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Time Warner Cable Seeks to Balance Pricing and Growth

Michael Hodel, CFA

The relatively weak subscriber trends Time Warner Cable (TWC) has posted recently carried into the third quarter and were exacerbated by the programming dispute with CBS, which resulted in the blackout of CBS-owned content in several markets during August. The firm shed 304,000 net television customers during the quarter, more than double the number of a year ago. TWC lost 24,000 net residential Internet access customers as well, its first-ever negative quarter on this metric. Management acknowledged that its decision to reduce emphasis on promotions to attract new customers has had a bigger impact on customer growth than expected. Increasing revenue per customer has allowed total revenue to continue growing, though only modestly.

We believe the dispute with CBS was a failure for TWC. With television service taking a backseat to Internet access in importance to TWC's long-term profitability, we would prefer the firm work constructively with its programming partners, giving more on programming margins to ensure the best possible customer experience. The firm’s satellite rivals can’t afford to be as generous. Still, we believe that TWC's competitive position remains strong and that better execution will enable it to improve its performance over time. We believe the current share price reflects overly optimistic expectations that the firm will be acquired, with Charter Communications (CHTR) the most likely suitor.

Solid Position Allows TWC to Make a Few Mistakes
Time Warner Cable has made tactical mistakes over the past several quarters, experimenting with various pricing and promotional efforts. The firm now seems to be moving in the right direction, emphasizing revenue per customer over raw customer growth. We continue to believe the firm enjoys a solid competitive position in the majority of the markets it serves, giving it the luxury of making mistakes without dramatically altering the steady cash flow the business reliably generates.

The strength of TWC's networks remains a key competitive advantage. The firm serves a bit less than one fourth of all households in the United States, offering packages of television, Internet access, and phone services that competitors in most areas can't match independently. AT&T (T), the phone company across about 40% of TWC's territory, has upgraded parts of its network to offer TV services and faster Internet access, but we're skeptical of its network's ability to match TWC's. Verizon (VZ), which covers about 30% of TWC's territory, has undertaken a more ambitious network upgrade, but its plans have been costly and time-consuming, and we expect it will avoid a price war to generate a return on its investment. Also, the Verizon network upgrade is currently only available to about 13% of Time Warner Cable households. This percentage should top out around 15%, limiting the impact on TWC's business overall. Other firms, notably Google (GOOG), have threatened to build completely new fixed-line networks and offer inexpensive service, but we believe the impact of these efforts will remain immaterial for the foreseeable future.

TWC has pressed its network advantage aggressively to boost customer penetration. The number of television customers served has declined fairly slowly despite the rising presence of the phone companies, continued satellite competition, and weak employment growth amid a very mature business. More important, TWC is taking revenue from the phone companies directly. The firm has continued to expand its Internet access customer base, now providing this critical service to about 37% of the households it reaches, and about 17% of the households in the firm's territory have switched to its phone service. We believe the phone companies will have a hard time justifying heavy network spending in areas where TWC has won a large number of phone and Internet access customers.

The future isn't without risk for TWC, though. New means of receiving video content, notably via the Internet, will probably pressure the firm's television business in the coming years. This trend increases the importance of a high-quality Internet connection, which matches well with TWC's strengths. But erosion of the firm's TV customer base threatens to cut into revenue and profit per customer. Wireless data services also present a threat to TWC's business. As wireless carriers roll out new technologies, wireless could become a viable Internet access and basic video option, pressuring TWC's market share and pricing power. We believe that wireless service is inherently limited in its ability relative to a wired network, though, and that TWC's ability to offer a high-quality experience in the home will remain well ahead of wireless technology for many years to come.

Strength of TWC's Networks Is Key
As with other cable companies, we believe the heart of TWC's moat rests in its networks. In most of the areas the firm serves, it is the only carrier capable of offering television, Internet access, and phone services over a single network. In addition, we believe the firm's strongest advantages are found in the Internet access business, which is likely to remain a staple utility for most consumers well into the future. TWC has been able to enhance the capabilities of its network in recent years at minimal cost, thanks to the architecture of its network and advances in technology. For example, the firm has rolled out technology to more efficiently use network capacity to provide television service while also investing in equipment that allows it to offer Internet access speeds of 50 megabits per second, around 3 times the maximum speed previously offered. Despite these investments, capital spending actually has declined as a percentage of sales each year since 2006.

Phone rivals AT&T and Verizon, on the other hand, have had to spend heavily on new cabling and equipment to improve network performance. After years of effort, these firms' networks reach about 40% of TWC's territory, with the superior Verizon FiOS network touching only 13%. We think expansion significantly beyond this point is unlikely because these firms have heavily lost share of total customer spending on fixed-line telecom services. Since the acquisition of Adelphia's properties in mid-2006, TWC's television penetration has declined gradually, from 51% to 41% currently. By contrast, we estimate AT&T's phone customer penetration has dropped from nearly 70% to about 32% during this period. TWC has picked up a decent chunk of these phone customers, with penetration at about 17%. AT&T has gained some television share, but its customer base totals only about 9% of the homes in its territory. TWC has also consistently gained share in the Internet access business over the past couple of years. The combination of growing market share and an efficient network platform should enable TWC to maintain a lead on the phone companies in most areas. In those areas where TWC's network is inferior, the firm will suffer, though it should still enjoy a cost advantage.

TWC's moat in the television business has eroded during the past several years. Satellite providers have gained the scale needed to compete effectively, and the phone companies have brought their resources to bear on the industry. The owners of unique, popular content have been able to extract large price increases as the number of distributors has grown. However, we believe TWC's diverse revenue mix places it in a stronger position than the satellite companies to weather the changing television landscape.