Wired for Gains in 2001

Wired for Gains in 2001

In a stormy market, some cable stocks may provide a refuge. Remember the optimism of January and February, when a gung-ho market was cheering for the Dow to reach 12,000 and for the Nasdaq Composite to hit 6,000? Remember, then, how tech stocks led prices into the abyss this fall?

Cable stocks went along for the ride.

While the MSOs weren’t exactly the darlings of the market this year, they have outperformed companies delivering cable programming, Internet and interactive services to viewers’ homes, such as Excite At Home, Terayon and OpenTV. These companies, high flyers earlier this year, plummeted earthward this fall, losing as much as 90% of their value.

That makes cable look like a haven.

"Cable could be a good place going into 2001," says Doug Shapiro, who follows the group at Banc of America Securities.

As an industry, cable is perceived as recession-resistant by market-watchers.

When families can’t afford tickets to The Full Monty on Broadway, staying home and watching movies on the small screen — pay-per-view, of course — looks like a mighty good alternative.

What’s more, analysts say, since cable operators in general are heavily leveraged, as a group they also tend to be highly interest-rate-sensitive — good news for MSOs if interest rates come down.

Shapiro also sees the competitive environment stabilizing and even slowing somewhat. Operators, he adds, have accelerated the deployment of new services, and investors are starting to get a better picture of how cable’s advanced services play into the bottom line.

That makes "a good recipe for outperformance," he says.

With that in mind, Cable World went in search of the best stock buys within the cable, broadband access, interactive TV and media worlds as we head into 2001.

Before looking forward, it pays to take a look at why the market turned upside down this year, prompting recessionary fears.

The Federal Reserve increased interest rates six times since mid-1999 in an effort to cool the super-heated economy; the dot-com sector collapsed; oil prices gushed; and the SEC’s Regulation FD pushed companies to issue warnings about the slimmest chance they might not meet projections.

To top it all, market concerns "hit a crescendo with the biggest uncertainty of all: a United States without a president," says Paul Kagan, president, Kagan World Media.

The result?

"We’re in a valuation valley right now," Kagan says.

"In an environment like this, with stock groups down anywhere from 40% to 90%, most stocks have limited downside," he adds. "Even the first recession in nine years seems to be built into the current prices of most stocks."

For investors with money to invest now, that appears to be a silver lining. With the advent of a new year just around the corner, money managers are welcoming a new quarter and a clean slate.

The following list of 10 picks to click for 2001 was compiled from conversations with a range of industry analysts. Overall, they expressed optimism and excitement about these companies’ prospects — particularly as we move closer to the convergence of the PC, Internet and television. All share prices noted are as of Dec. 12.

n Charter Communications stands out among cable operators for its heavy debt load, making it one of the MSO group’s best risk/reward stories.

St. Louis-based Charter, known as the company Microsoft co-founder Paul Allen built, shouldered $12.2 billion in total debt as of Sept. 30 — and it still needs more money.

Between this year and the end of 2002, Charter plans to spend $6.4 billion in capital expenditures, $3.5 billion of which will go toward upgrading and rebuilding Charter systems to 550 megahertz or greater. Charter projects a $1.75 billion funding shortfall through late 2002, which it expects to satisfy with additional high-yield offerings and additional bank debt.

That means risk-averse investors should stay away, but for those who can stomach the uncertainty, Charter is a play that could provide one of the better returns among cable operators, says Shapiro at Banc of America.

"When the market perceives that value is climbing, the stocks that are the most leveraged will do the best," Shapiro says, citing Charter and Adelphia Communications as examples.

Charter, he points out, has jumped into offering advanced services such as video-on-demand and expects to offer cable telephony services to selected systems. That additional revenue should help the company turn cash-flow positive by late 2002. For now, investors can take heart in Charter’s 48% cash flow margins, among the highest in the industry.

Bottom line: At $20.81, Charter is trading at eight times next year’s cash flow — a bargain by most standards.

n Cablevision Systems is also mentioned by industry analysts as a top stock pick for 2001, primarily due to speculation regarding the programming and sports assets it owns under its Rainbow Media Holdings division.

Analysts are predicting that the Rainbow assets now assumed to be up for sale (for the past 18 months or so Cablevision had been planning to spin out certain Rainbow assets into a tracking stock) could fetch as much as $4 billion. Watch for more news from Bethpage, N.Y.-based Cablevision by early January.

"If you’re looking at near-term triggers, Cablevision stands out" due to the benefit it could reap if it sells a portion of Rainbow, says Gary Farber, who follows the cable group at S.G. Cowen Securities.

In addition to the 3 million-plus subscribers Cablevision owns in the coveted New York metro area, its much-prized ancillary assets include Radio City Entertainment, the New York Knicks and Rangers, and long-term contracts with the Mets, the Islanders and the New Jersey Devils.

The MSO is also rolling out advanced set-top boxes from Sony, a move that will give it an edge in offering advanced digital and interactive services.

On top of that are the long-standing murmurs that Cablevision may be a takeover play when founder Charles Dolan finally decides it’s time for an exit strategy. If that transpires, Time Warner Cable, the second-largest operator after AT&T Broadband, with about one third of the New York area cable subscribers, would likely step in as a willing buyer, provided it can get around ownership caps.

Bottom line: The stock has been strong recently, having climbed steadily to $80.81 from a low of $55 in March. But at a 2001 cash-flow ratio of 10.8, it’s attractive.

For long-term investors, Comcast and Cox Communications, the third- and fifth-largest MSOs respectively, are consistently mentioned as the "blue-chips" of the cable industry.

n Comcast, the bellwether of the operator group, also owns more than half of television shopping network QVC, an asset valued at more than $7 billion, as well as interests in E! Entertainment Television, the Philadelphia Flyers hockey team and a regional sports network.

It hasn’t ignored its cable interests, spending about $15 billion over the past 18 months to acquire 3.5 million subscribers.

A leader in the digital cable realm, Comcast ended the third quarter with 1.13 million digital customers. Its market penetration for digital services reached 17%, and Comcast expects to end the year with 1.35 million digital cable subscribers. The company is also aggressively launching its high-speed Internet access product, Comcast@Home.

Bottom line: The cloud over the stock market has yet to lift from Comcast, which is trading at $35.81. That means its valuation, at 11.62 times next year’s cash flow, puts it in bargain territory.

n Cox Communications is also aggressively rolling out new services, using its cable networks to offer local phone service and reselling long-distance. Most of its cable plant should be upgraded by the end of this year, and Cox is leading the industry with its bundled service offerings of telephony, digital video and high-speed Internet access.

Cox observers also like its investment stakes outside the cable arena, namely Excite@Home, Sprint PCS, and Discovery Communications.

Excite@Home, for example, started as an operating asset before shifting to a financial asset with the influx of subscribers, says Farber at S.G. Cowen. It should now be viewed as a strategic asset, he adds, as Cox may end up swapping the stake for more cable subscribers.

Bottom line: Investors have typically awarded Cox with a valuation premium due to its leadership position, and that still holds true despite the downturn in the market. At $41.94, Cox trades at 15.76 times next year’s cash flow estimates.

n Liberty Media Group, the John Malone-controlled investment vehicle, will be spun off from parent AT&T next year and thereby gain its financial flexibility. It has certainly not escaped a drubbing — at $15.25, shares are about 50% off their highs.

Liberty "is the only way to participate in a couple of businesses that have tremendous opportunity" in the digital programming and services areas, says Morris Mark, chief executive of Mark Asset Management and a Liberty shareholder.

In addition to the assets Liberty owns outright — Starz Encore, half of Discovery Communications, and its piece of United GlobalCom, the largest cable operator outside the United States — Liberty’s four major investments should propel the shares, Mark says.

Liberty will be a large shareholder of AOL Time Warner when that deal closes, and its stake in News Corp. gives it access to valuable programming and satellite properties. Its telecom stakes in Sprint PCS and Motorola, Marks adds, give it opportunities in Europe and China.

Bottom line: Although Liberty has struck out with some of its investments — for instance, it will take a loss on its $500 million investment in bankrupt telecom ICG, and several of subsidiary Liberty Digital’s Internet investments were hit hard this year — the potential is clearly there with Malone at the helm, Mark says.

n AOL Time Warner’s birth is eagerly awaited on WallStreet.

Time Warner’s empire spans film and television, cable programming networks and cable systems, publishing, music and digital media. When Time Warner is officially merged with AOL in the coming year, the new entity will also control the largest Internet access provider in the country, with about 26 million subscribers.

Open access is the critical issue facing both company’s executives, but the combined company’s agreement with ISP Earthlink seems to have allayed FTC fears that Time Warner’s cable systems would favor AOL.

Bottom line: While an expected slowdown in ad sales could put a damper on the combined AOL Time Warner, analysts predict negligible impact on the colossus’ stock price.

Analysts are also bullish about several stocks in other cable-related businesses.

n Scientific-Atlanta generates nearly 90% of its revenue from the broadband equipment market, with nearly half of that coming from set-top boxes. With every major cable operator rolling out digital cable and advanced services that require a smarter set-top box, S-A enjoys an advantage in a quickly growing market.

"There are only a few real players in set-top boxes," says Andrew Vinton, a portfolio manager at J. Goldman & Co. Vinton counts S-A among his top picks because "Scientific-Atlanta has the relationships" that will allow it to outperform next year, he says.

The Norcross, Ga.-based company recently unveiled the Explorer 8000, its most advanced set-top yet, and also announced purchase orders from Time Warner that will span the next two years.

PowerTV, an S-A subsidiary, leads the market with software installed on about 5 million set-top boxes, one reason why both sales and revenue are jumping.

Bottom line: Analysts like the company’s diversification, with some calling it the Cisco Systems of cable and broadband. While Scientific-Atlanta shares have been cut in half this year, to $51.88 for the most recent quarter, S-A’s revenues jumped more than 70% to $600 million, reflecting the deployment of digital interactive services.

n Com21 is more of a cable modem pure play, a growing business for which it should be sitting pretty over the next few years.

While much of Com21’s modem business has been supplying modems manufactured elsewhere under its own brand, the company has wisely begun manufacturing its own modems.

The trend in the cable modem business has been the rise of Asian-based equipment manufacturers, says Patti Reali, senior telecommunications analyst at Gartner Group. She foresees a price war as that industry undergoes a transformation similar to what happened with analog modems.

The key to success in that type of environment is driving down costs and getting into niche markets, Reali says, two strategies Com21 has already implemented.

By producing its own modems, Com21 gains a higher margin than by selling third-party modems. Further, it is working in the voice-over-Internet protocol (VoIP) niche — a sector that cable operators are seeking to exploit as they deploy cable telephony.

Com21, the fourth largest modem supplier by market share behind Motorola, Terayon and 3Com, is also working on consolidating markets. To that end, it acquired GADline, an Israeli company that provides networking solutions to deliver high-speed access and data over hybrid fiber coaxial infrastructures.

Bottom line: At $8.50 a share, there is a lot more upside potential for Com21’s 2001 prospects than downside risk to the stock, says Anton Wahlman, who follows the stock at UBS Warburg.

n While Seachange International is in the sexy space of interactive TV, it also boasts a long-lived stable business that garners far less press.

Seachange owns a server system that manages digital video for television and telecommunications companies. Since this digital ad insertion is local, it is not expected to be affected by the national downturn in advertising that is anticipated to hurt the national cable networks.

Its spot system has captured nearly 80% of this market and accounts for a little more than half of SeaChange’s revenue. SeaChange also got a vote of confidence from Comcast earlier this month when the MSO took a $10 million stake in the company.

Comcast has already tapped SeaChange’s ITV system for video-on-demand in two markets, while Cablevision selected SeaChange for its VOD rollout in the New York area. The company also recently expanded its alliance with interactive products company Liberate Technologies.

Bottom line: The interactive TV space will be fiercely competitive in coming years, analysts say, but at $31.13, SeaChange is fundamentally cheaper than its main publicly traded rival, Concurrent Computer.

Vinton at J.P. Goldman likes SeaChange, as it is cheaper than its rivals, for starters. But, he says, SeaChange also has a "scaleable technology, and its underlying business can grow," especially if broadcasters decide to go digital.

n Antec shares took a big hit when AT&T Broadband asked all its vendors to stop shipments of hardware supplies to the cable operator until the end of the year.

No wonder — AT&T, which owns 20% of Antec, was responsible for more than 40% of its revenue. Antec’s product lines run from laser transmitters to cable and modems to brackets and bolts.

Bottom line: So why buy Antec now? At $9.50, Antec has yet to recover from the hit it took after the AT&T shock, but its price-to-earnings ratio is 8, well below the market average of 25. This may be a longer-term play, says Wahlman at UBS Warburg, but if cable telephony takes off using Internet protocal standards, Antec stands to gain.

The cable group has not been as sexy as the Internet and tech stocks have been in recent years, but it has also not been as volatile. Right now, the macro enviroment looks good for the group, and the introduction of advanced services should propel both cash flow and value per subscription.