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Monday, March 22, 1999

An Investment Opinion
by Alex Schay

Comcast: A Deal for Its Share of the Future

When discussing the cable TV business in the 1990s, a seminal event that seems to crop up constantly in both media coverage and among those conversant about the industry is Microsoft's multi-billion dollar investment in Comcast (Nasdaq: CMCSK) in the spring of '97. It was then, or so the presently accepted chronology goes, that the industry received the validation it needed -- and spirits as well as stock prices were lifted. As Michel Foucault might characterize it, "frameworks of knowledge" and "modes of understanding" are always changing, thus, cable went from being understood as a one-directional distributor of broadcast video to a platform for broadband connectivity to the home (and the conduit through which a whole new generation of advanced communication and entertainment services could be shipped).

At the beginning of 1997, the dominant perception of the cable business among investors was of a moribund industry -- on the verge of being eclipsed in popularity by digital broadcast satellite (DBS) and relegated to the role of a "leap-frogged" technology. The Cable Act of 1992 constrained revenue growth in an industry that had enjoyed strong pricing power, and the "new" services the cable industry was forced to hype never seemed to materialize. The combination of slowing top-line growth and the need to make even greater capital expenditures severely depressed the business.

However, the old "utility model" predicated on unit and price increases was easily shunted aside, as the possibilities inherent in the broadband world became more clear. Unless you've just recently arrived on Earth, you've probably heard the term "bandwidth" kicked around. Bandwidth can be confusing because it is used to describe both the size of the section of frequency spectrum (measured in cycles per second, or Hz), as well as the size of a bit stream (measured in bits per second, or Bps). The term "broadband" has morphed into a suggestion about anything that can provide a lot of bandwidth, although strictly speaking, broadband refers to "telecommunication that provides multiple channels of data over a single communications medium using frequency division multiplexing." Big fat pipes that carry lots of stuff.

With expected growth from voice and data services coming to the fore (as much as 40% of annual revenues by 2005) and the anticipated return to positive operating cash flow (after the completion of plant upgrades), it's easy to see how cable industry multiples to cash flow have soared over the last two and a half years -- from the mid- to high-single digits to present levels in the mid-double digits.

Today, not too long after the announcement by AT&T that it would engage in a joint venture with Time Warner, the nation's third-largest cable provider MediaOne Group (NYSE: UMG) moved up $7 3/4 to $68 1/2 after agreeing to merge with number four cable firm Comcast Corp. (Nasdaq: CMCSK). The $60 billion deal announced today values MediaOne at $80.16 a share (swapping 1.1 Comcast special Class A's for each MediaOne share), based on Friday's close, which represents about a 32% premium over MediaOne's last closing price of $60.75. Curious about the rationale for doing a deal now? Here's a review of some of the broader points of note:

-- Market density is not just an issue for the trash haulers. With 55% of the combined firm's properties overlapping, it represents a strong opportunity to leverage the infrastructure (about $600 million in cost savings) as well as generate new top-line options. In addition, increased customer density is estimated to give the combined firm $50-60 million in new advertising opportunities.

-- By year-end, both companies will already have 70% of their plant upgraded to the 750Mhz two-way interactive standard. From Comcast's perspective, it's great not to have to spend additional cash on plant upgrades to get an acquisition "up to speed" when it can align itself with a firm that has already been aggressively spending on the necessary technology.

-- When building a facilities-based business, scale is key, but it's also important on the regulatory front. Many technology standards and public policy questions are in the process of working themselves out. Increased size will give Comcast a more influential position at the table.

Despite all the broadband talk though, MediaOne will still probably only generate about 5% of its revenue from voice and data in 1999 (with digital video a wildcard in the second half of the year), and its operating margins are a solid 10 percentage points lower than Comcast's industry leading 48%. However, what these issues really seem to reinforce is that companies in the cable business are at a crucial juncture where long-term decisions have to be made now. While exciting, incorporating the cash flow changes into discounted cash flow (DCF) models can be confusing for individual investors because of the lack of visibility among the various service offerings.

It's important to note that for a very long time though, many industry observers felt that the cable firms would never get to the point of being cash flow positive. The plethora of services that will be available a mere two years from now presents a case for some optimism about returns on infrastructure investment -- a case that couldn't be made a mere two years ago. The cable business is still keeping its promises.

[Discuss this column on the FOTH message board.]

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