The Free-Cash-Flow Dilemma

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The cable industry is expected to generate $2.4 billion in free cash flow in 2004, according to a report by Fulcrum Global Partners analyst Rich Greenfield. This marks the first time the industry’s six major standalone MSOs broke into the black for free cash flow.

Those MSOs —Comcast Cable Communications Inc., Cox Communications Inc., Charter Communications Inc., Cablevision Systems Corp., Mediacom Communications Corp. and Insight Communications Co. — had negative free cash flow of $775 million in 2003. And Fulcrum expects the positive free-cash-flow trend to continue in 2005, with an estimated $5 billion in free cash flow from the public six.

But to listen to a group of largely sympathetic-to-cable analysts at the recent National Show, that’s not enough.

Several analysts at a panel session called for cable to think about announcing dividends or finding other vehicles to give money back to shareholders. After spending $80 billion to rebuild their plant, with a sizable portion coming from the public, the analysts’ message was that investors want cable to “give something back.”

The mini-drama in New Orleans didn’t go over well with the cable audience. For years they’ve been hearing the need for free-cash-flow generation. Now, once they’ve shown they are well on the road to getting there, the analysts, sitting as proxy for large shareholders, raised the bar even further.

Let’s be clear; it’s not the analysts’ fault.

They play many roles, and one is to be the messenger from the sometimes quixotic financial community. Cable, to be blunt, doesn’t stack up as well (in many investors’ eyes) as other industries. Those investors take a quick look, see lots of debt and lots of competition on cable’s three major fronts — video, voice and data — and go running for the hills. And it frustrates veterans in the industry, who feel they’ve just climbed one mountain, only to see yet another mountain ahead of them.

All this, directly, or indirectly, will have an impact on the evolution of cable’s new service rollouts. It is Greenfield’s view that investors are spooked that increasing competition will hurt cable, thus today’s lower valuations.

DSL, for instance, ran neck-and-neck with cable in high-speed additions in first quarter 2004, and Fulcrum expects DSL to beat cable in the second quarter. Not good. Already cable’s 70%-30% high-speed-penetration edge has shrunk to the low 60s, and some analysts expect DSL to actually catch cable by 2006.

Cable’s answer is to roll out voice-over-Internet protocol, but regional Bell operating companies could respond with even lower DSL pricing or increasing their marketing of direct-broadcast satellite.

Even the specter of fiber-to-the-home and telco video is arising in some quarters, fueling investor fears.

Yet cable has no choice. It has to get going on VoIP, which may be why Comcast — on the day of its annual shareholder meeting May 26 — made sure The Wall Street Journal knew of its VoIP rollout plans for 2005 and 2006.

So despite the increased costs associated with HDTV, digital video recorders, video-on-demand and increasing interactivity, cable seems to have no choice but to roll those services out to blunt competitive threats, since any further cannibalization to DBS will hurt cable values even more. At least more of the capital deployed would be “success-based” capital.

In this month’s On Demand section, executives from Charter and Time Warner Cable delineate the next steps they are taking to keep cable competitive. Time Warner has launched a raft of interactive-TV trials, so it can match or surpass whatever DirecTV might deploy.

Charter’s Kip Simonson talks about his MSO’s repositioning of VOD, with an emphasis on subscription VOD and VOD movies, once windows get better. Simonson correctly points out that most digital subscribers have premium packages, so SVOD from Home Box Office, Showtime and Starz! is a no-brainer. And he hasn’t given up on the $9 billion video rental market, which he believes is cable’s to take with VOD. It’s been a while since anyone’s heard that in the industry.

For cable, it was good the National Show was comparatively upbeat, even if that one financial panel rained on a few parades.

The industry needed a confidence boost. But it also has to recognize the investor community may remain reticent about its immediate prospects for some time. And it can’t afford to let that reticence distract from the day-to-day combat it faces.

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