Broadband is the future, but new threats leave investors confused

It’s never been easy to value cable stocks, but these days investors are understandably flummoxed.

With the advent of over-the-top competition and direct-to-consumer offerings from programming partners that bypass traditional pay TV providers, not to mention a highly profitable broadband business that ironically serves as the foundation for its competitors’ streaming video offerings, it’s getting more complicated.

To grasp just how convoluted it has become, look no further than the two largest cable operators in the country: Comcast and Charter Communications.

Comcast, with about 22.4 million video customers nationwide, on Jan. 23 reported yet another strong quarter of growth. It beat analyst expectations for broadband customer additions (351,000 vs. 350,000 in the prior year) and video subscriber losses (29,000 vs. 33,000 in 2018). Notably, the cable unit grew revenue by 7.3% and cash flow by 5.2% in the period.

Still, the stock trades at about 7 times forward-looking cash flow, anemic by industry standards. Comcast shares rose more than 5% on Jan. 23 after the strong performance, then inexplicably fell back about 2% a day later.

A ‘Vexing’ Dilemma

The disparity is not lost on the analysts that follow the stocks. In a research note after Comcast released its Q4 earnings, MoffettNathanson principal and senior analyst Craig Moffett wrote that no other stock in his coverage universe is more “vexing.”

“It’s the best-run cable operator and yet it is arguably also the cheapest (depending on the value one assigns to its non-cable businesses),” Moffett wrote. “And as the stock has languished in the mid-30s for for the better part of a year, it has only gotten cheaper.”

Comcast’s corporate architecture doesn’t help. It’s really two companies: a cable operator, representing about 60% of its revenue, and NBCUniversal, which could put off traditional cable investors because of the struggles inherent in the content industry. But the bulk of Comcast’s worth is tied up in cable operations, a sector where it has consistently been a top performer, and yet its story can’t seem to get traction with investors.

Comcast stock was down 15% in 2018; so far this year, it’s up about 6%. While a good portion of the 2018 decline was due to last year’s pursuit of 21st Century Fox assets (it abandoned that chase in July) and its $50 billion purchase of U.K. satellite company Sky (investors still aren’t convinced of the merits of that deal), most analysts don’t believe Comcast should be trading as low as it is.

Given its performance, Comcast should be trading between 9 times and 11 times cash flow, Moffett argues.

Comcast isn’t alone. A contraction of trading multiples is expected across the distribution sector over the next few years. According to Morgan Stanley media analyst Ben Swinburne, the cable and satellite sector’s trading multiples were about 8.5 times cash flow in 2018 and are expected to shrink to 6.8 times cash flow by 2020.

At the other end of the spectrum is Charter, the second-largest U.S. operator with about 16 million video customers. The cable company saw its stock fall 15% last year, but in the past 15 months it has had a steeper decline — it was a $402.50 stock in September 2017 and was priced at $287.58 each on Jan. 24, a nearly 30% plunge.

Charter Disappoints

Investors had high hopes for Charter after it completed its $80 billion purchase of Time Warner Cable in 2015, about three years after chairman and CEO Tom Rutledge took the helm.

Charter was supposed to be the industry’s new standard-bearer, upgrading antiquated TWC systems to all-digital, offering higher data speeds across the board, and packaging and presenting services in a new, innovative way.

Charter has done some of that. The all-digital build was expected to be finished by the end of 2018, minimum data speeds are at 100 Megabits per second throughout all of its systems, 1-Gigabitper- second Spectrum Gig service has been rolled out throughout its footprint and Charter has forged deals with Netflix, Apple TV and others to make their services accessible via its set-tops. But lately the operator is primarily known as the company that may lose its New York-area systems.

Last year, the New York State Public Service Commission said it would strip Charter’s franchises in the state because it failed to live up to buildout requirements tied to the TWC deal. Charter denied wrongdoing, and has until March 4 to file an exit plan. Whether Charter will actually have to leave the state is subject to debate.

Add to that what some believe was a missed opportunity in not selling the company to Verizon Communications last year, and some analysts are calling for a change. In a December blog post, BTIG media analyst Rich Greenfield called Rutledge out of touch and said it was time to look for new management.

“We believe the time has come for dramatic change in Charter’s leadership,” Greenfield wrote, adding that he believes the company has focused more on stock buybacks and financial engineering rather than investing in its infrastructure. Ironically, that was the same complaint Charter had of TWC management when it first considered its takeover bid for the company in 2013.

Lofty investor expectations have also weighed heavily on the stock. Once Charter finally won the TWC prize, it was expected to either start snapping up other cable companies (it didn’t) and/or turn around the former TWC systems to positive growth (the jury is still out on that). In the first quarter of last year, when Charter lost 122,000 video customers, three times more than the 43,000 most analysts expected, its stock plunged.

In a note to clients, Moffett said Charter’s video-growth metrics were weak, “but that weakness is magnified by the fact that expectations remain too high, particularly for video, where Charter’s repeated assertion that video subscribership can still grow has only sown confusion (or worse, has damaged credibility).”

One of Greenfield’s biggest beefs with Rutledge is his refusal to see the shortcomings of Charter’s video product compared to its competition.

That refusal to admit cable’s declining advantage over SVOD and OTT services is in contrast to other operators who have decided to embrace the competition and sow the seeds of a future aggregation of video apps. For some, and especially for Greenfield, evidence is beginning to mount that perhaps Charter, with its current leadership, could be left behind.

Charter declined comment, but the company has stressed in the past that it has been engaged in a massive system integration over the past few years — Time Warner Cable — which could account for much of the subscriber weakness. The hope is that once that integration is complete, Charter will be better able to focus on growing both video and data customers across the board.

Still, Charter has one of the strongest multiples in the distribution sector — about 9 times cash flow, mainly because it is the largest pure-play cable operator in the sector.

It’s never been easy to pin down the true value of a cable operator. Early on, a focus on capital expenditures to build out operators’ fledgling networks forced investors to value stocks on a multiple of cash flow, instead of the more traditional earnings multiple. More recently, competitive threats, first from satellite, then from telcos and now from over-the-top, affected bottom lines and sentiment across the board.

And the trading multiples have proven it, from the 1970s and 1980s, when the threat of greater regulation forced multiples into single-digit territory, to the go-go ’90s and early aughts, when consolidation valued systems in the 20 times range. But lately, even with the growing specter of increased over-the-top competition, cable doesn’t seem to get enough credit for what it does right and too much grief for what it doesn’t.

Always Hard to Value

“These stocks traded in the mid-teens to low-20s multiples back in the 1990s when they were levered at 9 times, they didn’t have free cash flow, they didn’t have earnings, yet they were [considered] more valuable than they are today,” FBN Securities media analyst Robert Routh said. “Today, you could make the argument that they are more viable than they ever were in the past because of environmental concerns, they have much lower leverage, they’re buying back stock, they have real free cash flow and they have earnings. Yet they are valued at half what they were in the mid ’90s.”

Routh said part of the reason for lower valuations is that there are only five publicly traded cable stocks, Comcast, Charter, Altice USA, Liberty Global and Cable One, and only three are large companies (Comcast, Charter and Liberty). Twenty years ago, investors could choose from Comcast, Charter, Cox Communications, Time Warner Cable, Cablevision Systems, Adelphia Communications, Insight Communications, Mediacom Communications and TCA Cable to place their investment dollars.

But perhaps more important than sheer numbers, is that cable’s biggest business — broadband — has markedly different characteristics than its former core business, video.

“The key is they should be valued based on connections,” Routh said. “They shouldn’t even break out video, data and telephony anymore. And they shouldn’t show the margins for that anymore. All that does is give people a reason to whack the names.”

A better gauge of success is how many households a company has a relationship with (either voice, video, data or a combination thereof), churn per connection instead of per product, and pricing flexibility.

“You could add a gazillion data subs, but if you lose a half-million video subs, it tends to net to zero,” Routh said. “That’s why the multiples stay at the mid-to-high single digit level, which has really been the case for these cable names for almost a decade.”

There is no question that cable operators have been bleeding subscribers for nearly 20 years — almost 17 million since the industry’s peak in 2000. But connections are a different story. For Comcast alone, customer relationships have been positive for every single quarter since it began measuring the metric in 2007 except for one (Q2 2014).

“If you look at it the way you should look at it, simple connections, you’ll see consistent growth, not only in the number of subs, but in the revenue and related cash flow,” Routh said.

But if video is the culprit in shrinking margins, why do operators bother selling it? Cable One took some criticism back in 2014 when it said it was deemphasizing video in favor of broadband, and has lost a total of 27% of its video subscribers since. It also has been the best performing cable stock for two of the past three years.

Leichtman Research Group president Bruce Leichtman said the answer for most cable operators is that video is the “glue” that holds its other services together.

Leichtman added that even Cable One — which was one of the first operators to de-emphasize video — has much-lower internet penetration (31%) compared with the 47% to 49% rates of its peers, even though broadband is its main product concentration.

“The bundle is the one thing that cable has,” Leichtman said. “To look at them in silos would be in error. You have to look at the company as a whole and their revenue derived by the footprint.”

Even Moffett, who noted that Comcast manages to squeeze out some profit on the video side (Cable One has said it loses money on the product), expects cable operators to eventually throw in the towel on pay TV, with the first steps likely being an IP offering that runs on an app using a third-party box like Apple TV, Roku or the Amazon Fire Stick.

“Later, they will wean themselves even from that and say why in the world would I want to continue to negotiate a contract with Disney and ESPN?” Moffett said on the American Cable Association’s Jan. 7 Cable Talk podcast. “Let the customer negotiate a contract with Disney and ESPN. I’ll happily help the customer choose their ideal video package whether it’s from YouTube TV or Hulu. Maybe I’ll even get a commission for it.”

That could bring the industry full circle yet again, with cable operators aggregating apps instead of networks and collecting fees instead of paying them.

“If consumers had to cobble together their own experience network after network after network, it would be an unpleasant experience,” Leichtman said. “And what would happen is somebody would come in and figure out a way to bundle the channels back together again, to make it easier for consumers.”

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