What If Cox Focused Solely on Cash?

The race to free cash flow has been a top priority for practically every analyst and investor ever since the accounting debacles at Adelphia Communications Corp. and Enron Corp. put companies that rely on earnings before interest, taxes depreciation and amortization (EBITDA) out of favor.

But one influential analyst — Ray Katz of Bear Stearns & Co. — has cautioned investors to be careful what they wish for.

In a report issued Sept. 13, Katz used Cox Communications Inc. as a model to present a "what-if" scenario for a cable company that abandoned a growth and investment strategy in favor of one maximizing free cash flow immediately. The result is not a pretty picture.

For Cox, Katz created what he called the "Cash Cow" operating model, which instead of incorporating growth and investment would focus on slashing capital spending, slashing operating expenses to boost margins and raising rates to the maximum politically acceptable level.

First, it should be clarified that Cox in no way signs off on this type of model, and that Katz is using the company as an example only because it is a pure-play cable operator with three distinct product lines, no significant acquisitions and no pro forma results to skewer actual operating results.

(Incidentally, on Sept. 9, Cox revised its 2003 capital spending estimates downward to $1.6 billion from $2 billion, leading analysts to project that the company would exceed their earlier free cash flow estimates by two to three times — to between $100 million and $200 million in 2003, and by $500 million by 2007).

At first, the Cash Cow model appears to be a winner. With this new operating strategy, Cox would generate $1.3 billion in free cash flow, versus the $48 million Katz currently anticipates. In 2004, the Cash Cow model generates $1.4 billion in free cash flow, compared to $166 million under the old model.

Over the five years between 2003 and 2007, the Cash Cow generates $8.1 billion in free cash flow, making Cox virtually debt-free by 2007. Meanwhile, the current growth model generates just $2.4 billion in free cash flow and leaves Cox with $6.4 billion of debt at the end of 2007, roughly a 2 times debt-to-EBITDA ratio.

Downside risk

Sounds great, doesn't it? But the Cash Cow has a dark side, Katz suggests.

The Cash Cow turns the cable plant into a wasting asset, creating decelerating customer and operating growth.

"By 2006, the business is in operational decline," Katz wrote.

While short-term free cash flow growth using the Cash Cow model is clearly superior, the estimated EBITDA compound annual growth rate is lower by 610 basis points — 7.4 percent, versus 13.4 percent under the growth model. In fact, according to Katz, EBITDA growth using the Cash Cow model starts to decline in 2004, and absolute EBITDA peaks in 2005 and decelerates in 2006.

Scaling back spending and investment causes customer growth to level off and decline by 29 percent by 2007, leaving direct-broadcast satellite to cannibalize the existing subscriber base with advanced product offerings like digital video recorders and high-definition television. Digital customers plunge 50 percent and high-speed data subscribers fall 34 percent over the same time frame.

With no money in the marketing, billing, information-technology or OSS budgets, it becomes increasingly difficult to market the bundle, and voice services begin to decline accordingly.

This also begins to affect the stock price, which should be of particular interest to investors.

Although Cox would be generating huge amounts of free cash flow, using three different valuation methods — enterprise value to EBITDA, discounted cash flow and equity yield — Cox's share price would range from $18.81 to $23.82, or 32 percent to 14 percent below the $27.68 it traded at when Katz wrote the report. Last Wednesday, Cox closed at $26.45.