The six-month slide in cable stocks has got some analysts arguing it's time for a rebound.

But looking back to two summers ago, it's easy to imagine things could get worse before they get better.

Buffeted by talk of rising competition, investors have deserted the cable business this year. Shares in Comcast ( CMCSA) are down 25% from their January peaks. Cox's ( COX) stock is down 24% over the past six months. As of last Monday, Credit Suisse First Boston's index of six cable stocks was down 17%, leaving it far behind the S&P 500's 1% gain in the same timespan.

But the group could be ready to bounce off the canvas. Saying that the perceived threat from regional telcos is overblown, analysts from Morgan Stanley and Oppenheimer & Co. have argued that the cable sector is ready for a turnaround.

The reports address two issues that perennially dog cable operators: How bad is the competitive threat from other technologies? And when will cable operators become dependable generators of cash for their shareholders?

Piggy Bank

The cash issue clearly weighs more heavily in some quarters. Morgan Stanley analyst Rich Bilotti, who last week upgraded the cable and satellite sector to attractive from in line, contends that these companies are about to change their ways -- a shift that will drive an overdue rally.

Media stocks have long suffered in comparison to the broader market because of investor pessimism that management will ever return capital to shareholders, Bilotti writes.

Indeed, cable operators have historically preferred to spend their money on acquisitions or upgrades to their plant. Generating free cash flow -- that is, cash flow from operations after interest expense and capital expenditures have been subtracted out -- seemed to emerge as an industrywide goal only in response to Wall Street skepticism that climaxed in the summer of 2002, when cable stocks tanked.


Peaking Early?
Comcast, Cox slump off January high


Current share prices, says Bilotti, indicate that investors don't believe that media companies will ever pay out to shareholders, in the form of dividends or stock repurchases, more than 25% of free cash flow.

But within the next year, suggests Bilotti, cable operators will combine their newfound ability to generate free cash flow with their desire to placate investors. By early 2005, he says, he expects most cable/DBS companies to adopt either dividends or share repurchase programs.

"The first company to establish a 30% or greater payout ratio of free cash flow," he writes, "will probably see 20% to 25% share price appreciation. Competitive envy should drive the other companies to follow suit."

The Corrections

Oppenheimer's Thomas Eagan, meanwhile, says that it's time for cable stocks to perform more in line with the S&P. He says various developments interpreted as bad news for the cable industry have been overblown.

Cable stocks' lack of correlation with the S&P 500 over the past six months contrasts with a close correlation from 2001 through 2003, writes Eagan. In the absence of any operational setbacks for the industry, he writes, it "suggests to use more that the stocks are ready for a 'correction' and less that historical correlation trends are to be broken."


Dog Days
Cox, Comcast's 2002 plunge


Like Bilotti -- who says that telco price wars won't cut prices as much as expected, and that threatened telco fiber builds won't pose a worst-case-scenario threat -- Eagan says competitive risks to cable are overblown in several respects. A recent Cablevision ( CVC) telephone service price promotion is unlikely to be copied by other operators, he says. Announcements by telcos such as SBC ( SBC) that plan video-capable fiber networks don't pose a real near-term or medium-term risk, he writes. Investigations into subscriber counts and a rise in interest rates aren't problematic either, he writes.

And yet, it's possible that cable operators won't be able to shake off these concerns so quickly. One media investor, speaking on condition of anonymity, notes that the perceived threat to cable from local telcos "goes in cycles, the impact on sentiment." Adds the investor, "The issue's been out there for four years." The investor has holdings in Comcast.

The buysider points out that another issue overhanging cable stocks is the fate of bankrupt cable operator Adelphia, since the financing for that deal will no doubt be weighing on the eventual buyer or buyers of the company.

Cable stocks, he argues, "trade more on sentiment and overhang" than they do on absolute discounted cash flow valuations or multiples of earnings before interest, taxes, depreciation and amortization.

In that light, sentiment has room to get worse. In the summer of 2002, for example, concerns about cable industry cash flow, or lack thereof, pushed Comcast's stock down below $18, and Cox's below $20.

And not all sell-siders are as optimistic as Bilotti and Eagan. Two and a half months ago, for example, Credit Suisse First Boston's Lara Warner cut her outlook on the cable industry , taking a much different view than the recent Morgan Stanley and Oppenheimer reports do. Increased competition for cable operators will lead to lower-than-expected free cash flow, she argued.

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