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Cable Operators

Comcast Exceeds Expectations — Even the Company's Own

9/22/2006 8:05 PM Eastern

Comcast Corp. rang in the New Year with some pretty big shoes to fill: Its own.

The largest cable operator in the country, with 23.3 million subscribers, had just come off an impressive three-year run — starting in 2003, with the successful integration of AT&T Broadband, completed a year ahead of schedule; and continuing in 2004, when it focused on video on demand, rolling the service out to its entire footprint and adding hundreds of hours of content, most of it free to customers; and in late 2005, when it began the initial rollout of its voice-over-Internet protocol telephony service, ending the year with 250,000 subscribers.

Comcast: By The Books
Six Months Ended June 30, 2006
Cable Content Corp. & Other Total
Revenues $11,584 $512 $98 $12,194
Operating Cash Flow $4,693 $110 ($148) $4,655
Operating Income
(Loss)
$2,448 $28 ($188) $2,288
Operating Cash Flow Margin 40.5% 21.5% NM 38.2%
Capital Expenditures $1,834 $13 $15 $1,862
Six Months Ended June 30, 2005
Revenues $10,533 $447 $78 $11,058
Operating Cash Flow $4,151 $169 ($129) $4,191
Operating Income (Loss) $1,908 $95 ($156) $1,847
Operating Cash-Flow Margin 39.4% 37.7% NM 37.9%
Capital Expenditures $1,832 $7 $16 $1,855
($ in millions, except for percentages)
SOURCE: Comcast

With 2006 officially the “Year of VoIP” for the cable juggernaut, Wall Street was watching intently, poised to pounce on any indication that Comcast's string of good fortune was about to end.

Not only did Comcast outperform even Wall Street's expectations — its stock is up more than 35% ($9.04 per share) since Jan. 3 — the operator even surprised itself. Long known for its conservative guidance, Comcast increased its year-end 2006 forecast in July.

That sprint at the end of its three-year run earned Comcast designation as the 2006 Multichannel News Operator of the Year.

In the past six months, Comcast has been on a tear. Not only did it post some of its best first and second-quarter results in years, it also cleaned up on the deal front. In the first eight months of the year, Comcast has:

  • Closed its $17.4 billion joint purchase (with Time Warner Inc.) of Adelphia Communications Corp., netting about 2 million subscribers from Adelphia and through swaps with Time Warner;

  • Unwound its Texas Cable Partners joint venture (again with Time Warner), gaining control of the Houston market with another 790,000 subscribers;

  • Completed a $540 million purchase of Susquehanna Communications Inc., with 230,000 subscribers in Pennsylvania, New York, Maine and Mississippi.

    Based in Philadelphia, the operator will move into the new Comcast Center (artist's rendering at center of picture) upon its completion.

SMOOTH OPERATOR

But the real story — and the main catalyst for the stock's growth — was in its operating performance.

Comcast kicked off the year with blowout first-quarter results: revenue rose 10% to $5.9 billion, cash flow increased 11% to $2.2 billion, and VoIP additions at 211,000 (more than it added in all of 2005) and basic-subscriber additions at 47,000 were its best numbers in that period since 2003.

But perhaps more telling was that the focus on the VoIP rollout didn't adversely affect its other services — digital-cable customers rose by 340,000 customers (its best first quarter in its history) and high-speed Internet subscribers increased by 437,000 (also its best first quarter on record).

The second quarter was more of the same — although it lost 66,000 basic customers, it is a typically poor period for the industry, as college students and vacationers disconnect service as they move to summer residences. But the rest of the quarter was anything but typical. Revenue and cash flow were up 11% and 12%, respectively, driven by 306,000 additional VoIP customers. And while VoIP growth was impressive, it didn't negatively affect other services — digital customers were up by 350,000 in the period and high-speed Internet subscribers rose by 305,000 — indicating that a large portion of the new phone customers were taking the triple play.

Some analysts — and even Comcast itself — had believed the funding of the growth of digital-calling services would drive down margins — at least temporarily.

The opposite has proven true.

“A year ago, we thought that the phone rollout would be a drag to our 2006 operating cash-flow growth rate by about 100 basis points,” or 1%, Comcast chief operating officer Steve Burke said on a conference call with analysts in July to discuss second-quarter results.

“In reality, due to the triple play, we're seeing the benefits of less discounting on our video and high-speed data business. We're also seeing the benefits of scale and running three products over the same infrastructure. As a result, operating cash-flow growth has accelerated from 10% to 13% and that acceleration should continue as we add more triple play customers in the future.”


"They have shown over and over their moxie in doing deals."
Craig Moffett
Sanford Bernstein & Co.

WRINGING MORE FROM DATA

In a research report, Moffett noted that monthly revenue per unit in high-speed Internet services was up to $43.78 in the second quarter, from $43.34 a year ago.

That performance prompted Comcast to increase guidance in several key metrics: Revenue is now expected to grow between 10% and 11% this year (versus previous estimates of 9% to 10% growth); operating cash flow should rise at least 12% (versus previous guidance of 9% to 10%); and revenue-generating units (a combination of digital, voice and data customers) should rise 20% to 3.5 million for the year.

On the cable side, revenue should rise between 10% and 11% (previously 9% to 10%) and operating cash flow should be at least 13% for the year (up from previous guidance of 10% to 11%). Comcast also said it expects to add between 1.3 million and 1.4 million VoIP phone customers for the year, instead of the previously estimated 1 million additions. So far, in the first half, Comcast has added about 517,000 VoIP customers.

Oppenheimer & Co. cable and satellite analyst Tom Eagan said that as a result of Comcast's first-half results, he has increased his guidance for the company for the rest of the year. Eagan anticipates that Comcast will grow revenue generating units, or total subscribers, by 45%, and cash flow should increase by 12% to 14%.

“We think Comcast is in the best position to show improved results,” Eagan said.

Comcast chairman and CEO Brian Roberts, in an interview at its Philadelphia headquarters last month, was equally proud of the company's run in the past year, but tried to temper his enthusiasm for the run-up in the stock price.

“Well, it's been a great year so far, and we're very optimistic about the second half,” Roberts said, adding that he doesn't let the stock price dictate the way he runs the business.

“I try not to let the highs and lows of the stock market penetrate the four walls of the building,” Roberts said. “It's really hard to achieve that objective. I think you have to have a long-range business plan and try to execute on it, and the pressure to deviate every 90 days is obviously not the way to run a business.”

Roberts noted that Comcast stock has actually declined from the $40 per share range it enjoyed for part of 2002 — about the time that Microsoft Corp. agreed to invest about $5 billion in Comcast stock as part of Comcast's purchase of AT&T Broadband that year. Microsoft had been a bidder for AT&T Broadband in the early rounds, but backed off as the price began to rise.

Microsoft had owned about $5 billion of AT&T convertible preferred shares, which were converted to 115 million nonvoting shares of Comcast stock after the AT&T Broadband deal closed.

CALL FOR RESULTS

Since then, cable stocks have weathered a decline — first, because of a perceived threat from direct-broadcast satellite service providers and lately because of telephone-company moves into video — that the sector is just beginning to climb out of. And the catalyst this time, for Comcast and the rest of the publicly traded cable companies, appears to be voice service.

“As an industry we've been revalued as to what our long-term prospects are, and I think we're in a show-me mode, with investors on both [sides of] the effects of competition, whether that's DSL versus high-speed data or the Bells and video or satellite and video,” Roberts said. “Right now, we seem to have swung the pendulum back, but we have a long way to go just to even get back to where we were two, three years ago.”

Still, Wall Street has reacted favorably, and analysts that follow the company have been heaping well-deserved praise on Comcast since the beginning of the year.

“It looks like they finally got traction on the voice side,” said Janco Partners cable and satellite analyst Matt Harrigan. “They've gotten more adroit on bundling — Brian Roberts used to call it 'closet discounting.' But they've kept their price integrity on data, they've differentiated themselves on VoIP and they've increased their RGU [revenue generating unit] guidance. Everybody is fairly thrilled with how they've delivered this year.”

Comcast was late to the IP-telephony game — Cablevision Systems Corp. and Time Warner Cable were the first two cable companies to rollout VoIP across their whole footprint. But the company says that its voice service — it still has about 1 million legacy circuit-switched telephone customers left over from AT&T — is available in 70% of its footprint. That should grow to near-full availability by the end of this year.

Comcast has outpaced many analysts' estimates on the phone rollout — it currently has about 700,000 VoIP customers, and is expected to end 2006 with between 1.3 million and 1.4 million VoIP customers.

But the truly amazing feat is the success of the three-product bundle of voice, video and data. In the markets where it has all three products, churn is down significantly. And in its most mature voice market — Boston — basic subscriber losses have been transformed into gains.

In the second quarter, Comcast said that the Boston market actually grew by 16,000 basic customers.

Sanford Bernstein & Co. cable and satellite analyst Craig Moffett said that while much of the growth in the stock price has been due to Comcast's voice gains, he added that investors aren't giving the company enough credit for its leadership on the video side of the business.

“Comcast, probably more than any other cable operator, has stayed true to its roots as an entertainment and media company,” Moffett said. “While they've done a bang-up job in rolling out voice they are first and foremost a video company. That is a somewhat different model than the others.”

Moffett added that Cox Communications Inc. has promoted itself as a consumer-services company, talking about the bundle even before most customers knew what that was; and Cablevision has reinvented itself as a telecommunications company, with a vision to deliver every product it can over a broadband pipe.

COMCAST'S VISION

“Comcast's vision still starts with video and reinventing the way people watch TV,” Moffett said. “They've taken some kicks for being late to VoIP, but they don't get the recognition they deserve for blazing the trail for video. They were miles ahead on video on demand. They are the standard bearer in creating a user experience built around what you want to watch, whenever you want to watch it.”

And though video may be the foundation for Comcast's product offerings, Wall Street is still looking for voice growth. Comcast senior vice president of product development Dave Juliano said that with the new VoIP customer guidance, Comcast will have to add between 800,000 and 900,000 VoIP customers to the rolls in the second half of the year.

According to a report issued shortly after Comcast second-quarter results were made public, Moffett said that while there is still a question as to whether Comcast can pull faster phone subscriber growth through the second half of the year, indications are that it shouldn't be a huge problem. Fueling Moffett's optimism? The expanded availability of the triple play in Comcast's footprint.

In the report, Moffett estimated that while Comcast's second-quarter triple-play footprint was dramatically expanded from the first quarter, but at 25% it was still too small to overcome the period's normal seasonality. That will change in the third and fourth quarter. Moffett estimated in his report that triple play availability was close to 60% by the end of July, with total digital voice availability at about 80%.

“In the second half, VoIP is positioned to make a much more meaningful impact on HSD [high-speed data] and basic video subscriber growth,” Moffett wrote.

ADELPHIA DEAL A COMPLEX ONE

The addition of the Adelphia and Time Warner markets — many without cable phone service — should also add to the growth on the VoIP side. While the Adelphia deal has been said to be another in a long line of favorable Comcast acquisitions — dating back to the Storer Communications deal the company did with Tele-Communications Inc. in 1988 — Roberts said that it was one of the more difficult deals Comcast has done.

Not only did Comcast pick up 2 million subscribers in the Adelphia deal, it also unwound the Time Warner Entertainment partnership, which was acquired through its purchase of AT&T Broadband. That partnership, created in 1993 by then-Time Warner Inc. chairman Steve Ross, had been an albatross for all of the parties involved for years.

The desire to unwind the partnership gained some urgency in 2002 when the Federal Communications Commission in its ruling approving the AT&T Broadband deal, gave Comcast five years to divest of its interest in TWE. That deadline would have expired in November 2007.

Add in the fact that Adelphia was in the middle of one of the more complicated bankruptcies in corporate history, and Roberts is not off-base in calling it one of Comcast's toughest deals.

“[Time Warner chairman and CEO] Dick Parsons shepherded this personally,” Roberts said. “This was a litigious asset that we didn't create, and he didn't create — it was done by Steve Ross and Dick McCormick [then chairman] of US West, and it had passed on to [former Time Warner chairman and CEO] Gerry Levin and [former US West chairman] Chuck Lillis and then [former AT&T chairman] Mike Armstrong, and Dick [Parsons], and then ultimately Dick [Parsons] and myself to unravel it.

“It had a lot of history that was all stressed, and we were able to completely unravel it in a way that both companies can today have really improved where they started, and I think that's the ultimate win-win outcome.”

As part of the deal, Comcast gave up its 500,000 subscribers in Los Angeles — allowing Time Warner to finally consolidate the L.A. market — and customers in Dallas and suburban Cleveland.

In return, Comcast received Adelphia properties in Palm Beach and Miami, Fla.; Virginia, New England, Pennsylvania and Colorado Springs, Colo.; bolstering existing systems in those areas and gaining control of Time Warner properties in Minneapolis; Memphis; Jackson, Miss.; Louisiana and Florida.

According to another Moffett report, Comcast appeared to get the upper hand in the Adelphia deal, unloading its underperforming Dallas market (Dallas/Fort Worth has one of the highest penetrations of direct-broadcast satellite customers in the country, at 34.6%, according to Nielsen Media Research) and its less-than-stellar properties in Los Angeles (including Compton and South Central Los Angeles).

According to Moffett's May 30 report, the systems Comcast receives from Time Warner in the Adelphia deal have operating cash flow margins (operating cash flow as a percentage of revenue) in the 38% range, while the systems it is giving up have margins as low as 28%. He noted in the report that Dallas “reputedly has some of the worst operating characteristics of any major cable system in the U.S.”

In an interview, Moffett said that the Adelphia transaction is just another example of Comcast's deal-making prowess.

“They have shown over and over their moxie in doing deals,” Moffett said. “There probably was a fair amount of horse trading, but I think it had to do with Time Warner's perception that L.A. was the strategic crown jewel of Adelphia. Comcast was willing to cede a strategic position in L.A. for a stronger set of systems.”

Roberts was reluctant to pick winners and losers in the Adelphia deal.

“In Time Warner's case, they got to consolidate Los Angeles, and many people would say they were the winner, because now they have New York and L.A. Those are two pretty important markets if you're in the television business,” Roberts said. “So it was not without great agony that we walked away from the L.A. market.”

While Roberts admitted that parts of its former Los Angeles systems were not as profitable as others, the systems that Comcast received in the deal — particularly in Palm Beach, Northern Virginia and Minneapolis — significantly strengthens its existing clusters.

Roberts also praised Parsons, who he said initiated conversations for the Adelphia deal, and a host of other Time Warner Cable executives involved in the process — CEO Glenn Britt and senior executive vice president Robert Marcus to name a few. Roberts also was quick to acknowledge his own team, led by executive vice president and co-chief financial officer Lawrence Smith and senior vice president of corporate development Bob Pick, for slogging through highly complicated bankruptcy, tax and structural issues to get the deal done.

'UNBELIEVABLY HARD'

The Adelphia deal was one of the hardest that Comcast has ever done, added Smith. Not only did they have to negotiate with a partner that was putting up most of the money, they also had to find their way through one of the more complicated bankruptcy cases in the history of cable.

“It was unbelievably hard,” Smith said of the Adelphia deal. “We started discussions in the beginning of 2004. We didn't have an agreement until mid-2005. Then we had to negotiate with Adelphia. We're all very happy with the way it turned out, but it was also very complicated, because there were a lot of things that could have gone wrong.”

But while Comcast will have one eye on the Adelphia integration and the rollout of phone, it likely will have the other fixed carefully on the rollout of video services by the regional Bell operating companies.

Already, Verizon has launched its own version of the triple play of voice, video and data — dubbed FiOS — in several markets. AT&T Inc. — formed after the merger between SBC Communications and AT&T Corp. earlier this year — also has plans for its own triple-play offering — called U-verse — which will be rolled out in the coming years.

And Comcast and other cable companies have some lead time. Verizon has said it will take at least five years to build fiber out to 50% of its coverage area. For AT&T, it could take even longer.

So far, FiOS TV is available in 60 markets across seven states. U-Verse growth is even slower — it is currently available in a limited market rollout in San Antonio, Texas, with plans to expand to 20 other markets by the end of the year.

So far, the telcos haven't made much of a dent in taking subscribers away from cable. In fact, early on it has been the reverse — cable phone has been capturing telco customers by the bucketful. Burke said that even though Comcast and the rest of the industry is taking the telco threat seriously, he believes that cable has the upper hand in that battle.

Burke estimated that the Baby Bell telephone companies are losing about 7% to 8% of their residential phone customers each year.

“Can you imagine what would happen if we lost seven to 10% of our subscribers in a year?” Burke asked. “I mean, it would be an uproar, and yet, that's what's happening to all of the regional Bell companies, and that's going to continue happening.”

Burke continues to be puzzled regarding the phone companies' strategies for the triple play, adding that while Verizon has said it will take about five years to take FiOS to about 50% of the country, that is a head start that cable can take advantage of.

“I think what they [the telcos] are going to do is try to really invest and double down in their wireless business, which is a very good business,” Burke said. “They will continue to have a very good, very large, large-size commercial business — we're not really going after their large-size commercial business — and there will be other opportunities for them. They'll be focused on other things, and we'll be focused on our thing, and yes, they'll be a competitor, but again, I like our hand. I would much rather have our hand than theirs.”

Moffett added that while the telephone companies are not expected to sit back and let Comcast and other operators take away that business, they may have little choice.

“The telcos are in a tight bind,” Moffett said. “They certainly won't roll over and let the business leave, but they can't start cutting prices. That would be cutting their nose off to spite their face.”

Somewhat related to the threat of telco competition, cable operators got a scare in early August after a CableLabs report was leaked to the The Wall Street Journal. That report said cable companies could be faced with a multibillion-dollar rebuild in the near future to keep up with the telcos' rollout of video services.

While that could have spelled doom for cable stocks just a year ago — when any hint of additional capital spending was instantly perceived as a threat to free cash flow — Wall Street's reaction to the report was tepid at most.

NO CAPACITY CRUNCH

Part of the reason for that less-than-alarming response was the fact that the report was mainly outlining worst-case scenarios — the report stated that cable's current hybrid-fiber coax architecture could keep pace with the competition at least for the next three years. The report also stated that the HFC infrastructure only becomes more costly than the fiber to the home being deployed by the telcos when node sizes — the number of coax-connected homes served by a fiber node — fall below 125 homes. Most cable operators typically design nodes to serve 500 homes.

Roberts said that cable companies have anticipated larger and larger bandwidth requirements with HFC and many, including Comcast, are reclaiming bandwidth through digital simulcast and eventually converting to all-digital networks, recapturing huge amounts of capacity.

“One day we will finish the job and get from 50% or 60% or 70% digital to 100% and be able to take back 500 Megahertz of bandwidth, which is twice the $100-billion dollar rebuild that the industry spent to go from 500 [Megahertz] to 750 [MHz],” Roberts said.

EASING FEARS

Comcast executive vice president, treasurer and co-chief financial officer John Alchin said in an interview that cable's performance over the last three quarters also helped ease Wall Street's fears over additional capital requirements.

“If you look at the Wall Street reaction to Cablevision [Systems Corp.], [they] had been investing healthy amounts in capex for the last couple of years, but at the same time Wall Street has seen a very healthy return as they've built up almost industry leading penetration levels in phone, high-speed data and digital,” Alchin said. “So the Street can see the return that they were getting for that capital. We went through a year of preparation last year, when we were investing a hefty amount of capital to get the network ready to deploy triple play. What they were not seeing was any incremental revenue and cash flow return from that preparation.”

That changed in the first quarter, when Comcast added 211,000 phone customers — more than the 202,000 subscribers it had added for all of 2005 — and continued into the second quarter, when Comcast added 306,000 phone customers.

“They could see that for the capital that we were investing, we were getting handsome returns,” Alchin said.

So the bottom line appears to be that Comcast has all of its bases covered. And save an unforeseen disaster, the performance of the past three quarters is expected to continue for many more to come.

“We've had 24 consecutive quarters of double-digit operating cash flow growth, and if I had to bet, we're headed toward another 24,” Burke said. “It's awful hard to look out six years, but we're certainly headed toward another few years of double-digit cash flow growth, quarter after quarter after quarter. That's an extraordinary position to be in.

“And the good news is, we made our investment, the huge infrastructure upgrade that the industry made, and now we're getting a chance to make the returns on that investment.”

September