If you listen to the parade of CEOs blaming the economy for their companies' lackluster performance, you'd never know there are actually companies out there that are not only having a good year but a great year.
Let me use one industry, the cable business, to show how this economy is working to separate the winners from the whiners.
We all know how terrible the cable business has been lately, right? Selling consumers on getting their phone service over their cable TV has been a tougher-than-expected sell. Upgrading systems to sell the new digital services has been incredibly expensive -- and demand for digital cable TV has been tepid in many service areas. Satellite services have been stealing market share.
In this environment,
cable division lost 432,000 basic subscribers in the first nine months of 2002 -- and showed an almost 4% drop in subscribers in the third quarter alone. The question seems to be not why AT&T decided to get out of the cable business but why
wanted to buy these systems in a deal that finally closed on Nov. 18.
The Trouble With Charter
To see how ugly this business can be, just look at
. Like AT&T, Charter lost subscribers in 2002 -- about 277,400, or 4% of its total, through October, reports UBS Warburg. But while that certainly has not helped, it isn't the crux of the problem.
The real problem is that it's costing Charter more to build out the system than it takes in. Charter estimated that it generated $74.19 in operating cash flow per basic subscriber in the third quarter but spent $87.33 in capital expenditures per subscriber during that period. That's a recipe for disaster, as many former Internet executives can attest.
Aligning build-out and customer subscriptions is a delicate balance. Build out too fast and sign up too slow, and debt levels rise as revenue lags spending. Build out too slow, of course, and you'll lose customers to the satellite companies and other potential competitors. (And remember that the company spent money to acquire each one of those 277,000 subscribers it has lost so far this year, and spent more money on building out its system to reach them.)
In Charter's case, debt is now at overwhelming levels. According to UBS Warburg, the company could finish 2003 with $20 billion in debt -- or about $3,050 for each basic subscriber. Growth is slowing, interest expenses are climbing as the company's credit quality slips, and Charter is unable to sell assets at attractive prices, because that's what every other debt-laden cable company is trying to do right now. So Charter can't easily de-leverage its balance sheet. The company has, under the circumstances, promised Wall Street a target that is almost impossible to reach: growth in EBITDA (earnings before interest expenses, taxes, depreciation and amortization) at double-digit rates in 2003, while cutting capital spending by 50% from the year-earlier levels.
No wonder the stock is down 90% this year. (
Securities and Exchange Commission
investigations into the company's bookkeeping haven't helped, of course. Nor have fears that the company will be forced into a financial restructuring that wipes out the remaining stake in the company held by owners of Charter's equity.)
A Different Angle
But you'll see a completely different picture of the industry if you look at cable companies such as
In the third quarter, Cox grew pro forma revenue by 16%. The company, with 6.3 million subscribers, is just slightly smaller than Charter. It looks on track to deliver 14% to 15% revenue growth this year and 14% in 2003. EBITDA should expand by around 14% in each year. The number of subscribers seems set to increase by about 1% in 2003 and then by slightly less in 2004. But despite the increase in the number of subscribers, capital spending should drop by about 10% next year and interest expense by 5%, according to UBS Warburg.
But that's not the big contrast with most of its cable industry peers. Cox looks like it will go boldly where few cable companies have gone before and turn free cash flow positive for 2003. In fact, after showing a tiny $11.5 million in free cash flow in 2003, according to UBS Warburg, Cox will produce $566 million in free cash flow in 2004.
Why the huge difference between Cox and other cable companies? Merrill Lynch recently took a look at Cox's Orange County, Calif., operation to see.
Part is luck -- or foresight. Cox started its Orange County unit in 1968. It was one of the first cable operators to upgrade its systems to include digital video and telephone over cable, available in Orange County since 1997. That gave the company time to work out the kinks in its infrastructure and make the necessary investments before the Internet-over-cable boom really took off. That partly accounts for the company's extremely high market share in the country; 85% of high-speed Internet customers in Orange County are Cox subscribers.
Disciplined Approach to Growth
But most of it seems best explained by a first-class understanding of the economics of cable and an extremely disciplined approach to growth. The Orange County unit constitutes a cluster of 320,000 affluent households. Putting that many potential customers for the new digital services in a relatively small geographic area with the relatively low installation costs that go with new suburban rather than older urban clusters maximized Cox's profit potential. (Going a step further, Cox services both this cluster and its San Diego cluster from a single service center, further cutting costs.)
Cox's execution was designed to push that cluster advantage. In a cluster, increasing penetration of the market, rather than reaching out to new neighborhoods, is the most effective way to grow margins. Cox spent to upgrade its systems in Orange County so that it could sell bundles of services to the same customer. So Cox not only has an extraordinarily high 76% penetration in basic cable, but 43% of those basic customers take its digital video service, and 30% have Cox deliver their phone service over their cable lines. Fifty-one percent of Cox's customers order two or more products from the cable company.
Cox shapes its capital budget to promote this bundling strategy. Relatively little goes to adding new digital cable subscribers; at $17 a month, the service is not that lucrative. More goes to building out Internet access -- $40 a month for a cable modem and high-speed service -- and telephone over cable, where the average monthly bill is $46.
A cable system built out and managed, such as Cox's Orange County operation, is also extremely resistant to competition. Direct broadcast satellite has about 18% market penetration on average nationally. In Orange County, it's just 10%.
The market isn't ignoring the Cox story -- the stock trades at a premium (based on EBITDA) to the average for the cable group. And at a recent $29 a share it is within 20% of a conservative one-year target price of $35.50. Certainly not a bad potential return considering the low risk in the stock.
Challenges at Comcast
But Cox isn't the only cable candidate I'd put among the winners and not the whiners. Before its acquisition of those cable systems from AT&T, Comcast looked remarkably similar. In some ways Comcast was even ahead of the curve. The September quarter marked the company's third straight free-cash-flow positive period. The company looks likely to finish the year with free cash flow of about $800 million.
So why's the stock down 34% year to date in 2002?
You don't have to look any further than the AT&T cable acquisition. Comcast is going to have to go back into capital spending big time to finish upgrading the systems that it has purchased. Comcast now estimates that it has to rebuild about 60,000 to 70,000 miles of cable system at a cost of $2 billion. The company thinks it can get the job done in two years. That's certainly possible since Comcast rebuilt 30,000 miles in 2001, but it will still be a challenge.
And that's not the only challenge. AT&T's unit overcommitted to telephone over cable -- perhaps only natural given the company's roots -- and neglected its video and data offerings. This means reorganizing marketing and pricing plans to beat back competition from direct broadcast satellite. AT&T's cable systems have seen huge losses to that competing technology.
All this means there's a big risk that Comcast could take its eye off the ball, flub the execution of the acquisition and wind up needing to spend more over a longer period of time to generate a lower return.
A purchase of Comcast at this point is a vote of confidence in management. If you think it's up to the job, buy the stock for the potential that the AT&T systems will eventually operate as well as the rest of Comcast did before the deal. If you think this deal will end up as just another case of overestimated synergies, then take a pass.
I'm adding the shares to Jubak's Picks with a target price of $34 a share by December 2003.
New Developments on Past Columns
continues to buck the trend among retailers this Christmas shopping season by turning in sales numbers above plan. The company announced that last week, sales at stores open for at least a year were running above projections, with solid increases in almost all categories and especially strong performance in fine jewelry, shoes and children's clothing. That's pretty impressive given that even
has hit a rough spot lately. That retailer said sales last week were near the low end of its plan for 3% to 5% growth.
Changes to Jubak's Picks: Buy Comcast
will appreciate quite handsomely over the next two years if the company can transform itself into a cash flow positive cable giant with a solid balance sheet. The company was clearly headed in that direction before it acquired AT&T's cable systems in November. On a stand-alone basis, Comcast is likely to generate $700 million to $800 million in free cash flow in 2002 with a debt-to-equity ratio of 71%. Comcast is only half as leveraged as the average company in its industry. Integrating and upgrading the AT&T operations and paying down the debt that came along with the assets isn't a minor challenge. But Comcast has been through this before: In the last five years Comcast has integrated assets from Maclean Hunter, E. W. Scripps, Jones Intercable and Lenfest Group while upgrading its credit rating to BBB from BB. I think it can do it again. I'm adding the shares to Jubak's Picks with a target price of $34 by December 2003.
At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.