Grading the MSOs

Morgan Stanley financial analysis of the eight largest cable operators puts Comcast on top
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Cable can look like a pretty homogeneous business. Systems offer a rather similar lineup of cable networks. They tend to raise basic rates about the same amount at the beginning of each year. And they are generally disdained by many of their customers.

But, financially, operators aren't the same at all. Some run consistently smooth operations; others are more erratic. Some, loaded with debt, push their cash flow and cash-flow margins as high as possible. Others run more conservatively, sacrificing cash flow to beef up marketing and customer service. Some, having starved their operations for capital, are now playing catch-up in the face of competition. Others have invested steadily for years and are prepared to fend off competitors and deliver high-end cable products.

To sort out the differences among the largest operators, BROADCASTING
CABLE teamed with Morgan Stanley Dean Witter media analyst Richard Bilotti and cable analyst Ben Swinburne to draft a report card on cable TV. At our request, Bilotti and Swinburne evaluated operators by several measures, some not typically tracked on Wall Street.

The goal was to sort out which companies seem best suited for grappling with competitors and growing revenue and cash flow through the launch of new products. Which operators are particularly well managed? Whose systems are physically fit for new products? Which face the greatest financial pressure?

Comcast is Tops

Despite its ranking in the middle of the pack on some measures, Bilotti considers Comcast the top performer. The company's revenue and cash flow per subscriber are strong. Cash-flow improvement is average but, unlike some other operators', consistent. Most important, the company's capital spending has been relatively low. While that's a bad sign for other frugal MSOs, Comcast balances it out with high sales and earnings. And that is the bottom line for any business, its ultimate return on investment.

"Rising cash flow per sub, stable cap ex per sub-that's a nice combination," Bilotti says. "I think the Comcast guys have created the best set of metrics in the industry."

AT&T Broadband shows up as the weakest performer. Cash flow per sub and cash-flow margins are dropping, not rising. Though some blame goes to the previous owner of most of its systems, Tele-Communications Inc., the telco subsidiary now generates a third less cash flow per subscriber than the industry average. And despite an aggressive plan for rolling out high-revenue digital and data services, AT&T Broadband's revenue growth is not dramatically better than those of operators moving more slowly on new services.

Bilotti particularly worries about declining cash flows in the face of such heavy capital spending. "Cap ex per sub is twice cash flow per sub, and cash flow is falling. There's a little problem there. How long can they afford this?"

Cox and Charter's capital spending also exceeds annual cash flow, but their cash flow is increasing.

AT&T responds that it expects to improve cash flow next year and that capital spending should slow.

The Study also Found

Cable operators are surprisingly uniform in their ability to increase revenues. Even operators that are aggressively drilling for new revenue by launching new digital and data products are growing sales at around the same rate as those that are unprepared or holding back. Are operators aggressive in new products neglecting basic revenues? Or do the aggressive MSOs foresee an inability to grow basic revenues coming?

There's much greater difference in operators' ability to grow cash flow. Differing mixes of properties, investment in fundamental operations like customer service and spending on new products can hurt rocky AT&T Broadband and well-respected Cox.

Supposed efficiencies from gobbling up other operators haven't clearly materialized. The most tightly clustered operators aren't necessarily the best.

Operators are increasing capital spending to upgrade systems at levels that were unfathomable a few years ago, fueled by favorable capital markets and rich backers like Paul Allen and AT&T. Charter is spending on upgrades almost what it cost to build systems in the first place. One MSO, Insight Communications, is playing catch-up, boosting capital expenditures six-fold since 1998. But Insight's spending is still merely in the middle of the pack.

The Rules

Bilotti looked at the largest eight MSOs, all of which he regularly follows for Morgan Stanley and all of which publicly report their data. The operators serve 85% of all U.S. cable subscribers. Results for 2000 are generally estimates drawn after companies posted third-quarter results and based on companies' guidance.

Bilotti, ranked as Wall Street's top cable analyst by influential
Institutional Investor

magazine, is unusual among cable analysts in that he follows AT&T Broadband. Most Wall Street firms have assigned their telcom analysts, who don't closely follow cable, to cover AT&T. That's understandable but leaves coverage of the company's cable operations spotty. Morgan Stanley, however, splits AT&T between Bilotti and telcom analyst Simon Flannery.

The report card gauges MSOs primarily on a per-subscriber basis. That minimizes variations created by varying sizes and pace of recent system acquisitions and reveals some interesting patterns that are otherwise buried in the multibillion-dollar numbers. Bilotti and Swinburne also include revenue and expenses from new media and residential telephone businesses. Cablevision and AT&T like investors to consider those services separately, but that's like saying, "Look only at the parts that make money, not the ones that lose."

In almost every case, the results are "pro forma"-that is, they assume that recent system acquisitions actually occurred in January 1998. For example, Cox's results for 1998 include the systems it picked up from TCA Cable TV, even though the $4 billion acquisition wasn't completed until August 1999.

Some MSO executives protested that they were being assessed-often unfairly penalized-on the performance of systems they didn't actually operate. True. But we saw the choices as these: assess an MSO's operating history or its system portfolio as it stands today. In years past, a similar report from Bilotti emphasized the history of operating efficiency. But with some takeover-hungry operators ballooning their subscriber holdings by 50% to 100% over the past two years, we wanted to look more at how a portfolio of assets might perform in the future.

Revenues

A lucrative, high-income Long Island and metro New York market lets Cablevision command the highest revenues in the business: a towering $52.90 per subscriber monthly, hardly any of that from new services. Comcast follows at $47.01.

Even though they're now free of federal rate regulation, operators have been moving pretty much in lockstep on rate hikes. Fearful of regulatory retribution, MSOs have not been led into temptation by their easiest source of revenue growth and have held the annual increases to 5% to 6%. That leaves MSOs dependent on ad sales, volatile pay-per-view revenue and new businesses for growth.

But those new businesses aren't boosting revenues dramatically. AT&T and Cox are the most aggressive in launching new businesses, but they're in the middle of the pack. Charter is second from the bottom when it comes to digital and data penetration yet the highest in revenue growth. It is true, however, that Cablevision, which has yet to launch digital cable services, ranks at the bottom.

Worse, AT&T and Cox haven't seen revenue gains even though they were the biggest spenders for system upgrades in 1998 and 1999. "Cap ex so far doesn't correlate to revenue growth," Bilotti said. "Mostly it was about expanding bandwidth for future services that are just getting financial legs."

Here's some math. Operators brag about getting $15 to $20 in new revenue per digital customer. But penetration averages 10% of basic subscribers. So that's $1.50 to $2 in new revenue per basic subscriber, or a gain of around 4% per basic sub. Add that to your 5% basic rate hike, and your revenue per sub goes to 9%.

The good news is that the $30 monthly high-speed Internet services will probably add about the same percentage.

Cash flow

Operators express much more individuality when it comes to how much money they squeeze out of each dollar of revenue. Not surprising, leaders Cablevision ($21.50 per sub per month) and Comcast ($21.25) also generate the highest revenue per subscriber.

But AT&T really sticks out here. Cash flow per subscriber dropped an alarming 16.2% in 1999 and recovered just 5.4% for 2000. That's down more than 5% on average for each of the past two years. Want something really scary? The old TCI systems are even worse than when they were run buy TCI Chairman John Malone, far from the most efficient operations executive in the business. Separating the recently acquired MediaOne Group systems finds that AT&T is generating about one-third less out of each old-TCI subscriber than TCI did.

AT&T Broadband Chairman Dan Somers says that much of the cost crunch comes from product launches and reorganizing recently acquired systems into new clusters. He noted that AT&T's Chicago cluster, which covers 80% of cable homes in the market, was stitched together from the properties of five different operators.

Somers is also looking toward the completion of AT&T's expensive system upgrades. That will allow greater deployment of new interactive, data and telephone products, all of which promise to generate high margins.

Bilotti questions how quickly AT&T can recover from its "dramatic" downturn in cash flow. "It's really hard to significantly and permanently push margins upward," he said.

Product launches are one reason margins have shrunk for some operators. Bilotti says Cox is now spending 7% of revenue on marketing, while some other operators are spending 4%. Cox's is high, he explains, because the company is one of just two launching residential telephone service. Five years ago, an aggressive operator was spending just 2% to 2.5% of revenues on marketing. "At TCI, it used to be 1.5%."

Capital spending

The starkest contrast among operators is in how heavily they're spending to upgrade their plants. Although all operators boast about advanced services, it's clear that some MSOs' systems are prepared and others are playing catch-up.

Cable and Wall Street executives' attitudes toward capital spending made a dramatic turnaround 1996. In past years, capital spending to upgrade systems was seen primarily as a burden, one penalized by investors worried more about a company's debt load than the condition of its systems. A few big spenders hit $200 per subscriber annually; $100 per subscriber was about average. The bare minimum to keep a system up and running was about $30 per subscriber.

But the threat of competition, particularly from satellite TV's DirecTV and EchoStar, convinced investors that spending money to expand channel capacity and prep for advanced services was a good idea. MSOs that expanded channel capacity, offered two-way communication and even laid the groundwork for carrying telephone calls saw their stock prices rewarded, particularly MediaOne Group and Cox. Today, annual spending of $235 per subscriber is average.

Charter is spending almost double the average, $427 per subscriber. Why? The company bought many small-town systems from owners that had neglected them for years, including Marcus Communications, Falcon Cable and Bresnan Communications. Those sellers spent as little as possible on plant upgrades, sticking their customers with systems of 450 MHz or less at a time when 750 MHz had become typical. Charter bought on the cheap, spending about $3,500 to $4,000 per sub at a time when $5,000 was common.

"Charter brags that they spent so little on acquisitions, but they're spending so much more on cap ex, that it was no bargain," Bilotti said. "Charter claims it paid a little over 13 times annual cash, but it ended up 15 times."

Charter Chairman Jerry Kent concedes that the sellers "didn't put much into the plant." But, he adds, Charter is building much more advanced plant than other operators, heeding the "Wired World" vision of Charter controlling shareholder Paul Allen.

While most operators expect an expensive fiber node to serve 500 homes, Charter's advanced plant is designed to carry just 360 homes per node and can be subdivided to just 60 homes per node. The smaller the number of customers on each node, the less likely its subscribers will get the cable equivalent of a busy signal when they use interactive and data services. "Under the most optimistic forecasts of voice video and data, we'll be able to serve our customers without degradation," Kent said.

Bilotti says going to 360-home nodes costs $100 per subscriber. "Take that way, you cut 25% of their cap ex budget."

For some operators, cap ex growth is slowing to a trickle. Time Warner Cable's capital spending per subscriber will increase just 9% this year, to $158. That's largely because the company has spent steadily for years. Cox's spending is actually dropping 3% in part for the same reason. Cox, however, spends twice what Time Warner does, $298 per sub, largely because it is trying to launch telephone services.

Some operators are in a terrible rush. Insight's annual spending has soared 486% since 1998. That's because the company's properties had spent the bare minimum in 1998, just $31 per subscriber. That includes some recently acquired systems that had been starved by Intermedia Partners and Cablevision Systems. "We have always said that we are late in our rebuild cycle," says Insight President Mike Wilner. "We'll be 90% when we're finished with our rebuilds by the end of this year."

So far, the rebuilds are paying off, with Insight's interactive digital services generating $22 in new revenue per subscriber and achieving 20% penetration so far. That's a big reason Insight's growth in revenue per subscriber is so high.

What will Bilotti be watching for his next report card? One element is which operators will boost digital penetration past 20%. Right now, AT&T is on top with 18%, while others are as low as 12% (Cablevision has only a few subscribers inherited from recently acquired systems.)

When Cablevision does launch digital, how much will it merely cannibalize its base of advanced analog customers that pay for extra tiers without requiring a $350 set-top box. That same question also applies to current digital rollouts on Time Warner and old MediaOne systems, both of which aggressively pushed advanced analog tiers over the past three years.

And after years of promising they would slow capital spending, will operators ever really stop laying out cash for upgrades, successfully sell their new products and prove they can generate strong returns on investment?

"They're got to hit the scale economics and start driving cash flow down to the bottom line," Bilotti said. "Otherwise, it's going to be hard to explain why they paid all these prices for acquisitions. You have to prove you can satisfy the demand, that you can execute."


Cash-flow margin/EBITDA as percentage of revenue

<p> <span class="small" id="d9e131-63-small">1998</span> </p><p> <span class="small" id="d9e136-67-small">1999</span> </p><p> <span class="small" id="d9e141-71-small">2000</span> </p>


Insight

48.0%


Adelphia

48.5%


Adelphia

48.4%


Time Warner

46.4%


Time Warner

45.9%


Charter

48.2%


Adelphia

46.0%


Comcast

45.8%


Time Warner

46.4%


Charter

45.8%


Insight

45.4%


Comcast

46.1%


Comcast

45.8%


Charter

44.6%


Insight

44.9%


Cablevision

41.1%


Cablevision

41.3%


Cablevision

40.5%


Cox

40.4%


Cox

39.9%


Cox

38.7%


AT&T

39.8%


AT&T

30.7%


AT&T

27.0%


Cash-flow margin

<p> </p><p> <span class="small" id="d9e334-214-small">Change 1998-2000</span> </p>



Adelphia



2.5%



Charter



2.4%



Comcast



0.4%



Time Warner



0.1%



Cablevision



-0.6%



Cox



-1.7%



Insight



-3.1%



AT&T



-12.8%


Monthly cash flow Per subscriber

<p> <span class="small" id="d9e436-297-small">1998</span> </p><p> <span class="small" id="d9e441-301-small">1999</span> </p><p> <span class="small" id="d9e446-305-small">2000</span> </p>


Cablevision

$19.51


Cablevision

$20.85


Cablevision

$21.50


Comcast

$19.34


Comcast

$20.29


Comcast

$21.25


Time Warner

$18.55


Time Warner

$19.52


Time Warner

$19.87


Charter

$18.49


Charter

$19.49


Charter

$19.85


Insight

$18.49


Adelphia

$19.09


Insight

$19.84


Adelphia

$16.63


Insight

$18.16


Adelphia

$19.42


Cox

$16.31


Cox

$17.50


Cox

$16.74


AT&T

$15.49


AT&T

$12.98


AT&T

$13.68


Cash-flow change

<p> <span class="small" id="d9e635-444-small">1999-2000</span> </p><p> <span class="small" id="d9e640-448-small">Avg. 1998-2000</span> </p>


Insight

9.2%


Adelphia

8.3%


AT&T

5.4%


Cablevision

5.0%


Comcast

4.7%


Comcast

4.8%


Cablevision

3.1%


Insight

3.7%


Charter

1.8%


Charter

3.6%


Time Warner

1.8%


Time Warner

3.5%


Adelphia

1.8%


Cox

1.5%


Cox

-4.3%


AT&T

-5.4%


Capital spending Per subscriber per year

<p> <span class="small" id="d9e773-547-small">1998</span> </p><p> <span class="small" id="d9e778-551-small">1999</span> </p><p> <span class="small" id="d9e783-555-small">2000</span> </p>


Cox

$271


AT&T

$347


Charter

$427


AT&T

$193


Cox

$316


AT&T

$294


Time Warner

$148


Charter

$213


Cox

$262


Charter

$125


Time Warner

$207


Cablevision

$229


Cablevision

$124


Cablevision

$162


Insight

$210


Comcast

$120


Adelphia

$159


Comcast

$173


Adelphia

$93


Comcast

$94


TimeWarner

$161


Insight

$31


Insight

$81


Adelphia

$152


Capital-spending change

<p> <span class="small" id="d9e972-694-small">1998-2000</span> </p><p> </p>



Insight



486.6%



Charter



240.4%



Cablevision



84.8%



Adelphia



63.3%



AT&T



52.9%



Comcast



44.6%



Time Warner



9.2%



Cox



-3.3%


The big eight

<p> </p><p> <span class="small" id="d9e1081-785-small">Basic subs(000s)</span> </p><p> <span class="small" id="d9e1086-789-small">Digital penetration</span> </p><p> <span class="small" id="d9e1091-793-small">Data penetration</span> </p>



AT&T



15,062



18.5%



7.5%



Time Warner



11,753



15.1%



7.6%



Comcast



7,594



17.1%



4.6%



Cox Communications



6,819



13.2%



7.7%



Charter Communications



6,340



12.6%



2.9%



Adelphia



5,488



13.7%



2.8%



Cablevision



2,832



0.2%



6.3%



Insight



916



14.6%



3.1%

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