In the cable TV business, holding onto basic video subscribers has become like running on a treadmill gone out of control. You have to work harder and harder just to stay in the same place.

That's what some people in the investment community are concluding after looking at basic subscriber figures over the past two years.

As investors have already noted, the growth in households subscribing to basic cable has slowed and even reversed in recent years. But behind that well-known problem is a lesser-known one that's equally troublesome or even more so for cable's future, says one short-seller.

That second problem is the decline in basic cable penetration -- the percentage of households in areas served by a cable operator that subscribe to the multichannel TV service. Because a shrinking percentage of households in a given area are subscribing to cable, operators must keep expanding their system into new neighborhoods in order to maintain subscriber growth or stave off losses, says the short-seller, speaking on condition of anonymity.

The deterioration of penetration -- which dogs even top-tier operators like

Comcast

(CMCSK)

and

Cox Communications

(COX)

-- eats away at cable companies' ability to get a return on the billions of dollars they've borrowed and invested over the past few years to upgrade their systems and offer advanced services. In the wake of the high-profile failure of

Adelphia Communications

(ADELQ)

, cable investors have grown less certain that returns on these upgrades will be around the corner as promised.

The De-Penetration of Cable
Basic Cable Customers as a Percentage of Homes
Passed by Cable Operators

Source: Company press releases. 2001 figures are pro forma, unless noted otherwise
* Actual, not pro forma
Note: 3Q 2002 figures not available for Cablevision and Charter.

Outstripping

Similar red flags about the falloff in penetration are raised in a report from J.P. Morgan analyst Jason Bazinet subtitled, "Why Basic Sub Growth May Be Worse Than You Think." In the August report, Bazinet asserts that cable operators are masking the basic subscriber problem by building up their systems faster than the natural rate of new household formation.

Year-over-year basic subscriber growth reported by the industry has sunk from 0.5% in the fourth quarter of 2000 to negative 0.2% in the first two quarters of this year, says Bazinet. But if cable operators built systems at the same pace of new household formation, they'd actually be losing subscribers at a rate of nearly 2% a year.

A particular troubling element of the penetration falloff, says Bazinet, is that the pace accelerated in the first half of this year. That runs counter to many investors' expectations that industrywide system upgrades, nearing completion, would stabilize the decline.

The declining penetration accompanying cable system expansion raises at least two worrisome questions for cable investors. One, how long will operators, facing competition from direct broadcast satellite service, be able to build their way out of steep subscriber losses? And two, are the new potential customers reached by plant expansion worth the cost of reaching them?

"If the only way you can grow your customer base is by doing line extensions," says the short-seller, "that implies you're losing customers on your base network. If that trend continues, where you have less and less customers per mile of plant, over time your operating margins will come under pressure."

Or, using an example from the food-service industry, the short-seller says, "If

McDonald's

(MCD) - Get Report

has to keep opening new stores to sell the same number of burgers, that's going to eat into their profitability."

Subsiding Subscriber Growth
How Slower System Expansion Affects Growth Rate
for Basic Cable Service

Source: J.P. Morgan report "(No) Growth, But at What Cost?," Aug. 19, 2002

Challenges

The questions surrounding penetration spotlight major ongoing challenges to the cable TV industry. As DBS services such as

EchoStar Communications'

(DISH) - Get Report

Dish Network eat into cable TV's traditional customer base, the question remains whether cash generated by a new generation of advanced cable services will offset a slowdown in demand for basic cable.

Over the past year, in fact, cable stocks have slid as investors have grown increasingly uncertain that the billions plowed into cable system upgrades in recent years will result in payoffs from advanced services as large and as timely as they previously expected.

Whatever the implications, the penetration decline is real and extensive. Judging from the pro forma figures issued by cable operators this year, nearly all of them showed falling percentages of basic customers among the households passed by their systems.

For operators

Charter Communications

(CHTR) - Get Report

and

AT&T's

(T) - Get Report

Broadband unit, the decline is dramatic. Charter, for example, went from 60.8% penetration in the first quarter of 2001 to 57.5% in the second quarter of 2002, the latest quarter for which the company has achieved full results.

At the other end of the spectrum is

Cablevision Systems

(CVC)

, whose New York-area systems boosted penetration from the first quarter of 2001 over four subsequent quarters, falling just below early 2001 levels in the second quarter of this year.

In between, the penetration problem is hitting even Comcast and Cox, which enjoy the reputation of being the best-run and most financially stable cable operators. Comcast, set to complete its merger with AT&T Broadband in November, has seen penetration fall from 61.9% in the first quarter of 2001 to 60.1% in the third quarter of 2002.

But cable subscriber growth fueled by extensions of Comcast's systems has hidden that drop. With homes passed by Comcast growing by 3.8% over that same time period, the company has reported basic subscriber growth of eight-tenths of 1 percent.

What It Means

As for nailing down the impact of waning penetration, Bazinet gives it a try in his report. First, he starts with the calculation that the cable industry is building out its systems to pass new homes at the rate of 2.8% per year -- more than double the 1.2% growth rate for countrywide household formation. After some other calculations, he says that cable, at its current growth rate, will run out of new homes to pass in eight years. But operators concentrated in rural areas, such as Charter and

Mediacom Communications

(MCCC)

-- which are expanding at a pace above the industry average -- will hit the wall in three years, Bazinet says.

Whether these new households add economic value is also hard to judge. Using average figures for construction costs, penetration rates and customer valuations, Bazinet says passing new homes does translate into incremental value for shareholders. But he tempers that conclusion with a caveat. Because it's likely that many of the households being passed by cable already are DBS subscribers, Bazinet suggests it's a stretch to assume that cable will enjoy the same acceptance rates it has in areas where cable is the incumbent, not satellite.

Making a less-precise argument, the short-seller says he believes the cash-flow return on system expansion is lower than the corresponding cost of capital.

To be sure, cable operators acknowledge that the basic cable business isn't what it used to be. But rather than focus on the weak basic business, they say investors should focus on successes with high-end, high-margin offerings, like the high-speed Internet service that Cox crowed about in its

quarterly results released earlier this week.

The short-seller, citing the higher churn rates of more advanced services, isn't swayed. Pointing to Cox and Comcast, he says that even the best-operated cable businesses "still can't fight the inexorable tide of satellite."

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