AOL Time Warner [Inc.], Viacom [Inc.], those stocks seem to be trading ahead of what people assumed is going to be a recovery, but also provide some good buying points in the cable stocks. Also, you had an equity issuance going in the name of Charter [Communications Inc.] that may have caused some reallocation. I think that's going to be more of an issue in the second half of the year.

MCN: [EchoStar chairman] Charlie Ergen may be making a bid for DirecTV. What's your take on this, and who do you think will ultimately end up with DirecTV?

We view EchoStar as very well-positioned to succeed in merging with Hughes over News Corp. The basis of that is, essentially, the Hughes shareholders who have the ultimate say in the outcome that [General Motors Corp.] ultimately decides to proceed with. The Hughes public shareholders effectively have to approve in a majority fashion essentially any transaction that's being contemplated now by GM. And I think the unanimous view of Hughes shareholders and the marketplace is that an EchoStar-Hughes combination offers substantially greater synergies than a News Corp.-Sky Global merger with Hughes.

MCN: What do you think about the regulatory front, though? With EchoStar-Hughes you'd be combining the No. 1 and No. 2 companies in the industry. There have got to be issues there.

The Department of Justice is probably the focal regulatory hurdle for an EchoStar-Hughes merger. I think the normal framework in which the merger would be looked at would be to, one, look at it in a market concentration analysis, and, two, look at the pro and con consumer implications.

In terms of the market- concentration analysis, clearly in the majority of the country — if multichannel video is viewed as the relative framework — you'd have one formidable cable company and one DBS provider competing.

I think the FCC has somewhat laid the groundwork for this being the model by virtue of its revision of the ownership rules to include DBS as a part of the competitive marketplace. Clearly, rural areas would raise an issue, given the absence of cable in roughly 8 to 10 million homes in the U.S.

But I think EchoStar certainly has the ability, through a consent decree, to address a lot of those issues through promising nondiscriminatory pricing or other means. So we actually look at the regulatory prospects as pretty favorable.

I don't formally follow these stocks. From an outsider's view, Charlie Ergen has nothing to lose making a run at [Hughes]. If [Hughes] goes for a high price, will people apply it back to him? If it does go for a high price, whoever is buying it is a little bit worse off, economically, out of the box.

The risks to the cable sector are a little bit different from my perspective. I think if [News Corp. chairman Rupert] Murdoch gets it, I don't think you can count him out. Five years ago, he was going to be the fifth operator in the space when he wanted to merge ASkyB [American Sky Broadcasting LLC] with EchoStar. That made no economic sense, but he was willing to do it. I think it shows you his agenda is not always near-term cash flow.

If he's the winner, there's more of a longer-term risk to the programming-cost angle. Does he play around with that at all, relative to the cable operators?

Looking at it the other way, if EchoStar gets it, it [becomes] less an issue of customer concentration [than] spectrum concentration. There would be an enormous amount of spectrum concentrated under one company, and it's a little bit different than customers. My other question would be — not following the company — without somebody else stepping up, how does he get the financing to do it on his own anyway?

Zia: Well, on the spectrum concentration, I think there is an argument that is the consumer benefit, that the combination of the two roughly 500-channel platforms of DirecTV and EchoStar would enable a deepening of local-into-local availability beyond the top 35 to 40 markets that exist today into, potentially, the top 100 markets. That means a significant portion of the remaining 40 percent of the U.S. that can't get local signals via satellite would be able to be addressed.

I think also you could argue that cable operators could be more adversely impacted by a News Corp.-Hughes deal because it could catalyze broadcasters associating with satellite companies.

If the cable operators had to face broadcasters associated with satellite companies, it could get a little ugly. We already saw that last year with the broadcasters wanting to renegotiate their contracts with the cable operators, and you saw ABC aligning with DirecTV. There are definitely risks to the cable operators in either scenario.

MCN: When the whole News Corp. deal was talked about, News Corp. said that DirecTV would be the jewel in Sky Global.

No, it was the Mona Lisa.

MCN: News Corp. doesn't appear to be paying a large premium for Hughes stock. What short-term benefit would the Hughes shareholders get out of this combination?

I think what we liked about it was that there is a premium. If you apply a 70 percent attribution to a $55 billion value, that's above where Hughes was trading.

But what we liked about it was the combination of content with DirecTV. So could Rupert allocate or utilize vast programming assets, whether it be from [20th Century] Fox studio or Fox television towards DirecTV subscribers? Possibly.

To us, that was a real attribute. Would they accelerate the window for DirecTV subscribers from pay-per-view to home video for Fox content? Possibly.

What puts them in an interesting position was the fact that DirecTV had a Blockbuster [Entertainment Inc.] deal. So in most scenarios, Blockbuster would be put off by an acceleration of the window to home video. But not with the DirecTV combination, because Blockbuster would benefit by DirecTV putting more titles into the home-video window.

I think the counterargument from the EchoStar side is that the premium that can be offered to Hughes shareholders directly and indirectly through the merger synergies could be substantially greater.

From purely a cost standpoint, the potential reduction in the subscriber-acquisition cost model in the DBS industry, from the over $500 that exist today to as conceivably low as $300 where it was a few years ago, based on the industry's current growth rate, which is about 6 to 7 million gross additions a year as opposed to 3 million net additions per year, suggests an immediate savings, potentially, of $1 [billion] to $2 billion in cash flow.

Before even accounting for the improved margins from combining the two platforms — the potential savings in programming costs from having the scale of over 15 million subscribers. So the cost savings could be measured in the billions of dollars, which an EchoStar merger would offer, which when capitalized would be a substantial increment in effective premium that Hughes shareholders would be receiving.

MCN: What is your outlook on the VOD front? Do you think operators are going to be hurt by the reluctance of some of the studios to let their content on VOD?

I don't see the cable operators, near-term, getting the "A" content. They're not going to get the window in the near-term.

On the other hand, that shouldn't disincentivize them to roll out the product. I think it is going to require other models. It's not going to be the Saturday-night blockbuster event that's going to drive VOD business, like the pay-per-view business.

It's going to be a more subscription-based business, and broad-based, whether it's HBO [Home Box Office] or kids' programming. Either way, even with the product offerings that are out there today, which may not be ideal, demand is still very strong.

I think investors' expectations — because they have seen this product for the past seven years but they've never seen wide scale deployments — are still pretty low.

I think that, contrary to popular thought, the reluctance on the studios' part to provide feature films to cable operators for VOD is OK for the cable operators. I don't think that [operators] are quite prepared to roll out VOD if all the films were available, whether it's on a customer-service front or on a technical front, in terms of having the infrastructure in place.

Moreover, all that takes cash, and right now the focus is on digital and high-speed [data]. It's actually working in their favor that they don't have the films available. I think what they'll roll out in the meantime is SVOD, HBO and Showtime on-demand. It'll give them an early taste of pricing, an early taste of viewers' habits, and they'll be able to parlay that in 2002 into a more robust video-on-demand service.

Turning it around another way, the lack of necessity for having first-run movies or popular release titles is underscored by the attractive cost model of the business. With the costs per stream dropping as quickly as they have, the implied up-front capital cost to enable video-on-demand for digital subscribers is in the $60 to $70 range and falling. That means the required return in terms of buy-rates, revenue, cash flow, is dropping as well, such that at one-and-a-half movies or equivalent movies per month, $5 or $6 of revenue per subscriber and close to a 50-percent margin suggests there is still a very compelling business model.

I'm not sure if the business model is quite that favorable. You're still seeing new costs of $500 to $600 per stream. So to us, there is an optimistic and a pessimistic scenario, depending on buy-rates and depending on studio splits that could get you from a one-and-a-half to a three-year payback.

Economics aside, does it change the churn rates for the industry? Has it got a value-added, distinguished product in the market? Do their basic churn rates go down? Does the digital churn go down?

These are all data points that hopefully the industry will be able to talk to, to a great extent, toward the end of the year. If there is anything besides the buy-rates and the margins that would get people excited about these stocks, it's seeing that the base business, while still very mature, has growth prospects to it.

MCN: What do you think ultimately happens with AT&T Broadband?

Investors may speculate on more asset sales from AT&T. Take the [Los Angeles] market, for example: There are four or five operators. Should there be more consolidation? Probably so. But it appears unlikely that any one operator could step in on its own and make a run at AT&T's cable properties, and it would also be a significant management challenge. I think what people are speculating on is if you get three or four operators to step up and just split it up.

Either way, whether AT&T spins out on its own or it gets bought, what's in the [AT&T Corp.] stock today is not very much value for the broadband unit. What's weighing on it is the other operations.

It's going to be interesting because so far this year, we have seen the cable operators get somewhat hurt by the integration of previous acquisitions and the impact that's had on their cash flow.

Comcast [Corp.] got hit by that in December. They gave their new pro forma guidance for 2001 and it dropped to 10.5 percent. That was because of the 2 percent pro forma growth out of the AT&T systems that they purchased.

I think it's going to be interesting because they realized that a lot of the AT&T systems have lower cash-flow growth, lower cash-flow margins, and therefore, by buying them, may have an impact on the weighted average pro forma cash-flow growth.

The deals are going to look, on a per-sub basis, accretive and, on a cash-flow-multiple basis, dilutive. The cable operator is trying to balance growth and a low interest-rate environment, in terms of financing costs, with the impact of what's going to happen to their cash-flow growth.

I think it'll be increasingly a relevant question as to where the industry does invest next. I do believe the capital cycle is turning as we speak. If you look on an aggregate basis, the industry spent nearly $17 billion last year in capital.

This year, it appears that that's going to come down a little bit. I think we're at an inflection point in that sense, where capital expenditures are no longer increasing 20, 30 percent a year. I think as we start to look into '02, I think the budgets for most of the companies outlined later this year will suggest a pretty sharp decline given the state of rebuilds, which will be about 90-percent done by the end of this year.

So it'll be an increasing question as to what the industry does with its deleveraged state and eventual generation of free cash flow. But apparently there don't seem to be too many interested sellers at this point.

It's clear in the second half of the year, whatever AT&T does is going to influence the stocks. If it spins out, will investors reallocate their portfolios in the sector? If it's taken out, does that cause — as Tom said — companies to assess the capex [capital-expenditure] outlook for the industry. But either way, on its own, it's going to impact the group because it's so large and then there's the satellite question.

If there's a domino effect in the satellite industry, does that domino down to the cable industry? Because a lot of people still believe the cable industry needs to be further consolidated, just on its own today.

So there's a lot of opportunity, I would say, in the second half of the year, either within the stocks based upon those assumptions or for individual companies to grow their base.

MCN: Comcast President Brian Roberts told us in an interview that his company is not working with a consortium to buy out AT&T Broadband— along the lines of the Group W Cable acquisition in 1985 — and said the tax implications of such a carve-up would be astronomical. Would taxes be enough to discourage a buyout of AT&T?

I don't know that the dynamics have changed from the transaction you referred to. I think it would require a very complicated limited-partnership structure that would essentially assume the cable systems and not be able to be distributed for several years.

I think it would be quite a substantial hurdle. I think maybe the more appropriate question is if it's one potential buyer of AT&T, could the deal be done in a tax-efficient way such that AT&T shareholders would be distributed on a tax-free basis? If anything were to happen, which clearly seems unlikely, with AT&T it would more likely be a single buyer.

I think it also raises a point, that looking at the leverage ratios of the companies, there's only one company that has an attractive leverage ratio: Comcast.

I haven't looked at the tax implications, but I still think it'd be very difficult for one person, not only to buy it, but to try to integrate it. If you look at the past couple of years in the industry, the deals that have been done, there've been some large deals done, but I think for several of them, there's been integration issues initially out of the box, particularly if the properties haven't been upgraded.

I think you're more likely to see opportunistic system acquisitions than one whole takeover. Obviously, the cable operators want to be accentuating some of the clusters that they've already created and hopefully wouldn't want to have to upgrade or sell a lot of the systems that they wouldn't want to keep, that AT&T currently serves.

On the other hand, I think AT&T has largely divested what it views as the nonstrategic cable systems. I think it will actually surprise people when this is unveiled through an IPO later this year, that when the smoke clears, this is going to be one of the most attractive collections of cable assets in the industry, in terms of having very big market clusters and systems that are actually very well upgraded. They will have lower-than-average operating margins, clearly, but the assets will be big markets that I don't think AT&T's going to be inclined to sell at all.

If you look at the markets they've got, they're national broadcast-type markets with broadband capability, and I think that would be a compelling thing to investors at the right valuation. But not following the stock, it's difficult to say. Looking at their stock price today, it looks like the multiples assigned to the broadband business are pretty depressed, particularly relative to the cable group as a whole.