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Monday, February 1, 1999

An Investment Opinion
by Alex Schay

Meteor Looming Over Competitive Landscape?

Today, the largest communications provider in the U.S., AT&T (NYSE: T), teamed up with the largest media and entertainment company, Time Warner (NYSE: TWX), to form a joint venture that has the potential of impacting the competitive landscape of the local telecommunications market like a meteor. Whether or not the meteor breaks-up before impact depends on the joint venture's ability to become the "real" low cost provider in the system -- as well as the subsequent adoption rates for the various service offerings in its target markets. Under the terms of the deal, AT&T will own 77.5% of the venture and Time Warner will own 22.5%.

The potential reach is certainly crucial -- as the number one cable provider, Time Warner gives the AT&T/Tele-Communications Inc. combination the potential to reach a total of 42.7 million homes (over 40% of the country). If affiliates are included in the calculation, the joint venture has the possibility of reaching half of the country with video and data offerings, and roughly two-thirds of the country with some form of telephony. If the joint venture meets with some initial success, more ventures could materialize rapidly.

Tele-Communications Inc. (to be acquired by AT&T)
- 17.7 million homes passed
- Majority of subs in CA, IL, WA, CO, TX
- 17.9 million affiliate households passed
(7.6 million already covered through joint
venture agreements)
- @Home Relationship

Time Warner Cable
- 20 million homes passed in 33 states
- Majority of subs in FL, NY, NC, OH, TX
- 70% of plant is 2-way
- Most systems upgraded to 750 Mghz
Source -- JV analyst presentation

For Time Warner, the deal is almost a no-brainer, fulfilling the oft-stated objective of maximizing the value of its broadband cable infrastructure. Time Warner has been spending gobs of capital on its two-way switched digital network, on the order of $6 billion thus far, or $1.5 billion per year. Through the joint venture, Time Warner is capturing some nice incremental growth with no investment of incremental capital beyond its existing plans to upgrade to the 750 Mghz architecture. The firm expects that roughly 85% of its upgrades will be completed by the end of this year, and the remainder will come by the end of 2000.

The joint venture will pay Time Warner $15 per home passed for the privilege of receiving access to each home reached by Time Warner's network ($7.50 on delivery of the home at signing -- contingent on the home being 2-way upgraded and powered -- and the balance a year from now). This comes to a total outlay of around $300 million. Of the 20 million homes that Time Warner currently reaches, roughly 12.6 million presently subscribe to the firm's cable TV services.

As well, Time Warner will receive benefits from the following recurring payment schedule once the telephony service is up and running:

The joint venture pays Time Warner a monthly fee for each telephony customer
--Yrs. 1-3 = $1.50; Yr. 4 = $3.50; Yr. 5 = $4.50; Yr. 6+ = $6.00

...and guarantees the following minimum penetration rates (market-by-market) of
--Yr. 1 = 0%; Yr. 2 = 5%; Yr. 3 = 10%; Yr. 4 = 15%; Yr. 5 = 20%; Yr. 6+ = 25%

Finally, Time Warner will also receive a 15% share of the average telephony revenues (in a particular cable system) in excess of $100 per customer following the fifth year of certification. Of course, the minimum market share guarantees don't reflect what the joint venture actually thinks the partnership can do. AT&T Chief Executive Michael Armstrong opened the "big" conference call today with the "conservative" assessment that the joint venture could see 25% penetration in the first three to four years -- or about $4 billion in revenues and a fourth year break-even point.

Assuming this penetration rate comes to pass, it could mean up to $400 million of incremental revenue and $300 million of incremental cash flow for Time Warner. That's pretty peachy for Time Warner (and is also good for AT&T, considering its overall ownership stake in Time Warner), but certainly doesn't jibe with the price move today, slipping $3/16 to $62 5/16 -- implying that current multiples might be a bit rich, or that the market is taking a wait and see attitude on the penetration rates.

Overall, AT&T expects the joint venture to spend $300 to $500 for each customer that signs up for the service -- assuming use of internet protocol (IP) telephony that will be available in the year 2000. For circuit switched network customers, the joint venture will pay $750 for each person who signs up for the service. AT&T noted that it will pay an additional $15 per subscriber to place backup power systems on the cable network.

AT&T fared better than its joint venture partner today, moving up $2 13/16 to $93 9/16. The firm took another strong step toward its goal of becoming the leading carrier of end-to-end facilities-based communications services, and investors are reacting warmly to the announcement. With twisted pair wire and coaxial cable providing only the most tenuous of links to the American consumer, it's extremely important from a strategic standpoint for telephone powerhouse AT&T -- which pays upwards of $10 billion per year to the local phone providers -- to try and control cable. And while AT&T continues with its cable adventures, it looks like it's going to redefine a number of industries in the process.

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