Cable skies cloudy but rainfall years off

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CHICAGO -- The potential pitfalls in cable's too-good-to-be-true story are mounting.

From accelerating capital expenditures, service saturation and slowing subscriber growth to increased competition and the out-of-home media explosion, the cable business is facing a more fundamental change in industry dynamics than even the largest cable operators are willing to concede, though that might not be evident for several years, when emerging trends have taken hold.

While their record free cash flow and double-digit growth rates are among the best in the media industry, even dominant cable operators Comcast Corp. and Time Warner are wrestling with issues they didn't anticipate even a few years ago. Unlike their $70 billion in system rebuilds, cable operators must add bandwidth capacity and speeds to stay competitive with bundled high-speed data, digital video and Voice over Internet Protocol services being attractively priced by telephone, satellite and other rival providers. Those expenditures will noticeably chip away at their robust free cash flow in coming years.

They also must meet the extraordinary consumer demand for peer-to-peer communications, file-sharing and other tools for producing and delivering broadband video. With high-definition channel availability easily doubling over the next year and cable operators scrambling to create more room through advanced video compression, switched broadcast and node splitting, the race is on for more bandwidth.

Estimated cable industry capital expenditures could top $12 billion in 2007, well below the more than $18 billion in collective investments made in 2001 at the height of the rebuild but well ahead of any significant offsetting revenue generated by the services and products launched off the increased bandwidth, analysts say. Those financial logistics become even more disconcerting when laid against a backdrop of data and video growth saturation that can't be offset fast enough by digital voice subscriber additions.

There simply is nowhere else to go for the kind of substantial growth that has accompanied new bundled services in the past. The 15% of the U.S. TV households not served by any multichannel providers represents the lowest-income households or elderly consumers resistant to change. At the other end of the spectrum, demand for high-end packages has peaked at about 50% of all basic subscribers.

Additionally, Morgan Stanley analyst Richard Bilotti points out in a Oct. 25 report that cable has had "only a modest lift from DVRs, but has not been able to increase rates significantly on digital tiers, and video-on-demand has not meaningfully increased interactive revenues." Over the next three years, cable digital revenue per digital subscriber will increase only about 4% annually. Advanced digital services like DVRs likely will drive modest improvement in average revenue per unit (cable's standard ARPU metric) but are unlikely to shift market shares, he said, reiterating what has been his "cautious view" on the cable and satellite sectors.

The result is a slowing of industry revenue growth from nearly 13% in 2006 to 8.5% next year. Bilotti estimates that all cable operators should generate similar top-line growth rates in the near term, which will deteriorate through 2010. Time Warner Cable is expected to display superior bottom-line growth because of the turnaround of its recently acquired Adelphia and Comcast systems, and Cablevision will display the worst earnings growth because of saturated service-penetration levels, Bilotti said.

It wasn't that long ago when cable operators thought they were completing what they considered the definitive major digital system upgrade and competing primarily with satellite in a barely interactive marketplace. But the rapid advancement, application and consumer adoption, especially of portable digital broadband technology, has surprised everyone.

With $2.4 billion in recently auctioned wireless spectrum under their command, dominant cable operators Comcast, Time Warner and Cox have a hedge to their unrealized wireless joint venture with Sprint Nextel but still are struggling to devise an aggressive out-of-home strategy. That ultimately will prove to be cable's most formidable and underestimated challenge, particularly when the likes of Apple, Microsoft, Sony, Intel and others begin waging an all-out war to provide an in-home hub for downloading, transferring, manipulating and creating content for use on myriad devices and platforms outside of the home.

"Internet bypass is increasingly an area to bear watching from a competitive landscape-changing standpoint, as content owners are establishing a relationship directly with users," Goldman Sachs analyst Anthony Noto said. "The emergence of three devices (Apple's iTV, Intel's Viiv and Microsoft's Media Center) that transmit downloaded Internet content to the television could have significant implications."

With billions of dollars in free cash flow on hand even after increases in capital investments, there's also the possibility that Comcast could buy its way into a larger wireless position by becoming an equity partner in or an acquirer of an existing company. While Comcast prefers to grow noncable businesses organically, time is running out for such approaches without already entrenched strategic partners.

CitiGroup analyst Jason Bazinet speculates that Comcast could use its cash resources to acquire a smaller cable operator, or a content or wireless company, which would depress its stock price and free cash flow levels.

Time Warner will have the stock currency of its majority controlled cable-system spinoff with which to do deals. The biggest deal left in cable is the eventual acquisition of Cablevision Systems, whether private or public, for what some analysts estimate should be as much as $34 a share, compared with the $27 a share offer from the controlling Dolan family.

The rollup of smaller operators will continue, spurred by cable multiples nearing 10-year lows, according to Bank of America analyst Douglas Shapiro, as will the unprecedented privatization activity that began with Cox Communications several years ago and has continued with Insight Communications. The betting is that private equity will play an increasing role in cable buyouts and maybe even in the controlling Dolan family's proposal to take Cablevision private.

But money is not the issue for cable. It's about the need to effectively leverage their wired world strengths in a marketplace exploding outside the home, where stiff competition is coming from unexpected places and consumer adoption of technology is the definitive catalyst for change.

The new concern is how best to compete with rivals -- some of them unexpected -- that can provide the same services, maybe even better or cheaper. Satellite, telephone and other providers are continuously introducing an endless array of integrated options, like the recently launched Homezone from AT&T and EchoStar that integrates DBS television and DSL-delivered broadband.

That has sparked a new robust round of deal activity that has media and entertainment players fortifying their core businesses and reaching for partners and acquisitions from other sectors to improve their competitive muscle in related fields.

So, despite having more cash than they know what to do with, coverage of about three-quarters of U.S. television households and double-digit growth by all measures, cable operators are beginning to reel from some of the same inevitable change agents annoying even the Internet sector, including the leveling off of initial meteoric adoption and revenue growth.

Since dial-up hit an inflection point in 2005, total Internet growth has flattened this year. "Growth in personal computers and total Internet households is unlikely to match the growth over the last decade," Bilotti said. Even MySpace, expected to swell into a $15 billion enterprise in just a few years, concedes to slowing user growth.

Broadband unit growth is slowing to less than 10%% annually through 2010, and cable service pricing is declining on its own without net neutrality mandates. In fact, Bilotti observes that deeply discounted pricing of bundled services will only result in "significant dilution" to cable's revenue per household, total revenue, earnings and free cash flow.

While Comcast has most impressively demonstrated the power of the bundle, which is optioned by 75% of its digital voice subscribers, expected to number around 1.6 million by year's end. The company still has lots of leverage left, with the bundle now available to 95% of its nearly 24 million basic subscribers.

But, even the triple play and voice IP that have been solidly driving Comcast's better than expected returns will begin to level off. They will be clipped by consumers' love affair with wireless telephony, which should comprise 20% of all U.S. households by 2009, matching or surpassing cable telephony despite having it available in 80% of operators' footprint, Bilotti estimates.

At the same time, Comcast cable capital expenditures will jump from $3,6 billion in 2005 to $5.2 billion in 2007, dipping only to about $4.8 billion by 2010. However, the variables and uncertainties notwithstanding, Comcast's free cash flow also is expected to at least double to $4.8 billion by 2008, analysts estimate.

As Bernstein Research analyst Craig Moffet points out, cable operators need a comprehensive strategy for spectrum management in managing the unknowns and in utilizing digital switching, node splitting and shrinking the analog tier instead of a costly all-digital conversion not only for their sake, but the sake of the companies that are part of the cable food chain. Cable operators are not the only ones with something to lose.

"Cable's emerging technology roadmap creates winner and losers across the cable value chain," Moffett observes.

The big winners include equipment manufacturers and suppliers (especially of switched broadcast video and node splitting wares, such as BigBand and OpenTV), while the big losers potentially could be the independent programrs which do not have the supporting leverage of large corporate parents behind them in analog-to-digital distribution negotiations (such as Rainbow Media, Discovery Networks, Crown Media and Hearst). For instance, Comcast expects its analog tier to shrink from 70 channels to 35 channels in five years, he said.

Still, Bazinet is one of the Wall Street analysts who contends that there remains sufficient growth in voice, data and video to keep cable metrics buoyant for the time being, recognizing the growing long-term risks for what they are.

"Try as we might to conjure up a bear case for cable, we simply don't foresee any major operational or financial hiccups on the horizon," Bazinet said. "In fact, we think our near-term metrics are apt to get better, not worse."

But, if history has taught us anything about the media business, it is the importance of even the dominant players remaining vigilant about the unknowns and the long term.
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