Overbuilders' Problem: Slim Returns

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With all the hype surrounding the competitive threat of telcos, overbuilders and new technologies like wireless fidelity to the cable television “monopoly,” Sanford Bernstein cable and satellite analyst Craig Moffett offered a compelling argument against third-party entrants into the pay TV business: there is simply no money in it.

Moffett, in a new research report, finds that while marginal returns for cable companies are strong, the total returns on assets are paltry — return on assets being net income divided by total assets. And total assets is defined here as the total investment made by cable companies for property, plant and equipment, franchise rights and goodwill.

ROA is a useful barometer of how well a company converts its investment capital into earnings.

Moffett looked at Comcast, the largest cable operator in the country with 24.5 million customers. He calculates its total return on assets — including the billions of dollars spent on rebuilding its network in the 1990s — will be a mere 2.9% in 2007. And it only took about 40 years to get to that point.

Current cable investors don't really care about the past ROA of incumbent cable operators, the analyst noted. What's important now are year-to-year returns going forward — or marginal returns.

The problem comes for those companies that haven't built a network yet, because “then all capital is marginal capital,” Moffett wrote.

So, according to Moffett's estimates, new entrants into the pay TV business are clamoring to achieve a 3% ROA.

“And, heaven forbid, what if those returns were to fall?” he wrote. “After all, it's hard to argue that a business with only 2.9% returns with only one provider is going to be a better business once it has two.”

After numerous wireline and wireless efforts to overbuild cable failed over the last decade, the big regional phone companies — most notably Verizon Communications and AT&T — are attempting once again to crack the code to profitability in pay TV.

Moffett wrote that the telcos have significant assets — including brand recognition and staying power — but also have competitive disadvantages, such as higher labor costs and the fact that they can't count most of the revenue on the network as incremental.

“So costs will be higher, and revenues will be lower,” Moffett wrote. “But perhaps they can make it up in volume. What they have most of all, we'd presume, is a desire to share in those huge excess returns being earned by the cable companies.”