Investor anxiety hounds cable

Financial markets question the very underpinnings of the industry
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Cable companies are accustomed to angry subscribers, but lately they're seeing a deeper furor from a new direction: shareholders.

"I believe the wrath of God will come down on all of you who screw shareholders," said a letter that came into the headquarters of one MSO last week, copies of which were addressed to each member of the board of directors. After being drawn to the company's plan to grow by launching new services, the investor called the company's strategy "more of a scam to defraud investors."

That MSO isn't alone. Every public cable operator is under assault in the financial markets, battered by angry investors who have lost billions of dollars and by short-sellers and hedge funds that profit from declining stock prices. Long-routine and long-arcane accounting policies abruptly make headlines as critics worry about abuses similar to those seen at scandal-ridden Adelphia Communications.

Investors who clamored for growth and shoveled cash at operators to invest in new services are suddenly questioning the size of their spending.

Cable operators have all seen dramatic slides in their stock prices during recent months, hit by a combination of worries about Adelphia-esque book cooking to general anxiety about heavy debt. On average, MSO stocks have plummeted about 73% this year. That's even worse than the already vicious 36% drop in the NASDAQ Composite Index.

What's maddening to cable executives is that the stock slump comes just as MSOs are hitting their operational stride. MSOs just posted uniformly great gains in operating cash flow for the second quarter, the best showing in years. The major MSOs posted 10%-15% revenue growth and 12%-27% operating-cash-flow growth. And unlike networks and stations posting gains only in comparison with terrible performance last year, the cable guys are building on fairly strong, recession-resistant 2001 performance (except for AT&T).

Cox Communications CEO James Robbins expressed enormous frustration over the contrast between the stock market and Cox's success in bundling new data, phone and digital cable services. "We're just in the ditch," he said. "Until we can prove the bundle and where it's leading us, we're going to stay in the ditch."

A frustrated Mike Willner, Insight Communications CEO and chairman of the National Cable & Telecommunications Association, said cable stocks are trading at "hysterical lows." He pointed to the last downdraft in 1996, when MSOs faced scary competitive threats from telcos and DBS, $70 billion in capital spending to upgrade systems, and the uncertain prospect of new digital and high-speed Internet services on those upgraded systems.

Willner argued that $60 billion of that $70 billion has been spent, with DBS competition manageable, telcos gone and the new services clearly strong. "With all those risks behind us, does it make sense that cable stocks are selling at historical lows again?" he asked.

Indeed, the best-performing cable stock is Comcast, which gets to brag that it's down only 46% for the year. Scandal-plagued Adelphia, of course, has dropped pretty much 100%.

Stocks that were trading at 20 times annual operating cash flow 18 months ago are trading at 6.5-9 times today, levels last seen during the "highly leveraged transaction" lending crisis in 1991. Investors are valuing MSOs at $2,500-$3,000 per basic subscriber, down from $4,500 or so early last year. The stock slide makes it difficult and expensive to raise money, either equity or debt, and pretty much impossible for operators to look for any acquisitions. And it completely stresses out employees, especially senior executives holding stock options now badly under water.

Why is cable so special? After all, the recession and 9/11 have battered the broad market and even other media sectors just as badly. Disney and its ABC network have taken shareholders on Mr. Eisner's Wild Ride. Fox Entertainment has been off 30%-40%. TV station groups Young Broadcasting and Granite Television trade as if they were heading into Chapter 11. Radio-station giant Clear Channel has plunged 50% in the past three months.

The difference is that the ad-supported media are being pounded largely by the ad cycle. If not crippled by a huge debt load, they'll probably bounce back when the ad spending turns back upward.

Cable's crisis is more fundamental. Investors and lenders are questioning the very financial underpinnings of the business. They're doubting, for example, whether operating cash flow—the fundamental measure of cable operators' performance for years—is a valuable yardstick any longer. They're criticizing cable operators' strategy of not just plowing all their spare cash into system rebuilds but borrowing even more to add more services in more markets.

They say they want to see "free" cash flow. Not EBITDA earnings "before" interest, taxes, depreciation and amortization, and capital expenditures but the money left over after the cash-burning elements of that equation—interest, taxes and capital expenditures—are paid for.

That's a dramatic crisis of faith, because cable operators have hugely negative free cash flow. A long history of stable cash flow has let them operate with much more debt than businesses more vulnerable to a recession, such as newspapers or retailers, would ever dream of trying to carry. That can dramatically increase an operator's return on capital—the most important of all financial measures—but interest costs also eat up free cash flow.

More important, to prepare for new services, operators have spent heavily to rebuild their systems: new headend gear at every central office, new trunks down every major road, new nodes in every neighborhood, new amps on every block, new drops from the pole to almost every house. That creates the opportunity for huge new revenues from digital, high-speed data and, for some ops, telephone services. But every digital subscriber requires capital for a new $300 set-top box. Almost every data customer needs a new drop from the pole.

Operators call that "success-based" capital spending, which investors should like because it brings new money. But it also means that Cox will add $1 billion in debt this year, according to Bank of America analyst Doug Shapiro. Charter is adding $1.6 billion; Cablevision, $1 billion. Comcast's cable operations should generate $457 million in positive free cash flow but turn negative for a year after it buys AT&T Broadband's systems.

The heavy-capital-spending cycle is supposed to be coming to an end, and some companies are predicting that they will start generating free cash flow within a year. Robbins said that's the way cable has always worked. "There's two to three years of heavy spending, then you harvest."

Investors want more evidence that the harvest is really coming.

"There's a crisis of confidence in capital-consuming companies," said one hedge-fund manager. "I'm not sure there's a lot the companies can do except demonstrate eight quarters of movement toward free cash flow."

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