For the cable industry, it may be time for a back-to-basic curriculum.
For years, cable TV operators have focused on the revenue and cash-flow growth to be garnered from offering a bundle of advanced services including high-speed Internet access, telephony and high-definition television.
But it now appears that the basic video business -- the plain-vanilla offering on which operators have built their menu of advanced services -- is eroding to a greater degree than previously believed.
Reporting their second-quarter financial results this past week, the nation's largest cable TV operators released numbers indicating that the basic video business is problematic, and suggested that it deserved greater attention than they have been paying to it.
The revelations led one cable analyst Friday to lower his ratings and price targets on the two biggest stand-alone cable operators in the U.S. --
, the nation's largest operator of cable TV systems, and
, the third-largest operator. The move came before Cox on Monday fielded a $32-a-share take-private offer that set off an
UBS's Aryeh Bourkoff, who downgraded both stocks from buy to neutral, says he still believes in the strength of cable's competitive positioning and the growth it can generate by offering a bundle of services.
But, Bourkoff told
Friday, "The slippage in the core video business was a little bit worse than our expectations." That, he says, leads him to believe that operators will have to institute additional discounting or promotions to retain basic customers. The resulting lower pricing on video, he says, "does hurt the model" for cable operators.
Citing lower growth rates for basic subscribers, average monthly video revenue per subscriber, and overall growth rate for the cable business, Bourkoff cut his price target for Comcast shares from $40 to $31, and for Cox from $39 to $30. UBS has done recent investment banking for both Cox and Comcast.
Cable company shares have dropped steadily this year on fear of competition and doubts about cash flow growth. On Monday, the group reversed field, with Cox surging 20% on its controlling shareholder's buyout offer and Comcast rising 5% on its coattails.
Basic worries came to the forefront last week. While raising its operating cash flow forecast for the year, Comcast reported
larger-than-expected basic cable losses and cut full-year basic cable guidance. In place of its prior forecast of 0.5% growth in basic cable subscribers in 2004 -- an increase of 100,000 subscribers -- Comcast now says its basic video subscriber count will remain flat at 21.5 million.
Cox also reported
greater-than-expected basic cable losses, and executives at both Time Warner and Comcast alluded to the need to pay greater attention to basic cable marketing.
Though one element of the quarter's losses is seasonal second-quarter weakness, the basic falloff comes amid a larger trend, one which
discussed in October 2002. At the same time that basic cable percentage growth numbers are slowing down, cable operators are building out their systems to reach greater numbers of potential customers in new neighborhoods previously not served by cable.
So while Comcast, for example, had 10,000 more subscribers at the end of the second quarter than it did a year earlier, the number of households it could potentially serve ("homes passed," in industry parlance) grew by 600,000 to 40.3 million. And the percentage of homes passed that take basic Comcast service (the "basic penetration" rate, as it's known) dropped from 54% to 53.3% over the past year.
Yes, grant cable industry bulls, basic growth has stalled alongside continued market-share gains by satellite operators
). But that negative, they say, is overwhelmed by the growth and the cash flow that operators can generate from new services.
Up to a point, perhaps.
The second-quarter weakness in the unbundled basic video subscriber numbers, writes Bourkoff, shows an increased risk for cable in holding its market share of the core video business: "We are incrementally more concerned that the risks of the core video-only subscriber loss may partially outweigh the value of the strength of the bundled offering."
Roughly 60% of cable subscribers, points out Bourkoff, are analog-only customers, meaning they don't subscribe to the extended channel lineups, high-definition television and/or video on demand services that come with digital video.
Despite the upsurge in high-speed Internet and other services, those analog-only customers make up a significant portion of revenue and operating cash flow (also known as EBITDA or operating income before depreciation and amortization). Bourkoff, for example, estimates that in 2005, the analog video business will amount to 47% of Cox's operating cash flow and 57% of Comcast's.
Devising a scenario to illustrate the possible impact of continued basic weakness, Bourkoff concludes that either of two hypotheticals -- 1% annual subscriber losses or flat pricing for basic video -- could affect his valuation of Cox or Comcast.
Again, it's important to note that cable operators have shown strong revenue and cash flow growth this quarter, with Comcast raising guidance for cable operating cash flow growth.
But one investor -- who is shorting cable stocks and is long satellite operators -- argues that the basic video issue is a precursor of problems to come. Comparing the cable business to a restaurant, the investor -- who spoke on condition of anonymity -- says it's easy for a restaurateur to trade on the goodwill of longtime customers by raising prices and increasing profits in the short run. "But there's a lag between that and when you start scaring customers away," says the investor.