A major Wall Street analyst covering the cable TV industry dropped her rating on the sector, citing factors such as competition in the high-speed data business and overoptimistic free cash flow estimates.The analyst, Credit Suisse First Boston's Lara Warner, also cut her price targets on Comcast ( CMCSA) and Cox ( COX), two of the biggest players in the cable business. Warner's report spotlighted an incrementally pessimistic outlook on issues that have dogged cable stocks for years, and will continue to do so: competition from regional Bell operating companies and skepticism over whether cable operators can cut capital expenditures and increase free cash flow. Cable stocks generally traded lower Tuesday, but not by much. Comcast's shares were trading at $30.60 Tuesday afternoon, down 6 cents, while Cox dropped 31 cents to $32.54. In her report, Warner says several "negative catalysts" may drive cable stocks lower over the next 12 months, starting with new sources of competition in the areas of broadband Internet, video and telephony. New competitive pressures, greater-than-expected capital expenditures and higher cash tax burdens, writes Warner, will drive lower-than expected free cash flow -- usually defined as cash flow from operations after interest expense and capex have been subtracted out. Finally, the cable industry's increasing participation in network-based services, increasing competition from RBOCs and slower growth all will invite comparisons to telecom stocks rather than media stocks, says Warner -- a trend "likely to create on-going pressure on valuations," she says. Warner's views on the cable sector today don't match up to the prevailing assumptions held by cable investors nine to 12 months ago, she writes. Back then, the industry appeared to be moving in a positive direction, she writes: "new products generating incremental revenue with older products exhibiting pricing power, programming expense pressure expected to begin to ease, and investment requirements declining."
But now, "we believe a different, more sobering picture is emerging," she writes. "New products are more defensive than they are incremental revenue generators, pricing power is eroding in the more mature products (video and data), programming expense growth is not slowing significantly, investment requirements are not declining as previously expected, and it appears that the federal government will be getting a larger share of cash flows than previously thought." Among other problems nagging the industry, writes Warner, is that video on demand, digital video recorders and high-definition television -- all seen as incremental revenue generators for an industry with slowing basic video growth -- are turning out to be defensive, customer-retention products in the face of satellite competition, and they won't be reaping as much additional revenue per subscriber as previously expected. The RBOCs, which are allying themselves with satellite operators to offer video service, are putting more pressure on basic video than investors have expected, writes Warner. Though cable operators are expanding into the telephony business, the competition in that market will pressure pricing for cablers, she writes. And, as Warner discusses in a separate report, cable is losing share in the broadband market at a rate faster than she expected last year, though unit growth was larger than she had forecast. Average monthly revenue per high speed data subscriber appeared to deteriorate in the second half of last year, and Warner expects it to drop further this year. "To be clear, we are not projecting the end of the cable industry," writes Warner. "We believe the industry is well positioned to compete with the RBOCs and satellite industry over the long term. We do believe, as we have stated previously, that today's valuations for cable do not reflect what we believe will be an increasingly competitive future."
On Tuesday, Warner lowered her price target on Comcast, the nation's largest operator of cable systems, from $36 to $32. The analyst cut her estimates for Comcast's free cash flow generation in the years 2006-10, based on increased capex on converting Comcast's systems to fully digital signals, and higher cash taxes. Warner, whose firm has done recent banking for Comcast, kept her outperform rating on the company's stock. Warner also cut Cox's 12-month price target from $34 to $32, saying that digital conversion capex and cash taxes would similarly hurt free cash flow, though not on exactly the same schedule. Warner rates Cox neutral; her firm has done banking for the Atlanta-based operator.