Comcast Has A Big Problem

| About: Comcast Corporation (CMCSA)

Summary

Comcast has criticized the FCC's set-top box proposal and suggested an alternative.

The ongoing debate has made clear that neither side will allow STB fees to emerge unscathed.

Analysts are wrong in believing STB fees and baseline price increases are interchangeable.

The fees are a form of price discrimination, which cannot be replicated by baseline charges.

The loss of those fees will substantially impair Comcast's profits.

Introduction

Despite the Brexit bloodbath, Comcast (NASDAQ:CMCSA) has largely rebounded from its late 2015 swoon. Capping off the good run for the company was the news that the FCC's proposal to force open the cable-box market to competition had stalled. A counter-proposal from the cable companies was enough to persuade one of the commissioners to swing her vote, shattering the bare majority Chairman Wheeler had built for prompt action before President Obama leaves office. Comcast is now back over $63 a share.

Investors should take that opportunity, and sell their Comcast stock. Comcast's cable box profits are still on the chopping block, since both proposals allow customers to replace boxes with far cheaper alternatives, and their loss will mean a substantial correction for the stock.

The Prevailing Assumption

It has been suggested that the ultimate fate of the cable box fees themselves is unimportant, little more than a mere accounting exercise. Cable box fees, so goes the argument, are just a way of hiding the rate hikes made necessary by the continuing rise in programming costs, which have been averaging about 9% per annum the last few years. If that sleight of hand is outlawed, Comcast and its ilk will simply go back to hiking prices the old-fashioned way, on the core video offerings.

This view is wrong. It may or may not be true that rising programming costs are part of what spurred cable companies to raise fees for cable boxes. I don't know and it doesn't matter, because regardless of what caused them, cable box fees are different from other fees cable companies charge, and they will not be easy to replace if they are banned or competed away. In fact, it may not be possible to replace them at all.

Cable And Boxes

Cable box fees are an obscure but highly important piece of the current economic model for television. They account for $20 billion a year in revenues, over 18% of the total Americans pay each year for television services. But even that understates their importance, because of how revenues flow from customers through distributors to producers.

Like many economic middlemen, distributors like Comcast, Charter (NASDAQ:CHTR) and DIRECTV - now owned by AT&T (NYSE:T) - face somewhat of a dichotomy in their money management: suppliers like Disney (NYSE:DIS) and Fox (NASDAQ:FOX) (NASDAQ:FOXA) are paid differently than customers are charged. Customers face a confusing array of base prices, surcharges, taxes, discounts and fees.

The relationship between distributors and producers, on the other hand, while fraught with tension, is also much simpler to understand. Channels from producers are allocated to one of several tiers of service. For each customer who chooses to subscribe to that tier, producers of each channel are paid a mutually agreed - though often highly contested - fee per month, per subscriber.

The end result is that most TV revenue cable companies take in promptly flows right back out to producers. At least, the revenue that comes from selling the tiers of TV service. But cable box fees are not part of the tiers of service. They accrue 100% to the cable companies, and cable companies don't have to pay more fees to producers when they sell more boxes. So while cable boxes are a relatively small slice of the revenue pie, they are also the one pie slice cable companies get to keep for themselves.

It helps that their pie slice is so profitable. Customers pay a lot more to rent the boxes than Comcast pays manufacturers to buy them. Last year, the STB equipment market for all of North America only came to a little more than $6.5 billion. That would yield a profit margin of 67% even if not a single cable box was sold in Canada, which of course it was. If we call the U.S. share $6 billion even, the profit margins on boxes comes to a staggering 70%.

Boxes And Houses

All of which explains why cable boxes are profitable. To understand why those profits can't be replicated somewhere else, it is necessary to understand what makes cable boxes unique.

Although consumer bills have a lot of line items in them, by and large all those charges have one thing in common: they look the same on every customer's bill. Except for the discounts, which customers usually lose if they don't keep calling in every few months and whose exact sizes vary depending on each customer's persistence and negotiating skills. But the Sports Add-On Package and the Basic Cable price are the same in one house as they are in the one five blocks down. In a large city like New York or Los Angeles, they are probably the same in the house five miles uptown.

Cable boxes are different. Sold in a variety of sizes and configurations, with HD and without, with DVR and without, they vary from household to household. And those variations are not random. Rather, they tend to correspond to income.

Because Pay-TV distributors are rather secretive about their cable-box business, it can be a little hard to establish this link directly. But it can often be inferred from other data that is publicly available. One of the best examples of this is DVR. DVR can be seen as an imperfect proxy for cable boxes, since it requires a box to work and some providers, such as DIRECTV, automatically include DVR in all the boxes they sell.

DVR allows customers not only to record programs for later viewing but also to skip commercials in programs they are watching, a premium service. Most higher-income households who can afford them thus have a strong incentive to do so, while lower-income households often find it to be a luxury they cannot afford. One recent study found that 30% of DVR viewers had incomes in excess of $100,000, twice their share of total households with Pay-TV. Meanwhile, incomes below $25,000 had only a 7% chance of having DVR services.

The other major determinant of cable box numbers is the size of the house. And housing size, in turn, also tends to vary with income. A house with more rooms needs more cable boxes for all the TVs in those rooms. Richer people can afford bigger houses. They can also afford cable boxes to put in them.

Market Structure

Because cable box fees tend to track income, the highest fees tend to fall on those households, which can most afford them. They are a way for Comcast and other distributors to engage in price discrimination, thereby padding their profits. These fees are almost tailored to each household to extract the maximum amount possible from each family, but also to leave the base charges low enough that lower-income families cut boxes rather than cutting the cord entirely.

The real significance of the loss of cable box fees is the loss of Comcast's ability to price discriminate. While it certainly could respond to that by simply raising prices across the board, such an increase would not hit just the families with the highest incomes who are least likely to cancel service. Rather, they would fall equally on all households, including those with low-incomes or less interest in cable who might already be on the verge of cancelling.

Given the ongoing threat of cord-cutting, it seems unlikely that there is as much scope as some believe for an across-the-board price hike. That conclusion is further amplified by the fact that Comcast is already a profit-maximizing enterprise in a less-than-competitive market. If it thought it could squeeze more from the base rates, it probably would have already.

In fact, there is growing evidence that a lot of lower-income consumers are already at their breaking point, even though they probably don't pay for nearly as many boxes. One last big price hike might actually break them, and send revenue spiraling even lower. The only true replacement for cable box fees would be some other income-sensitive price discrimination tool. But I cannot think what that might be, and the rather hysterical reactions to the FCC's initial proposal suggest to me that Comcast hasn't thought of one yet, either.

Financial Implications

It seems to me rather that Pay-TV operators will be the ones absorbing this $20 billion hit. All will suffer, including AT&T and Charter. But some will suffer more than others. At an imputed profit margin of 70% and with Comcast controlling 22% of the Pay-TV market, Comcast's profits from cable fees compute proportionally to approximately $3.1 billion per year, in a company, which made $8.25 billion in net income the last twelve months. But it may be worse for Comcast.

Cable-box fees are not identical across the industry. DIRECTV charges only $6 a month, while its parent AT&T charges $8 in its U-Verse service. DISH Network (NASDAQ:DISH) charges varying fees that average out to about $9. But all of these competitors include DVR service in all boxes for one flat price.

Comcast charges $10 per HD box, already the high post. But then it charges an additional $8 per month, per box to include DVR. It seems likely that Comcast's box revenues are probably the highest in the industry. And its share of the profits is probably even higher. Charging less for a box doesn't mean you pay any less to buy it from the manufacturer. DIRECTV probably makes little to no profit off of boxes, at only $6 a month. DISH and AT&T probably get some, but the true profit king is undoubtedly Comcast.

At a current trailing P/E of 19.1, Comcast stock has little slack, and would almost certainly correct sharply downward to match the decline. That suggests a potential loss of as much as 35% if cable box fees fell to cost levels and Comcast's loss was proportional. Since it's probably not, the hit could easily cross the 40% mark.

Conclusion

Comcast has a well-regarded CEO, and its acquisition of NBCUniversal seems to have been a strong win. But Comcast cannot simply wave this incoming FCC torpedo away by rejiggering the price schedule a little bit. The loss of cable box fees, if and when it happens, stands to make a severe dent in their cash flow. I would avoid Comcast stock.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in CMCSA over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.