Cable Operators

Analysts to Cable: Keep on Investing

4/10/2005 8:00 PM Eastern

San Francisco— Cable companies might have a competitive edge over telephone companies for the moment, but Morgan Stanley & Co. media analyst Rich Bilotti warns MSOs not to get complacent, lest history repeat.

Bilotti had three messages for cable: don’t take your eye off competition; continue to push technological innovation and move to measure your financial health by earnings per share.

Bilotti — the last of four analysts to speak at an April 5 National Show finance panel led by former Comcast Corp. vice chairman Julian Brodsky — said cable’s biggest mistake was underestimating direct-broadcast satellite competition in the early 1990s.

DISMISSIVE TALK

Back in 1992, Bilotti said that MSOs dismissed direct-broadcast satellite because it was run by huge, moribund General Motors Corp. and weighed down by terrible labor agreements. Bilotti finds striking similarities in attitudes toward the regional Bell companies (or RBOCs), which plan an aggressive rollout of fiber-optic plant to deliver video signals as well as voice and high-speed Internet.

“You’ve got the RBOCs on the ropes right now,” Bilotti said. “But if you let them off the mat, it can be very, very dangerous. The single biggest problem they have is that their labor costs $80,000 a head. They can’t change their head count — they’re locked into labor agreements for the next three years. You have a three-year window to do as much damage to them as you possibly can.”

Bilotti also praised cable’s success in rolling out voice-over-Internet protocol telephone service, but again cautioned against complacency.

“If you don’t make that mistake again, you can easily lay waste to the phone market,” he said.

On technology, Bilotti again reminisced back to 1992, when financial analysts were urging cable operators not to spend capital on upgrades.

“Thank God you didn’t listen to any of us,” Bilotti said. “If you hadn’t made that base investment in the systems, high-speed data would have never happened.”

But Bilotti cautioned that with upgrades completed and capital-expenditure budgets coming down, MSOs shouldn’t get the idea the work is done.

“Technology is a lot more granular,” Bilotti said. “Now is not the time to pull back on investing in bandwidth and platforms and systems.”

Bilotti also shrugged off attempts to value cable companies by free cash flow, or cash flow after interest payments and capital expenditures are made, because that figure is easily manipulated.

An MSO that wanted to boost free cash flow merely would have to lower its capital expenses to zero — obviously a bad business move.

“Earnings are for mature companies,” Bilotti said. “This is now a mature industry. You’re big boys and girls; you’re the leaders in high-speed data. You need to move to earnings.”

Fulcrum Global Partners media analyst Rich Greenfield agreed that free cash flow can be manipulated, but that depends on what definition of the metric a company follows.

Free cash flow is not unlevered free cash flow — which doesn’t take into account interest payments — and it isn’t cash flow less capital expenditures, nor is it cash flow before working capital.

Greenfield defines free cash flow as cash from operations less capex, adjusted for real non-recurring items.

“Free cash flow is cash that the business is actually generating — cash that they can invest in making acquisitions, cash that they can pay out as a dividend, cash that they can buy back stock with,” Greenfield said.

As an example of how free cash flow isn’t always what it seems, Greenfield pointed to Comcast Corp., which reported $1.94 billion of free cash flow in 2004. That was before working capital of negative $938 million and intangibles of $628 million (at least half of which are one-time costs). By Greenfield’s calculations, Comcast generated only $371 million in actual free cash flow in 2004.

Greenfield also pointed to the myth that cable capital expenditures are likely to come down in 2005.

Time Warner Cable’s 2004 capex was up by 5%; Comcast’s 2005 guidance is 30% higher than its estimates two years ago and at Charter Communications Inc., Insight Communications Co and Mediacom Communications Corp., 2005 capex guidance is up 8% to 26% from reported 2004 levels.

SPENDING ITEMS

The culprit, Greenfield said, is additional spending on digital video recorders, HD DVRs, voice over Internet protocol telephone service, video on demand and digital simulcast. All he described as so-called success-based capital expenditures.

But rather than focusing on driving free cash flow, Greenfield said operators should continue to invest in products and technology to maintain its subscriber base, like digital simulcast, more VOD content and aggressively discount VoIP to drive digital and data further.

“I worry that a lot of this is being done to please Wall Street and investors in the near term, and maybe it’s not the right decision,” Greenfield said. “Once you get a data subscriber, it’s very hard to not continue to own that data subscriber for the long term. So why not go out and aggressively as you can try to grab new subscribers?”

September