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How Far Can Cable Stocks Fall?

Cable investors are sleeping like babies these days—they’re more likely to wake up every few hours and cry.

After several years of heady gains, cable stocks are getting pummeled. Five of the top operators lost more than 200,000 basic subscribers in the last quarter alone, in part due to fierce competition from satellite and deep-pocketed telecom companies. Recession fears loom over an uncertain economy, making complicated cable stocks something to avoid. And perhaps worse than anything, cable’s old nemesis, the FCC, is threatening new regulations that could hamper profits. All this has cable stocks trading near their 52-week lows.

Chris Marangi of Gabelli & Co., like many analysts covering the sector, has been frustrated by underperforming cable stocks that he says do not reflect their growth. “It’s tough being a cable bull these days,” Marangi says. “I’ve never seen sentiment shift so violently, so quickly against the sector as has happened over the past three months.”

Industry bellwether Comcast, which is the largest cable operator in the nation, was down 35% to $19.66 from its 52-week high of $30.18 as of Nov. 15. While the stock was trending lower throughout the summer, most of the pain was felt after the company kicked off the cable earnings season by reporting a loss of subscribers.

When Comcast reported its third-quarter results on Oct. 25, revealing a loss of 65,000 basic subscribers, its shares dropped 10% and the whole sector followed it lower. As cable operators continued reporting, the subscriber losses kept coming. Mediacom reported it lost 13,000 subscribers, Time Warner Cable 83,000, Charter Communications 40,200 and Cablevision Systems 16,000.

Meanwhile, cable competitors were adding subscribers. Direct broadcast satellite providers added 350,000 net new customers in the quarter, while telcos added 277,000 customers.

It was a bloody two weeks. In the period since Comcast reported, its stock sank 17.5%, Time Warner’s 21%, Cablevision’s 16.5% and Mediacom’s 27%. A particularly battered Charter slid 47%.

To be sure, part of the recent slide is in lock-step with the meltdown in the broader market as investors look for a safer place to park their money than an equity market increasingly susceptible to the fallout from the mortgage crisis and signs of a weakening economy. The S&P 500 index is down 3.8% in the month of November alone, as of the 15th.

Weaker economic data has some investors worried about a recession. That is weighing on the stock market but is not helping cable, which is traditionally viewed as a haven during recessions because of their quasi-utility characteristics. “It makes intuitive sense,” says Marangi. “If anything, the cable companies have become more like utilities in that they are providing phone service.”

Comcast Corp.’s Chief Operating Officer Steve Burke said during the company’s third-quarter earnings call that while cable is still recession-resistant, “it stands to reason that in difficult economic times, people are more price sensitive, and less likely to upgrade or add a second or third product.”

Lately the specter of competition from DBS providers and telecom companies offering video services has spooked cable investors. Signs of slowing subscriber growth in the second quarter left investors wondering if heavy marketing campaigns by satellite, the rollout of Verizon’s FiOS and AT&T’s U-verse systems, and aggressive pricing of satellite and telco bundles weren’t taking a bite out of cable.

And cable operators are openly addressing the effects of increased competition to analysts and investors. “We have two very strong competitors in the air. We have two or three strong competitors on the ground in the form of the RBOCs and they’re not going away,” Comcast’s Burke said at an investor conference in September.

DirecTV is particularly aggressive in positioning itself against the cable companies with its rollout of high-definition programming, targeting carriage of 100 linear channels by the end of the year. Cable currently lacks the bandwidth to match such an offering, carrying an average of only 20 to 25 HD channels. Cable operators are pushing back with high-definition on-demand offerings, which the satellite companies cannot match.

On the telco side, Verizon’s FiOS service is gaining traction, racking up more than 700,000 subscribers. Though its current overlap in many cable operators’ footprints is not significant, it is a particular threat to Cablevision’s territory, where FiOS is available to more than 20% of households.

Behind the loss of subscribers is another story that cable operators don’t like to talk about: The TV industry as a whole is contracting. While DBS providers DirecTV and EchoStar Communications added subscribers in the quarter, the 110,000 net additions from EchoStar’s Dish Network were lower than expected and revealed a weakening trend for Dish. The company caters to the lower end of the pay-TV market, which is particularly susceptible to the housing meltdown.

It also signaled that the subscriber losses for cable were being felt elsewhere and were not wholly related to competition. In the third quarter, the pay-TV industry reported a total of approximately 410,000 net new subscribers, but analysts were anticipating better results.

“That was a lot lower than we were expecting,” says Oppenheimer analyst Tom Eagan. “Either fewer TV households were added in the quarter, which is understandable given what we are seeing in the housing market, or fewer folks abandoned their antenna-only viewing.”

For comparison, in the third quarter of 2006, when the telco rollouts were less of a factor, the pay-TV market added 530,000 net new subscribers.

A central contributor to the slump is one that is causing the economy as a whole to stumble: the housing market. The collapse of this market in the wake of the sub-prime mortgage crisis is causing lenders to be more stringent with their mortgage terms, spiking foreclosure rates and cramping the market for new homes. With fewer homes being built, the pool of households for cable companies, or any pay-TV provider for that matter, is growing smaller.

Foreclosure filings jumped 30% in the third quarter, according to mortgage research company RealtyTrac. On Charter’s third-quarter conference call, CEO Neil Smit said the company had access to fewer households because it faced higher vacancy rates in its footprint.

If increased competition and a tight consumer market weren’t enough to deal with, cable is also facing a test from regulators. The cable industry has a history of butting heads with authority, and the current administration of the FCC is no exception.

Last week, FCC chairman Kevin Martin said the commission would invoke the so-called “70/70” threshold to impose more regulation on the cable industry (see Washington Watch, this issue). The rule kicks in when cable systems with 36 or more channels are available to 70% of U.S. households and achieve a 70% penetration rate of those households.

Invoking the rule would give the FCC broad powers to advance an agenda that includes instituting a la carte programming, lowering rates for leased access, enforcing multicast must-carry and capping the growth rates for large cable companies at 30% of households.

The FCC is expected to announce soon that the threshold has been met when it releases its 2007 multichannel video competition report. But Wall Street and the National Cable & Telecommunications Association counter that the threshold has not been met.

“The provision itself is a relic of decades-old regulation and there is no basis for reviving it now,” said Kyle McSlarrow, president and CEO of the NCTA. “Twisting statistics in order to breathe life into this rule is simply another attempt to justify unnecessary government intrusion into a marketplace where competition is thriving.”

According to Sanford Bernstein analyst Craig Moffett, the “basis for invocation of the 70/70 rule appears untenable.” That’s because one of the conditions for the rule is that cable’s penetration of available households must exceed 70%. According to Bernstein estimates, cable’s penetration falls well short of that, in the 50%-54% range.

Either way, the announcement is not doing cable stocks any favors. Says Oppenheimer’s Eagan, “This could not come at a worse time for cable operators, whose stocks are down significantly since this summer.”

But with all these obstacles lined up against cable operators, why do so many analysts have a “buy” rating on cable stocks?

It’s not all gloom in cable, bulls say. While losing basic subscribers, the industry can still upgrade customers and grow additional services. Indeed, industry leader Comcast added 662,000 phone subscribers and 450,000 data subscribers in the same quarter it lost basic subscribers.

The industry-wide number of digital cable subscribers grew 16% year-over-year to 35 million in the second quarter while phone customers grew 62% to 12 million, according to the NCTA. That’s why the investment community sees upside in cable, exemplified by nine out of 14 analysts that rate Comcast Corp. some variation of a “buy,” according to SNL Financial.

Meanwhile, cable operators argue that the growth potential for new services far outstrips concerns over competition. Says Time Warner Cable’s president and CEO Glenn Britt, “We are all too aware of the recent stock performance, but we remain focused on running the business in a manner that maximizes returns and value creation.”

Some investors feel the same way if the recent battle over Cablevision is any indicator of the sector. Investors blocked a bid by the Dolan family to take the company private because the offer price of $36.26 undervalued the company. If investors see upside at that level, they should love it at $26.

Morgan Stanley analyst Ben Swinburne, who remains cautious on cable, says many people are struggling with the investment case for cable because while the stocks look cheap, they don’t always perform well in a challenging environment. “Cable stocks really never worked as value stocks in the traditional sense,” Swinburne says. “They’ve usually outperformed when there is an expectation for growth accelerating.”

But not everyone on Wall Street is singing the same tune. Tuna Amobi, an analyst with Standard & Poor’s, has a “sell” rating on some the sector’s top players. Amobi says a “dramatic slowdown” in revenue-generating units at big cable companies, on top of a challenging competitive and economic environment, is cause for concern.

The hang on cable stocks will likely continue at least through year’s end. Moreover, analysts note that there doesn’t appear to be a good, hard catalyst to boost the stocks higher in the near term, so it will be up to an investor’s sense of value to lift these stocks.

“It’s going to take time for investors to get comfortable that cable companies can continue to grow cash flow in times of economic stress and competitive stress,” Marangi says.

With competitive, economic and regulatory pressures in place, investors are not likely to drive stock prices back up without a reason.

Says Oppenheimer’s Eagan: “[Cable] stocks are going to stay depressed until we can get a better sense of how the companies are doing late in the fourth quarter.”