Cable Operators

Cablevision's Three Faces

9/29/2006 8:06 PM Eastern

The revelation earlier this month that Cablevision Systems Corp. issued stock options to a dead man — in this case, former vice chairman Marc Lustgarten, who died in 1999 — is to some just the latest in a long history of the somewhat bizarre happenings at the Bethpage, N.Y.-based cable company.

As anyone who has followed the cable industry for any length of time is aware, there is a perception that Cablevision is actually two companies: the fine-tuned cable-systems operation that has outperformed the rest of the industry and the one run by a highly unpredictable father-and-son team — chairman and founder Charles Dolan and CEO James Dolan — that at times appears to act from pure emotion.

TWO COMPANIES?

“You have the 'B' stock company and the 'A' stock company,” said Jefferies & Co. cable analyst Robert Routh, referring to Cablevision's super-voting Class B shares (controlled by the Dolans) and its Class A common stock, which is held by most shareholders.

While the Dolans have weathered more than their fair share of criticism in the past, to its credit Cablevision has the highest penetration of digital-cable subscribers in the country at 73% of basic subscribers, even though it was the last big cable provider to roll out that product. Cablevision also has the highest penetration of high-speed Internet services, at 41% of homes passed, and leads the pack with voice-services penetration of nearly 22% of homes passed.

In addition, Cablevision has reported nine consecutive quarters of basic-subscriber growth (something no other major cable company can currently claim) and has turned in 11 consecutive quarters of double-digit revenue and adjusted operating cash-flow growth.

Through that boom period, the Dolans were securely at the helm, overseeing every major initiative. Also during that time, Cablevision's stock price has increased from $4.67 per share in 2002 to $23.05 as of last Wednesday.

But most of the credit for that growth has been heaped on one of Jim Dolan's hires — former Time Warner Cable president Tom Rutledge, who joined Cablevision in January 2002 as president of the cable operations and was promoted to chief operating officer in 2004. Almost straight out of the box, Rutledge focused on improving Cablevision's customer-service reputation, and oversaw the rollout of its triple-play offering of voice, video and data.

Rutledge himself has given most of the credit to Jim Dolan — in a 2005 interview, he said it was Jim's idea for the $90 triple-play package — and while the Dolans give him free reign to run the day-to-day cable operations, Rutledge regularly consults with Jim and Chuck on every major business decision.

Rutledge is Cablevision's Wall Street face, at least for the cable operations. At investor conferences, it is Rutledge who has taken Jim Dolan's place on the podium and during earnings conference calls, Rutledge speaks for cable while Jim speaks about the part of the business on which he's focusing — Madison Square Garden and its sports teams. Rutledge also represents Cablevision on the National Cable & Telecommunications Association board of directors.

Perhaps that is the reason several people on Wall Street agree that not having Rutledge around could be a disaster for the stock. “It wouldn't be pretty,” said Janco Partners cable and satellite analyst Matt Harrigan. “And they [the Dolans] know that. They are very incented to keep Rutledge around until the company is sold.”

FOLLOWING A PLAN

The catalyst of much of Cablevision's recent growth is a plan announced on Aug. 8, 2002, when Jim Dolan — credited as its chief architect — mapped out a strategy to complete its systems upgrades by 2003, accelerate its digital rollout, pare capital expenses and reorganize its non-core businesses, such as the consumer-electronics retail chain The Wiz and the Clearview Cinemas movie theaters.

Investors that day were hoping the company would reveal more on its plans for its struggling satellite service — Rainbow DBS, also known as Voom — so the stock dropped more than 26%, to about $5.85.

Cablevision argues it was the right plan and was executed even better than they expected. Today, the stock is at $33, adjusted for a $10-per-share dividend issued earlier this year, which is a 600% increase over that period.

LUSTGARTEN ISSUE

But the Lustgarten option imbroglio is considered by some to be just another example of the Dolans letting their emotions get the better of them.

Lustgarten, who joined Cablevision in 1975, had been the company's key deal-maker for years, before succumbing to pancreatic cancer in 1999. Aside from helping to make the Dolan family a boatload of money, Lustgarten also served as a mentor to James Dolan, often serving as the buffer between James and his father.

Whether the Dolans decided to issue the options to help out the Lustgarten family remains to be seen. But some observers believe they could have done it another way.

“The unfortunate thing about this is that from an emotional point of view, they were probably doing something good for the estate, helping out the widow of a former employee,” said an executive from another cable company, who, like other cable executives interviewed for this story, declined to be quoted by name criticizing another operator. “But it's just plain wrong. I don't know how these things happen, except that there is a tone from the top that says it's OK.”

Cablevision counters that it initiated an investigation, had findings of that probe and shared its results both with the proper government agencies and the public.

The non-Cablevision executive added that the recent string of investigations — in 2003, it revealed discrepancies regarding the accounting of expenses at its Rainbow Media Holdings unit — could be a sign that Cablevision has installed the types of stringent accounting measures that have become commonplace at other publicly traded companies since the dawn of Sarbanes-Oxley Act of 2002.

“After the number of investigations they've had, you'd think they have found everything,” the cable executive said. “The whole internal-audit procedure, the checks and balances now, seem to be significantly better than ever before.”

What is most striking is that Cablevision's top management seems to have an uncanny knack for occasionally diverting attention toward issues that have less bearing on how the company is actually running. That's not lost on analysts who follow the company.

“I think there is certainly a sense of privilege there, and I think that the public shareholders resent that,” Harrigan said. “Chuck was one of the pioneers in the cable industry. He's certainly an entrepreneurial guy and I think there is an impulse to do entrepreneurial things even when the world has changed quite a bit. I think he's probably more comfortable with an entrepreneurial risk profile than your typical investor in a cable stock.”

But according to Cablevision, it is just that entrepreneurial spirit that has driven such high returns, beginning with predecessor Sterling Manhattan Cable's idea to wire Manhattan for cable in 1965.

“The spirit of entrepreneurism is what has built the company,” a Cablevision official said, speaking for the operator.

Cablevision first announced the possibility that it improperly backdated options for some executives on Aug. 8, and said that because of the ongoing investigation it would not be able to file its 10-Q quarterly report for the period. It also said financial statements for the past nine years could not be trusted.

When Cablevision did file the 10-Q on Sept. 21 — earlier than most analysts expected — it revealed that the financial impact had been relatively minimal. Net income had been reduced by a total of $89 million over nine years, most of it before 2000.

“Although Cablevision did ultimately file its second quarter financials and avoid a technical default of its debt, the company has an extensive record of surprising investors with negative news, including Rainbow accounting improprieties, financial restatements, loan-covenant violations, failed asset spinoffs and going-private transactions,” Merrill Lynch & Co. media analyst Jessica Reif Cohen wrote in a research report last week. “These recurrent events continue to detract from the strong operating performance of one of the country's premier cable operators.”

Reif Cohen later downgraded the stock to “neutral,” stating that the shares are fairly valued.

'DOLAN DISCOUNT'

Analysts who've followed Cablevision's stock for years factor in what one at least calls a “Dolan Discount” to account for such happenings.

“You have to have a 'Dolan discount' on the stock,” Harrigan said. “If you didn't, you'd have a price target in the mid-$30s.” Harrigan's price target is $28 per share.

“I think the stock still has some great growth prospects,” Harrigan continued. “There's no doubt that based on where the stock is, it's in the penalty box in the equity market. And the only real reason I can see for that is concern over the Dolans.”

Despite such concerns, investors apparently have learned to look beyond any family peccadilloes and focus on the cable operations' actual performance.

Cablevision stock was actually up as much as 50 cents on Sept. 22, the day the Lustgarten story broke — signaling a lack of investor concern — and finished the day down just 2 cents a share, on a day when stocks generally were down.

The next day of trading — Sept. 25 — Cablevision stock was up 31 cents, to $22.90.

Cablevision disputes any notion of a Dolan discount by pointing out the stock price is up 600% in four years. It contends that the $10 dividend unlocked value that was not recognized in the equity market.

“Which was precisely the point the Dolans argued in recommending that dividend,” the Cablevision official said.

While there have been other near-scandals — the firing of 14 employees at Rainbow's AMC and WE networks in 2003 (including president Kate McEnroe) after finding improprieties in recording expenses — and other investigations into accounting issues; failed spinoffs; a brief attempt at going private; and boardroom battles that ended with Chuck Dolan firing three board members said to have voted against him — the outside cable executive who asked not to be named didn't think the latest imbroglio would force Cablevision to do anything drastic, such as selling its cable systems.

“They have been much closer to the edge than they are now,” that executive said.

Harrigan didn't think a sale was imminent either. “I don't think that Chuck wants to sell for a couple of years,” Harrigan said. “I think they think there is a much larger advertising and business-telecom opportunity.”

Harrigan and other analysts also predicted that the most recent controversy may follow the same path as previous ones: People will be upset initially, but will forget about it after it is revealed that the impact is minimal.

“Cosmetically, this is not good, and given the history of the company, it exacerbates it,” Harrigan said. “But when you look at Voom, there were people that thought that was a $2 billion cash burn at one point in time. Image-wise this is bad, but as far as running the numbers go, this is a pinprick.”

THE MAVERICK

Chuck Dolan has been known as a maverick in the cable industry, caring little what others think of his vision. And it has paid off in spades.

He was the first to wire Manhattan for cable, created what would later become Home Box Office in 1972, started the first regional sports networks (SportsChannel) in 1976, created the first regional cable news network (News 12 Long Island) in 1986 and built his current cable empire from just 1,500 subscribers in suburban Long Island to the 3 million-subscriber powerhouse it is today.

Any discussion of a sale also assumes that Chuck Dolan wants to sell. Dolan reportedly was closest to a sale of the cable company in 1993. Time Warner CEO Gerald Levin — who worked with Dolan at HBO in the 1970s — was reported to have reached a deal in which Time Warner would gain control of the cable operations at a hefty premium and Dolan would retain the Rainbow programming networks.

According to a 2001 article in The New York Observer, Dolan's financial team worked for more than a year on a deal that was said to be a defining moment for Dolan. All that remained was for him to sign on the dotted line. But Dolan balked.

Frustrated about Dolan's foot-dragging, Levin went on to Plan B, buying Ted Turner's Turner Broadcasting System Inc.

Granted, many of the cable executives who sold out during that era have regretted doing so, and Cablevision has delivered impressive returns since then. But Routh said that emotions probably got in the way of completing the Time Warner deal.

Dolan was pushed into divesting his interest in the Manhattan Cable operation and HBO to Time Warner in 1973.

“He regrets both of those transactions a tremendous amount,” Routh said. “Do I think he'd rather sell to another party? Probably, based only on principle.”

THE MAVERICK'S SON

And though Chuck has been lauded as a visionary — albeit an unpredictable one — Jim hasn't received half as much credit.

But a closer look at some of the younger Dolan's deals — and a little 20-20 hindsight — show that the younger man shows some flashes of the older one's foresight.

It was Jim's idea to purchase bankrupt New York electronics retailer The Wiz in 1998, a deal for which he was heavily criticized at the time but one that arguably laid the foundation for Cablevision's high-speed data dominance. Although The Wiz ultimately lost millions — and was shuttered in 2003 — it also heavily marketed and sold cable modems, championing the concept of self-installation and saving the parent company uncounted truck rolls.

Jim Dolan also was responsible for Cablevision's New York-centric strategy, according to company officials. Cablevision sold off cable operations in Cleveland and Boston in 1999 and 2000, making Cablevision the best-clustered cable company in the largest advertising and media market in the country.

Perhaps most importantly, Cablevision said it was Jim Dolan who initiated the cable company's $90 triple-play package of voice, video and data, a strategy that many pundits claimed would set off a disastrous price war with the phone companies. No price war has materialized and now every major cable operator has a triple-play package that closely resembles Cablevision's.

There have been a few missteps, as well, although Cablevision also disputes much of that.

In 2003, Cablevision attempted to create a tracking stock for Rainbow — called Rainbow Media Group — but scrapped it after one year. Later, Chuck Dolan's plan to create an HDTV satellite network, Voom, crashed to earth after investors cried out that the service would cost too much money. After a protracted boardroom battle with his son, Chuck agreed to scrap plans to launch satellites and agreed to sell the service to cable operators. To date, only one company has agreed to a Voom deal — EchoStar Communications Corp., which purchased Voom's satellite for $200 million.

And then there is the latest stock-option scandal, obviously an embarrassment to Cablevision and its two mercurial head honchos — but one that might ultimately fade into the ether, another example of the company's bifurcated nature.

“The outstanding performance of our company highlighted by our core cable, phone and Internet business over the past four years since we announced our growth plan in 2002, should speak for itself,” Cablevision said.

September