Cable Operators

All Ears On Earnings

5/30/2009 2:00 AM Eastern

The notion that cable operators should be measured by their earnings performance — as in net income or net losses — rather than on a cash-flow basis, has been bandied about for years, but for one reason or another has fallen on deaf ears.

With net income becoming an increasingly consistent financial metric for cable operators, perhaps the time has come for analysts and investors to listen up.

“Is it time for the cable industry to grow up?” asked Gabelli & Co. media analyst Chris Marangi, adding that growing net income and earnings suggest that the time may be now for earnings valuations.

Cash-flow valuations, which disregard interest payments, taxes, depreciation and amortization, have been the rule for at least two decades. Cable operators successfully lobbied analysts and the financial press in the 1980s to value them on an earnings before interest, taxes, depreciation and amortization (EBITDA, a measure of cash flow) basis, mainly because the industry was so capital intensive. They argued that the billions spent on system upgrades did not reflect the actual performance — i.e. the cash coming in the front door — of most cable operators.

One criticism of cash-flow multiples is that they have fluctuated wildly for cable companies over the years and haven't always gauged the true health of the companies.

“Back in 2000 and 2001, when cable companies were trading at 17 times to 20 times cash flow, they were burning cash,” Miller Tabak media analyst David Joyce said. “Now they're trading at 5 times to 6 times and they are generating cash.”

Most recently, free cash flow — cash flow after interest payments and taxes are made — has been a more popular metric and more accurately reflects performance. But the gold standard for many investors remains net income, which uses a simple metric (the price-to-earnings ratio) to gauge overall health.

Most analysts who follow MSO stocks include an earnings per share (EPS) estimate and price-to-earnings ratios in their research reports, but earnings are never a major factor in evaluating the respective health of the companies. That distinction still falls to cash-flow and free-cash-flow multiples.

Free cash flow also is thought by most in the investment community to be the next step before earnings. And it's not a very large step either. By most definitions, the difference between free cash flow and net income is cash taxes. For some companies, that can be a large amount of money — Time Warner Cable pays about $200 million a quarter in taxes.

“That's the benefit of making money; you get to pay taxes,” Joyce said.

For the past five years, Comcast and Time Warner Cable — the two largest MSOs — have reported increasingly strong earnings. Comcast's earnings have more than doubled over the past five years, from $970 million in 2004 to $2.5 billion in 2008. Time Warner Cable grew earnings from $726 million in 2004 to $1.1 billion in 2007. Time Warner Cable reported a $7.3 billion loss in 2008, but that was mainly due to a one-time $10.2 billion dividend it paid to shareholders connected to its split from media giant Time Warner Inc.

Cablevision Systems has reported positive net income in two of the past five years and appears poised for consistent positive earnings growth. Mediacom Communications, the remaining publicly traded cable operator, has had one year in the black over the last five — 2004, when it reported $13.6 million in net income.

Charter Communications, which filed for Chapter 11 bankruptcy protection in March and is expected to emerge later this summer, also has not reported positive net income in the past five years. But once it emerges from bankruptcy, with a healthier balance sheet, its chances of reporting positive earnings are much higher.

For those companies that are generating earnings, their P/E ratios are not that distant from their free cash flow multiples — Comcast has a 2009 P/E ratio of 14.2 and a free cash flow multiple of 12.4; Time Warner has a 2009 P/E ratio of 10.1 times and a free cash flow multiple of 7.1 times.

Adding fuel to the argument for earnings valuations is the simple fact that companies that generate earnings are considered to be healthier.

“There is a perception difference,” Joyce said. “That's another positive. You still have a lot of the general press and retail investors used to looking at P/E.

“There has been an uphill battle to get those constituents to look at cable companies a little differently than they would look at Kellogg's. P/E and EPS are the simple core valuation metrics.”

Joyce added that earnings valuations could open up the sector to new investors, those funds that are restricted from investing in stocks that don't show positive EPS — but said that in the end, cash flow will continue to rule the day.

“Any debt covenants look to EBITDA multiples and leverage ratios rely on EBITDA,” Joyce said. “It's smoother to go by cash flow than by EPS.”

Joyce said that swings in interest expense — due to swaps, floating rate debt or foreign currency exposure — could affect EPS adversely, as could changes in tax rates and payments.

“EBITDA is just a smoother and more visible metric,” Joyce said.

Marangi agreed that earnings won't supplant cash-flow valuations for cable, nor should they. Investors, he said, will use the metrics they want to use to value cable or any other industry.

But, the analyst added, earnings valuations would allow investors to compare cable companies to other sectors and perhaps give prominence to a common cable operator complaint — that the difference between their stock prices and their asset values, the so-called valuation gap, is too high.

“There is significant EPS growth ahead of this industry and the multiples don't reflect that,” Marangi said. “Cable is ultimately a consumer-products industry and by comparing it to other companies in the consumer area, you can see how these companies have resilient earnings but also significant sustainable growth.”

Marangi also agreed that investors won't abandon other metrics in favor of P/E multiples. It will be just another valuation tool to add to their arsenal.

“Investors take all these metrics and put them into a mosaic and they make a judgment using all available information and comparisons. No one is going to focus on any one number,” Marangi said. “But EPS is certainly a more relevant concept today than it was five or 10 years ago.”

NET GAINS
Cable operators have reported surprisingly strong growth in net income over the past five years:
($ Millions)

  2004 2005 2006 2007 2008
SOURCE: Company reports
Comcast $970 $928 $2,500 $2,600 $2,500
Time Warner Cable $726 $1,253 $1,976 $1,123 ($7,334)
Cablevision ($676.1) $89.3 ($126.5) $218.5 ($227.6)
Charter ($4,300) ($970) ($1,400) ($1,600) ($2,450)
Mediacom $13.6 ($222.2) ($124.9) ($95.1) ($77.5)

PRICE TO EARNINGS
The price-to-earnings ratios for the five publicly traded cable operators, as of May 21. Earnings per share (EPS) figures are the average estimates from analysts that cover each company, according to CNBC.com:

  2009E EPS P/E ratio
SOURCE: CNBC.com
Comcast $1.02 14.2
Time Warner Cable $2.94 10.1
Cablevision $0.97 18.7
Charter N/A N/A
Mediacom $0.58 17.1
June