Cable's Defensive Nature Is Underappreciated

• BySteve Birenberg, RealMoney Contributor
• On 9:22 am EST, Monday November 24, 2008

Despite slower current and forecasted growth, the major telco stocks, AT&T and Verizon , have recently outperformed the major cable stocks, Comcast , Time Warner Cable and Cablevision . Telco stocks have gone down less when the market crashes and gone up less on rebound days like Friday.

Both industries are feeling the effects of the recession, especially the impact of fewer housing starts, more foreclosures and lower housing turnover. Both industries also face large ongoing capital expenditures to keep their networks competitive. Overall, though, the competitive environment has remained fairly stable as the industries battle head-to-head for TV, telephone and Internet subscribers. I suspect that lingering negative sentiment toward cable due to past unexpected increases in capital spending budgets and the lack of significant dividends from the cable stocks are the primary culprits for cable's underperformance. Telcos have proven themselves in the past as defensive investments; cable has not.

Also contributing to cable's recent lagging relative performance was the statement from Time Warner Cable that it witnessed a "dramatic decline" in RGU growth in October. RGUs are revenue-generating units and represent subscriptions to the various services offered by cable companies, including basic TV, digital TV, telephone and high-speed Internet. This could clearly be read quite negatively, possibly indicating that growth in new subscribers to digital TV, telephone and Internet has halted and that the loss of basic cable TV subscribers has accelerated. Keep in mind, however, that RGU counts exclude add-on services like DVRs and HD subscriptions, which add to monthly bills and support stable average revenue per user (ARPU).

I strongly suspect that the demand shock hitting the economy has caused a pause in new subscriptions to advanced services. This could is probably being offset to some extent by slowing housing turnover, which takes the pressure off competitive environment and reduces churn.

But let's assume that RGU growth has stalled completely and remains at zero for several quarters, inducing no new subscriptions to add-on services like DVRs and HD. This is more conservative than even the most bearish cable analysts assume. They are still looking for growth of several hundred thousand RGUs per quarter for Comcast and TWC and higher penetration of DVRs and HD.

Subcribers 4Q07 1Q08 2Q08 3Q08 Telephone 15,121 16,515 17,665 18,749 Broadband 35,621 37,025 37,810 38,820 Basic TV 64,880 64,863 64,646 64,353 Digital TV 37,144 38,280 39,162 39,994 Sequential Growth 1Q08 2Q08 3Q08 Telephone 9% 7% 6% Broadband 4% 2% 3% Basic TV 0% 0% 0% Digital TV 3% 2% 2% Annual Growth 4Q08 1Q09 2Q09 Telephone 24% 14% 6% Broadband 9% 5% 3% Basic TV -1% -1% 0% Digital TV 8% 4% 2% Source: SNL Kagan

The first table shows actual subscriber counts for the major services offered by the cable industry. The second table shows sequential growth. Sequential growth is clearly slowing, but it remains positive and will be positive if the most bearish estimates are met. But assuming sequential growth goes to aero, the final table shows how year-over-year growth would look assuming third-quarter subscriber counts remain unchanged.

Assuming stable ARPU -- a good assumption for several years (especially given the lift from DVRs and HD) -- the first half of 2009 would still show nicely positive revenue growth. The third quarter of 2009 would obviously be flat year over year, but the message here is that even if Time Warner Cable's "dramatic decline" takes RGU growth all the way to zero, the major cable companies will still grow revenues by low- to mid-single-digits in 2009.

This should translate into similar EBITDA growth, as margins are pretty stable. Positive EBITDA growth is leveraged into a higher growth rate in free cash flow if capital expenditures are held flat, but if subscriber growth disappears completely, capital spending will likely fall because much of it is made up of modems, set-top boxes and other subscriber-based equipment, leading to double-digit free cash flow growth even in a no-growth environment.

The bottom line is that cable stocks are more defensive than currently perceived. The negative sentiment and mistrust of cable that has built up over many years is somewhat deserved and will be difficult to overcome. The best way to overcome it, though, is for the industry's leading players to prove their financial model is defensive in a downturn.

The downturn is upon us. I think it is a good bet that cable results over the next several quarters will increase investor confidence in the industry. When that happens, the defensive characteristics of cable will be rewarded, just as it is being rewarded now at AT&T and Verizon. This makes cable stocks an attractive investment relative not only to the telcos but also to many other industries that will have a much harder time keeping revenue growth in positive territory for the next three or four quarters.

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Know what you own: Birenberg mentions Time Warner Cable, of which 84% is owned by Time Warner . Other companies in the CATV industry include Viacom and Shaw Communications .

Buzz up!