Interesting Days on Wall Street

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After an impressive two-year run, cable stocks have been hammered this year, dropping between 40 percent and 50 percent since December. The heady days of major acquisitions that drive up stock values may be gone, but that may be good news for investors,
who, for the first time in years, can look to the cable sector for bargains. All in all, it makes for interesting times for cable investors.

Multichannel News
finance editor Mike Farrell sat down with three top cable-stock analysts-Rich Bilotti of Morgan Stanley Dean Witter & Co., Barry Kaplan of Goldman Sachs & Co. Inc. and Gary Farber of S.G. Cowen Securities Corp.-to discuss the future of cable stocks and the outlook for operators as they move into the next stage of development. An edited transcript follows:


MCN: AT&T Corp. recently announced its plan to restructure into separate units-wireless, broadband and consumer long-distance with business services. What's your take on this? Did the market's reaction disappoint you?


Rich Bilotti:

I think the stock reaction is being driven by what they had said on the long-distance business and what it meant for the overall earnings. There's still a large proportion of institutional investors, leaving aside retail, that are driven by EPS [earnings per share], or adjusted EPS. The cable side of it was actually rather good.

While I've had concerns that I've written about, this quarter I would say the unit growth broadly came in line with expectations. A little better on cable modems, a little worse on digital set-tops. Just about what we thought for telephony, which might have been a bit behind the company's plans.

The next stage in the equation is [that] the pricing power looked OK on everything but telephony. And the real news was that they did a pretty good job with the margins.

The operating margins on the cable business took a turn upwards against expectations.


Gary Farber:

I don't follow the stock formally, but my take would be that they [AT&T] can distance themselves from the long-distance business, which is kind of the death of 1,000 cuts. It should provide some valuation relief for the cable systems.

Looking at results they put up, it's difficult to put them in the box with the industry leaders. They're just not there as far as cash-flow growth.

I think what would be compelling to people who look at the stock at the right value is, look at the number of net adds that they put up in telephony. They put up in the quarter probably as much as Cox [Communications Inc.] has put up for the year, and in data, they've put up as much as Cablevision [Systems Corp.] is going to put up for the entire year.


RB:

Unit growth was pretty good. Their margins were pretty good. The only question in the financial results this quarter was that capex [capital expenditures] is still high. But that's somewhat to be expected. The pricing power on telephony looks like it might have been a little bit looser than it was in the first half, and God knows where it will be in the fourth quarter.


GF:

I think last year, investors were more bullish on telephony as a rollout. This year it doesn't seem like there's a clear consensus. Cox is doing it, it's got the benefit of the bundle, but also digital and data actually have good pricing and they're value-added products. There's clearly an argument why you'd want to push hard on those two products today as opposed to a telephony product-which has a large market but where the only competitive advantage is price.


MCN: What does the split-up mean for the cable industry?


GF:

It clearly opens up an investor base and investor focus on the entire group. I think this has become more [of] a sector that people will just be more than mildly interested in, as they had been this year. People tend to be

interested in the peripherals this year and not the sector itself. It will change that.

I think from a comparative standpoint, while clearly, on the numbers, there are other companies in the sector that have grown faster, it's no longer the cable business, it's the customer business. That's probably an area where AT&T is ahead of the curve relative to everybody else in the space. But I think it's probably an interesting thing. It will pick up from watching what AT&T is doing as far as bundling new products together.


RB:

Depending on the size of this [AT&T Broadband] IPO, there may be more investable capital in what we consider traditional cable stocks than there is in traditional RBOCs [regional Bell operating companies] by the end of next year.


Barry Kaplan:

Certainly it's become a very large capitalization industry from one that looked like it was going away not too long ago.


RB:

Yes. One that looked like it was going away in '96, to unbelievable in '99, to sort of a dismal first half of 2000. When you cut the rose off, there may be more capitalization in the sector at the end of all this than in the beginning, on the day before AT&T announced the deal.

I think the interesting thing it brings up is the following thought: What if there isn't a cable sector? We've always wondered that-first because it [was] going out of business, then because two industry leaders were absorbed into bigger companies.

But what if it's become the broadband sector? It isn't about video anymore, but it's about 20 or so companies, including some cable companies, some wireless companies, some satellite companies and some traditional telephone companies all competing to sell an array of products, some optimized to sell one rather than another. Obviously satellite is optimized to video. RBOCs really are the cheapest delivery vehicle for local telephony, given their historical monopoly status and given the fact that twisted pairs are perfectly good telephone technology.

Cable is the one that can do voice, video and data as a bundle. What if it's really a sector of 20 stocks and the three of us are really co-sharing a sector with our friendly satellite and telephone colleagues? What if what it's really about is, which four companies show an ability to really prosper in their environment?


MCN: What's your take on competitive threats?


RB:

I wrote a piece recently about the ebb and flow of competition. It was about the idea that every six to nine months, you see a whole cycle of competition go through. The decisions the RBOCs and the satellite companies made this year in the middle of the year will affect them in the second half of this year, in the early part of '01.

As they go through their budgets and their business planning this year, late in the year, they'll start to implement new strategies in the early to middle part of '01, and that will affect the way both industries compete in the second half of next year. There is this natural move, countermove, move, countermove.


BK:

But there is, from the cable perspective, this inexorable march-the role of the plant upgrades and the rollout of digital. At the end of the day, there is no way a satellite provider can completely overwhelmingly deal with that.

They can resort to price. They can enhance the product, which they are doing. But they can't change the fact that cable, which has historically had what was a demonstrably inferior product, now has at least a comparable product and as they move to true two-way capability, a superior product.


GF:

Satellite is coming out with interesting products [like] more storage capacity on the box. The key thing is their national reach, which cable doesn't have. But the advantage of cable is that the in-home entertainment market is becoming fragmented, whereas cable sits on pretty much of most of the platform. That's their opportunity.


RB:

Their upside and their downside come from the same basic premise-that 70 percent of their growth is from services other than add-on video. If an RBOC truly wanted to compete with a cable company, it need not take away the video business, it need only take away the data, the video-on-demand, and the telephone opportunity, if you consider that an opportunity.

You could stagnate the cable company. Alternatively, the cable company has the same opportunity. Because if it takes away the data business, and it even chops away a little bit at the telephone business, it could make that bundled long distance less successful than the RBOCs think it's going to be.


BK:

That raises the total issue of overbuilders. We've written extensively on the issue of overbuilders and we find it very difficult to make the model work. Overbuilders are getting a lot more attention, in large part, because a whole bunch of them emerged over the course of last year and got a bunch of franchises and private-equity financing from pretty impressive household names in the private-equity market.

Of course, since then, as the markets have gotten difficult, they've found it much more difficult to raise capital. That's been one of the other diminishing concerns from a competitive standpoint.

We generally have taken the position that it's very hard to make an overbuild work because if you do the math, you need somewhere between 25- and 30-percent penetration with at least two of the three major services to earn your cost of capital.

The problem is that in the process of them figuring that out, it can cause a lot of pain in terms of taking growth on new services away from the cable operators.


RB:

That also brings up the argument: Where is the endgame on the excess capacity that these big companies built? Because if they're up on a network that's only signed up a third of the homes in the market, a lot of raw capacity is sloshing around for either an incumbent or yet another party to come in for them to use.


BK:

Except that with another party, there's no reason to believe they'll have any better economics. The economics only seem to work for an incumbent. The incumbent can buy the competitor-unless they basically are given the plant.


GF:

The other thing is, look at the history of the business. You can go back to inferior technology, like wireless cable-it had a churn rate of 3 or 4 percent. When you start to get up to that level, you're in a horse race fighting for customers who eat away at your equity value until there's nothing really left.

So for the numbers to work, they probably need to get 20 percent on data, 30 percent on video, 30 percent on telephone.

Even if you could assume that you'd get the first two, how are they going to get 30-percent telephone penetration and make money on it at the same time?


MCN: With the way the stocks have turned south, do you think the good times are over?


BK:

From my perspective, I wouldn't be doing this if I thought the good times were over. I think, particularly over the last several weeks or couple of months even, I have detected almost a fundamental shift in investor sentiment about these stocks.

A lot of it relates to diminution of competitive concerns. I think in the case of both satellite-given it has proven itself to be fallible-and the whole situation with the financing of overbuilders, the competitive concern has diminished and people are starting to refocus on cable. At the same time, you see quite a rapid and perhaps surprising acceleration in new-service deployment.


RB:

The good times aren't over. I've had the weird situation this year of having downgraded the entire sector in January and upgraded the entire sector in August.

I've been on both sides of this fence.

What happened last year wasn't just cable. It was all of telecom, media and technology. There was a period of insanity in the market with valuations. They became perverse. There was even commentary in the financial markets that valuation didn't matter.

If one goes back and looks at the last several times that that phrase was uttered, it has almost always been followed by a correction. So to those members of the financial community that said that valuation doesn't matter, perhaps they should consider becoming Communists.

The second part of the story is the industry made a fundamentally correct decision, which was to add a lot of people in the first half of the year, and it did cause some pains in the cash-flow growth. Nobody really had great numbers in the first quarter or the second quarter. But it certainly gave the ability to drive the unit growth. The combination of those two elements is, one, we flush the froth out of the market, and two, we've created sustainable fundamentals.

I kind of agree with Barry. We may go back to thinking that cable companies should have a relatively high degree of leverage compared to other types of companies. Given where interest rates are overall, six times debt-to-cash flow is a pretty healthy level for a cable company to be talking about. It means lots of excess funds floating around.


MCN: Are you looking for a catalyst to boost cable stocks or will it be more blocking and tackling on the part of operators?


BK:

Stocks are working now.


RB:

They've had a nice, sustained run. Part of it has actually been fueled by the whole idea that the sector is less economically sensitive than most others that involve better than 10-percent growth.

That's really helped draw interest. But you know what the other thing is? I think that by the time, if we get together this time next year, the word catalyst will have been retired from the investment lexicon, and thankfully so.

Because what it suggests is that a company would disclose some events that would be moving of the stock that you couldn't reasonably predict. Which is saying companies would manipulate news flow which now, given the situation with [U.S. Securities and Exchange Commission] Regulation FD, no longer exists. I think we will go back. I think Regulation FD will force the investor community to get away from worrying about what this quarter's disclosures are. Then that word [catalyst] will be gone and my job will be a better job.


BK:

There are some environmental "factors." Rich touched on one, which is the whole economic sensitivity or lack thereof on the cable stocks. We've been in this environment where telecom stocks broadly have been in a meltdown and it's been brutal for the early-stage emerging companies. Cable has looked like almost the safe port in the harbor, given that it's combining a very healthy revenue base, a very healthy current EBITDA [earnings before interest, taxes, depreciation and amortization] generation, but also is growing at double-digit rates. So it's kind of a best-of-all-worlds when people are looking to get out of the way of a truck.


RB:

It is predictable. It evolves over time. An investor makes a decision to own it today, and they can chart where they think the stock might be in 12 to 24 and 36 months. I think that's a totally different investment style than what characterized 1998 and 1999.

There hasn't been an investor in months that has called me asking about the potential for electronic-commerce revenue derived from cable-modem platforms, and that's a very good thing. To date, no company has created even what we would call an immaterial amount of revenue from that type of business. It has been a business dominated by portals as opposed to ISPs-which is what a cable company really is.

So I think we've taken the froth out of the way people look at stocks. That's a fundamentally good thing for this sector. These stocks do best when people use them in two- or three-year evolutionary businesses. When they get moving on short-term events, then there is no sustainability to the valuation.


MCN: What about programming costs?


RB:

The key issue that I don't think a lot of people focused on this year has been a subtle shift in the way the programmers have been behaving. I think the programmers have noticed the success of cable.

I've heard programmers say privately they are willing to consider moderating the size of their basic analog programming wholesale price increases for access to the digital tier.

I think Comcast [Corp.] should be credited with probably the most clever transaction of the year. They essentially bought the local sports business for the Baltimore-Washington [D.C] area and signed new long-term programming agreements with Viacom [Inc.] The cash considerations for the sports programming looked relatively meager and the reason was [that] they gave big long-term carriage agreements on a lot of the new channels.

It clearly looked like a win-win for both sides. I think that is a very clever type of structure, and we don't know what the basic-rate increases, basic programming increases are versus what they would have been. But the mere fact that they were able to purchase the sports programming at such a cheap price will keep the programming costs down.


GF:

And I think there's also a revenue-enhancement side of the story. You look at Comcast, you look at the rollouts.


RB:

Digital basic in that market using those channels, which generates another $5 a customer. Two points for Brian Roberts. In fact, let's give him three. He hit it from the top of the key.

But that was the most vivid example of trading long-term carriage commitments for a lucrative programming opportunity and presumably, at the very least, acceptable basic-programming contracts. That was really clever. That was the best example of industry leadership this year. Hands down, bar none.


[Bilotti, who has another
appointment, leaves shortly

after this.]


MCN: Do you think we have seen the last of the big, outside corporations getting into cable?


BK:

Some of these companies themselves have become large. It's an enormously expensive proposition, getting into this business, unless you can see some sort of synergy and you can have a very high degree of confidence. People have watched missteps happen in the past.

[America Online Inc.-Time Warner Inc.] is obviously an example of where the parties certainly think there's some synergy. You can certainly make an argument for that making sense. But there aren't that many types of companies that have the combination of access and businesses where it would make sense to combine them.


GF:

The only thing that might preclude that is just the extent [to which] the business gets more regionalized than it is today. You take Comcast in the mid-Atlantic, half their customer base is there. Adelphia [Communications Corp.] has 40 percent of their customer base there. Or you see some partnership of some of those businesses, some sizeable footprint that might hold interest for somebody. Maybe not on a full basis, as a full owner, but as a partial transfer.

Maybe in the L.A. market, which is really fragmented. To the extent that regions come together and to hold systems, that might hold some attraction to somebody who has a regional focus.


BK:

But the regional footprint thing can be rationalized without any outside help. And I think it probably will be, ultimately, between the parties that own those assets today.


MCN: Is there a company that you think is going to be taken out?


BK:

If you think about the universe out there, there are a handful of super-majors, and then there are companies that probably don't necessarily, long-term, have the critical mass, nor do they necessarily have the strategic direction to be there forever.

Cablevision has slimmed down to about 3 million subs. You have to ask yourself the question, 'What is the

long-term direction there?'

Many of the other companies are family controlled, and you wonder, as they go through family transitions, what the long-term plan is. There is clearly a rationale for some sort of getting together from a geographic standpoint of Comcast and Adelphia and/or Charter [Communications Inc.] and Adelphia.


GF:

The other thing is the issue of price. The stocks have come back maybe 7 percent this month. They still have got a long way to go to where they were. Part of the driving factor behind that is new products. If people are going to be interested in selling, obviously they're going to be interested in selling for the 20-times-plus multiples you've seen before. Digital at the end of the year maybe has 15- or 16-percent penetration of the customer base. High-speed data maybe 5 or 6 [percent]. There is still room, beyond the family-control issue, for the operators to drive the growth.


BK:

I think a lot of the operators today don't feel like they have maximized, by any means, their opportunity and there's a lot more value to be created before they are ready to call it quits.


MCN: How much credence do you give interactive TV
when you're looking at cable companies? There is a lot of hype about interactive services, but do you see it as something that happens soon?


GF:

There's a pecking order to it, too. Obviously with video-on-demand, there's an $8 billion video-rental market. That's a no-brainer. These guys should be attacking this. After that, it looks like Internet access is the next type of functionality they want to put on the TV.

But I think you're still very early in seeing these things out there. Moreso the Internet access and e-commerce applications. The industry is making a shift. Eight months ago, everyone thought thick-client [Motorola Broadband Communications Sector] "DCT-5000" boxes would be the way to roll this product out. Where you've seen in the past six to eight months [companies] like WorldGate [Communications Inc.] get more traction because it's on a thin client, headend-based solution which actually makes a lot more sense.

If there is anything I would be particularly bullish on, it's video-on-demand. When you talk to the companies, you hear that it's going to be a decent part of the operating plan for next year. It's not clear how much.

But again, they can do it on the 2000 box? By the end of next year, there are probably over 14 million digital-TV customers out there to attract.


BK:

It depends on how you define interactive television. Everybody has their own definition of what that is and what it encompasses.

I think of the digital box as being the Trojan horse in the house. It starts off with some pretty obvious services that are pretty important and pretty powerful, but those build on one another. You layer on top of the basic digital-video applications, video-on-demand.

I think the guide is a simple thing, but if you look at the market cap of Gemstar [TV Guide International Inc.], people think it's a pretty important thing, even down to where it is now.

I think it's going to take some type of economics to be sorted out, what ultimately is going to happen with the intellectual property, with the competitive environment. But I think the guide is going to be a very important source of economics for somebody and I can't believe the cable operators aren't going to have their hands pretty heavily in that pie. Video-on-demand, I think, is going to be a big business. Just because of the economics with the film studios, it's going to be less profitable than a lot of these other opportunities, but it will be, nonetheless, a good business.


MCN: How important is a programming guide's first screen?

BK:
I think it's very important. It depends on how you define the first screen. I think the cable operators are, obviously, highly protective of their real estate. To the extent that guide providers essentially want to effectively be the portal to the television space, there is no circumstance under which that's going to happen.

Anecdotally, [a cable operator] told somebody that I know, 'Before I put a guide on that insists on being the portal, I'll put my home phone number up and people can call me, ask me what's on, and I'll tell them.'


GF:

It's the relationship with the customer. You take that away and then you're just the pipe to the home. The battle isn't over the guide. It's not over whether you want to go to a WorldGate guide or a Gemstar guide, it's all the things that could come out of the guide. Why would you want to sell yourself short at this point and give it away, when you're actually first in the queue to offer those services?


MCN: Direct-broadcast satellite hasn't really turned out to have had that much of an impact on cable. But now you've got DirecTV Inc. in play, and [News Corp. chairman] Rupert Murdoch is circling around. If Murdoch or another big corporation gets hold of DirecTV, do you see DBS as that much more of a threat?


BK:

I don't think it will make that much of a difference. I think that from the customer's standpoint, whether you're buying DirecTV or DirecTV branded or Fox DirecTV, or Fox TV over satellite, it's not going to have that great an impact on your purchasing decisions.

You're going to look at the product and what the product is. It may ultimately make economics better, because those providers have more scale. I'm not sure it will help them to sell that many more.


GF:

It's also about the upgrades. Where the cable guys are upgraded, they're growing at above-average rates; where they haven't, they're flat. DBS will always be an issue, but less so. And then as far as someone else owning those companies, my take is that in the near-term, operators will focus very aggressively on subscriber adds, less so on issues of cash-flow growth. I think if somebody else buys DirecTV, they just may run the business model differently than it's being run today. But they'll drive the cash flow on their own.


MCN: How important is telephony? Not too long ago everybody wanted to do deals with AT&T. Now nobody really seems to care.


GF:

The competitive environment [today] isn't demanding a telephone product. Cox is doing a great job-it's got 20- to 40-percent penetration in markets.

But look at the products. Digital, there's a clear competitive issue there. Cable guys actually have a pretty good price on the product with good functionality.

You've got a reason to want to go hard on that. High-speed data, same situation. They have a better product, better pricing. That's the reason you'd want to go hard on that.

Telephony today, it's questionable whether competing on price outside of the fact you could offer a bundle is going to get people more interested in rolling out that service in the near-term.


BK:

When it comes to telephony, there's probably not that much urgency because the ILECs [incumbent local-exchange carriers] today have the whole market. Everybody has a phone already. Competitively, there aren't that many other people that on a facilities-based basis are going to be going after that market.

They have satellite prospectively competing with you for that market. You may ultimately have overbuilders.

There is more of an attitude: Let's see what happens with the technology. Let's see how quickly they move to IP [Internet protocol]. Maybe if we get to IP in a couple of years, it's robust and efficient, we can roll out telephony on a much more efficient basis.


MCN: Is it a convincing bundle without telephony?

BK:
I think it's a good bundle, the video and data. I think it's a better bundle if you've got the telephony, because the telephony is more like the data than the video is like the data. And if you're in an IP environment, it's basically the same modem that's operating the telephone service and the data service.


GF:

I think that the surprise of telephony has been the demand level. I don't think anybody on the street would have forecast Cox-type penetration rates, high double- digit rates, so quickly. The next issue really is going to be profitability. How should we do telephony? Do we do telephony as an essential part of the bundle, but not an overly profitable, cash-flow positive product, or is there a point where the focus becomes we want to make money on that product as well? Right now I would say there's not enough people rolling it out to really reach a conclusion one way or the other.


MCN: There has been a lot of talk lately about how stock analysis is heavily influenced by investment-bank activity. What would you say to someone who


believes investment research is biased, or that companies that do a large amount of banking business with a firm exert influence over that firm's research?


BK:

I would say two things. No. 1, from an internal-compliance standpoint, we have layers and layers and layers of rules to avoid any improper flow of information. My ability to say anything about a company where there is any specific transactional or investment banking in terms of activity is very limited.

Goldman Sachs is an enormously successful investment bank, and the good news and part of that process is we basically do business with everybody-you end up being an equal-opportunity offender. It's not like this is our client and this is not our client, so I can say something bad about him, but not about him.

Obviously, it's your reputation and your credibility. Your usefulness to the investment banking department to help you win deals is, in the long-term, predicated on your credibility as an analyst.

Obviously, you try to bear that in mind through the whole process.


GF:

I would agree. There are internal mechanisms to prevent that, but there's this base level of credibility. There are too many people covering these stocks to think that you can bypass that and still have a core product that people are going to be interested in.

In the past year or two, given that the business has changed a lot, I don't know if we've formed much of a consensus opinion anymore in this space than you might have found two, three, or four years ago.

I think today there's a diversity of opinion.

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