Cover Story: Cash Business9/06/2009 2:00 AM Eastern
Cable operators are warming to a new way to measure their health.
With the economy reeling, basic subscribers drifting away and no more double-digit growth in operating cash flow, analysts and cable operators are using the metric to highlight the inherent strength of the industry.
While cable may no longer be the growth industry it once was — and has 1.4 million fewer subscribers in the past 18 months to prove it — it is consistently doing one thing it never has done before: It is generating cash. Lots of it.
Free cash flow, essentially the cash left over after capital expenditures and interest payments are made, is not the only metric to watch. But it is gaining steam as an indicator of financial strength during a period when the overall economy has battered companies across the board.
It's a slight departure for the cable industry, which has primarily been gauged by cash flow (earnings before interest, taxes, depreciation and amortization), mainly because of its capital intensity. But as capital expenses have fallen sharply over the past few years, free cash flow has emerged as one of the better indicators of financial health.
“Smart investors look at everything — they look at RGU growth, they look at EBITDA and they look at free cash flow,” said Collins Stewart media analyst Tom Eagan. “If you look at just one metric without the others, you could be missing something. You look at RGU growth to see what the future earnings potential may be. You look at EBITDA to see how much they're generating in an ongoing operations basis before capex. And they have to look at free cash flow because it gives you a sense after you invest in the plant and invest in growth how much you have left over.”
While free cash flow is gaining traction, it will still be years before cable companies are gauged by the same metric as other Fortune 500 companies like General Electric or ExxonMobil — net income. Although Comcast and Time Warner Cable have been the most consistent earnings generators, the other public MSOs have not raked in earnings. And even those that have been reporting net income have been slightly inconsistent (Time Warner Cable had four straight years of net earnings, but posted a loss of $7.3 billion in 2008 because of one-time charges).
Cash flow is simply a smoother valuation metric, considering the vagaries of cable economics that impact earnings: heavy debt loads for some operators; acquisitions and accounting charges; swings in interest expense due to swaps, floating-rate debt or foreign currency exchanges; and changes in tax rates and payments.
The bigger operators — Comcast, Time Warner Cable and Cablevision Systems — have generated increasing amounts of free cash flow at least since 2004. The difference this year is that all of the cable companies are reporting significant free-cash-flow growth. And they are doing it in one of the worst recessions in memory.
“Someone laughed at me because I said we're hitting a sweet spot that has been anticipated for a long time,” said Time Warner Cable senior executive vice president and chief financial officer Robert Marcus. “It's a strange thing to say on some of the most difficult RGU net-add environments that we've ever experienced, probably the most difficult.”
The gains in free cash flow have been especially dramatic in the past two quarters and were not limited to just the bigger players. The five publicly traded cable companies generated a combined $2.48 billion in free cash flow in the first six months of 2008. In the first half of 2009, the free cash flow tally was $4.1 billion, a 65.3% increase. No other metric comes close to that growth rate. Not cash flow (up 7.4% in the first half of 2009); not revenue (up 6.9% in the first half). Nothing.
Also in the first half of this year, all five publicly traded cable operators reported positive free cash flow — the first time that has ever happened. Comcast led the way with $2.5 billion of free cash flow in the first half of the year, a 36% increase over the first half of 2008. Next in line was Time Warner Cable, with $1.03 billion in free cash flow in the first half, a 27.9% increase; Cablevision Systems, with $402.6 million in free cash flow, a 23.9% increase and Mediacom with $62.5 million, a 396.3% increase.
Even Charter Communications, which filed for Chapter 11 bankruptcy protection on March 27, managed to show positive free cash flow of $66 million for the first half of the year, compared to a $523 million free cash flow deficit in 2008. The main factor in that performance was that Charter didn't have to make payments on its debt through the bankruptcy period.
When Charter has to start servicing its obligations again, once it emerges — hopefully by the end of the summer — its debt load will be considerably lighter and it can theoretically start generating free cash flow on a consistent basis.
Marcus said he has been touting the free-cash-flow mantra to investors for the past 18 months. While the cable business has weathered slowing subscriber growth, he added, it is still performing well in a bad economy. Cable's revenue growth has been steady and a new top-line driver is on the horizon in the form of business telephony service.
“The punch line of all of that is that we're [the industry] able to generate that growth while still generating a huge amount of free cash flow,” Marcus said. “And the reason were able to do that is in large measure due to the fact that, after years and years of increasing capex relative to revenue, we're now in a mode where we're able to decrease capex on both an absolute basis and as a percentage of revenue as revenue rises.”
Still, being able to maintain some level of growth in the other metrics is important, because there are several ways to manage for free-cash-flow growth. The easiest is to cut off the capex spigot entirely, which would result in big gains in free cash flow, but would ruin the business in a matter of months as no investment would be made for new equipment, new services or customer support.
What's harder is to find a balance between reasonable capital expenditures and free cash flow. “The main driver is continued OIBDA growth and the ability to manage capital expenditures,” Marcus said.
Mediacom has had the most dramatic rise in free cash flow — it was up more than five times in the first half of this year — to $62.5 million from $12.6 million in the first six months of 2008. The company said at the beginning of the year that it expected to increase free cash flow by more than 10 times to $1 per share ($67 million). In the second quarter, Mediacom raised that full-year guidance to at least $1.30 per share.
Mediacom executive vice president and chief financial officer Mark Stephan said the road to that growth was basically paved with good business sense and execution across the entire cable industry.
“We're actively managing capex, devoting more and more to success-based investment and doing all the right things to maintain our very reasonable cost of debt,” Stephan said. “If you can manage these outlays wisely and continue with operating cash-flow growth, you can grow free cash flow at a rapid clip.”
Helping Mediacom to fuel that rapid rise in free cash flow was a big drop in capital expenditures — to $225 million in the first half of 2009 from $290 million in the same period in 2008, a 22% decline.
When Cablevision was spending a lot of money to build out its network and drive penetration of new services to industry-leading levels, its capex was about 20% to 25% of revenue. Today, now that its penetration gains have leveled off, capex represents about 10% of revenue.
Mediacom's capex is now less than 15% of revenue, a level Stephan believes the company can maintain, even with driving penetrations higher and making product development investments to maintain its competitive position. Couple that with operating cash flow margins of about 38%, and free cash flow growth becomes “a question of how well we manage interest expense and our balance sheet and this is where we have excelled historically,” Stephan added.
For the rest of the industry, capex as a percentage of revenue ranged from about 17% (for Time Warner Cable) to 9.9% (Cablevision) in the first half of the year. And those percentages are down across the board — capex was 20% of revenue at TWC and Charter in the first half of 2008.
Not everyone is convinced that the free cash flow train will continue to run smoothly. The high growth numbers cable operators are enjoying now are essentially a product of the sluggish economy and declining subscribers, argued Pali Research analyst Richard Greenfield.
“On a relative basis, you're seeing Cablevision and Mediacom outperform expectations,” Greenfield said. “But everyone is seeing a significant boost in free cash flow as subscriber growth slows. The difference is with Cablevision it's more because penetration levels are at maturity as with the rest of the companies it is far more related to the economy.”
Once RGU growth returns to past levels as the economy recovers, in Greenfield's view, free cash flow will wane. In a recent report, he estimated that Cablevision will grow free cash flow by 52% in 2009 to $754 million and by 24% in 2010 to $935 million. But the analyst believes that free cash flow will decline by 12.7% in 2009 and by 29% in 2010 at Time Warner Cable and by 27.8% and 12.5%, respectively at Comcast.
Marcus took exception to Greenfield's logic. While TWC is making no predictions, Marcus said, he can't see how a company can grow subscribers and revenue and lower capital expenditures and not generate more cash.
“We will be spending more but all-in, your free cash flow ought to go up,” Marcus said. “It would be a pretty strange phenomenon if, over a long period of time, our business would be better off if we didn't sell units.”
Cable cash flow comparison
Dollars in millions
|Q2 '09||Q2 '08||% Change||1H '09||1H '08||% Change|
|Source: Individual company and analyst reports
OCF: Operating Cash Flow
AOCF: Adjusted Operating Cash Flow
OIBDA: Operating Income Before Depreciation and Amortization
AOIBDA: Adjusted Operating Income Before Depreciation and Amortization
FCF: Free Cash Flow
|Time Warner Cable|
|Q209||Q208||% Change||1H09||1H08||% Change|
|Q2 '09||Q2 '08||% CHANGE||1H '09||1H '08||% CHANGE|
|Q2 '09||Q2 '08||% CHANGE||1H '09||1H '08||% Change|
|Q2 '09||Q2 '08||% Change||1H '09||1H '08||% CHANGE|
Cash Flow: What's in a name?
Cable operators define free cash flow in different terms, but generally speaking, it's the cash derived from the business after capital expenditures and interest payments are made. The official definitions from the publicly traded cable operators.
|Source: Company and SEC filings|
|Time Warner Cable: “The company defines Free Cash Flow as cash provided by operating activities (as defined under GAAP) plus excess tax benefits from the exercise of stock options, less cash provided by (used by) discontinued operations, capital expenditures, cash paid for other intangible assets, partnership distributions and principal payments on capital leases.”|
|Comcast: “'Net Cash Provided by Operating Activities' (as stated in our Consolidated Statement of Cash Flows) reduced by capital expenditures and cash paid for intangible assets; and adjusted for any payments related to certain non-operating items, net of estimated tax benefits (such as income taxes on investment sales and nonrecurring payments related to income tax and litigation contingencies of acquired companies).”|
|Mediacom: “Free Cash Flow: adjusted operating income before depreciation and amortization and non-cash, share-based compensation charges, less interest expense, net, cash taxes and capital expenditures.”|
|Cablevision: “We define Consolidated Free Cash Flow from Continuing Operations, ('free cash flow'), which is a non-GAAP financial measure, as net cash from operating activities (continuing operations) less capital expenditures (continuing operations), both of which are reported in our Consolidated Statement of Cash Flows. Net cash from operating activities excludes net cash from operating activities of our discontinued operations.”|
|Charter: “Free cash flow is defined as net cash flows from operating activities, less capital expenditures and changes in accrued expenses related to capital expenditures.”|