Plugging Into an Improving Market for Cable Stocks

Includes: CHTR, CMCSA, CTL, DIS, T, VZ
by: Morningstar
By Michael Hodel
The competitive landscape for the cable industry improved slightly in 2009, in our opinion. Our recent reports on the industry have focused on three major competitive threats to cable firms: competition from the phone companies, the expansion of wireless data services, and the prospect that alternative video distribution methods shrink demand for traditional television services. Our view is that the first of these threats has subsided a bit, but the second and third have remained stable. However, we think that the stocks have already moved to reflect a more positive outlook for the industry, and none of the stocks we follow in the industry look as attractive on a valuation basis as they did when we last visited the industry. Shares of our long-time favorite Comcast (NASDAQ:CMCSA) have moved up a bit, and we also lowered our fair value estimate modestly in the wake of the NBC Universal acquisition announcement last December. Shares of Time Warner Cable (TWC), soon to be the largest pure-play cable operator, have run well beyond the price at which we'd consider buying in recent weeks. We would keep this wide-moat firm on the radar, though, should cable stocks fall back out of favor with investors--which seems to happen with regularity.

Among the three threats facing cable, the tenor of phone competition has changed the most lately. Verizon (NYSE:VZ), in particular, has pulled back on promotional activity around FiOS, its network upgrade initiative. Customer growth has slowed as a result, even within its relatively nascent television business. The chart below shows the pace at which Verizon and fellow phone giant AT&T (NYSE:T) have been stealing television customers over the past three years. The dip in the second half of 2009 at Verizon is particularly interesting because the number of homes to which the firm can offer television service has doubled over the past two years, meaning the rate at which the firm is penetrating the market is slowing more rapidly than the drop in raw customers added. (Click to enlarge)

On the firm's fourth-quarter earnings conference call, Verizon CEO Ivan Seidenberg stated that the firm has gained confidence in its ability to gain share with FiOS over time, that it doesn't feel the need to "overheat" the market with promotions, and that it has to be careful about profitability. That sounds to us like the sort of rational competition that should provide the cable companies with room to compete in FiOS markets. Verizon's actions are in keeping with our view that it will need to maintain pricing discipline in order to drive a decent return on its FiOS investment.

AT&T, on the other hand, has much less capital invested in its U-Verse network upgrade and likely feels it can price and promote more aggressively as a result. In fact, the firm has claimed that the dollars and effort behind U-Verse promotions haven't changed recently. Interestingly, however, AT&T's television customer growth has also stalled out a bit, despite the fact that it too is steadily expanding the reach of its offering. The cable companies, with only a couple years of experience dealing with this threat, seem to be doing a better job of battling phone-company entry into the television business. We also suspect that the massive phone customer losses the phone companies have endured over the past several years are hindering their ability to quickly penetrate new television markets. We believe this is an important point looking forward, as growing existing customer relationships is far easier than building (or rebuilding) new ones. While the cable companies are also losing customers, the pace has been much slower. The chart below shows the aggregate phone customer penetration as a percentage of households passed versus aggregate television penetration for the cable companies. These figures serve as an approximation of the percentage of customers in the average neighborhood that each group of firms serves.

The worst of the phone companies' initial push into the television business is likely waning. Verizon has stated that FiOS expansion will end in 2010, and it appears to be making good on that promise. Municipalities like Alexandria, Va., that were in the process of granting the firm a franchise to roll out the network have been told recently that the firm is no longer interested. AT&T is more than three fourths of the way to its U-Verse deployment goal, while Qwest (NYSE:Q) recently reaffirmed its decision to stay out of the television market altogether. We doubt that the phone companies' appetite to expand their network upgrade plans will change markedly in the coming years. As these firms lose customers in a given neighborhood, network investment becomes harder to justify. The chart below shows average revenue per home passed--adjusted to remove fees that are passed through to content providers like Disney (NYSE:DIS)--that Verizon, AT&T, Comcast, and TWC receive. The phone companies are likely faring far better in markets they've upgraded and worse elsewhere.

On the wireless data front, the launch of Apple's (NASDAQ:AAPL) latest device, the iPad, and the Federal Communications Commission's call to free up additional spectrum as part of its National Broadband Plan both shed some light on the future direction the technology will take. As with the iPhone, AT&T has secured an agreement to provide wireless data services for the iPad, at the same $30 per month price point charged to smartphone users for "unlimited" use. We suspect, however, that the iPad will enable the consumption of significantly greater data quantities than the typical smartphone. AT&T defended the pricing plan saying, in part, that it expects the iPad to find the most use in offices, homes, and other places where a WiFi connection is available. This contention assumes that wireless service won't serve as a replacement for fixed-line broadband service anytime soon.

The FCC hopes to expand the capabilities of wireless data services quickly to create more competition for wired providers. The key component of the FCC plan is to make 500 MHz of additional spectrum available to wireless carriers over the next 10 years. Wireless spectrum is the "raw material" required to provide wireless services--the more spectrum available, the more capacity for customers to enjoy. There are a couple of problems with this approach, however. First, much of the spectrum the FCC hopes to offer is in the hands of television broadcasters that will likely fight to keep it, at a minimum delaying the process. Second, once the spectrum comes to auction, the federal government will want to raise as much money as possible. The FCC assumes auction proceeds keep its plan cost-neutral to the government. But the firms with the ability to pay the most are the existing carriers. These carriers will need to price services in a way that generates a return on the tens of billions of dollars this spectrum will likely cost.

Finally, with respect to the threat that new video distribution methods pose to the traditional television model, the good news is that we still haven't seen much of an impact. The number of pay-television subscriptions continues to grow in aggregate across the phone, cable, and satellite companies we follow, and the pace of growth in 2009 was actually better than the prior year. That said, we are clearly still in the early days of Internet video adoption, and consumer habits will likely continue to change. For example, Nielsen recently published a study indicating that the amount of time consumers spend simultaneously online and watching television is growing rapidly. Content creators also continue to develop their online offerings. ESPN, a stalwart of the traditional television model, recently announced plans to rebrand and enhance its ESPN360 online offering to reflect its view that the site increasingly serves as a viable network. ESPN360 remains tied to an Internet access account rather than a traditional television subscription.

Regardless of the path that consumer habits take, we expect cable networks will remain a vital communications link. Internet access is likely to form the foundation of customer relationships over the long run, and we continue to believe cable companies are best positioned to dominate this business in most communities across the nation. Below we take a look at one final set of data--the percentage of customer growth captured each quarter by the major cable and phone companies we follow. Though the figures bounce around, the second half of 2009 clearly went in cable's favor. We expect this trend to persist for some time.

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