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April 13, 2005

Morgan Stanley Downgrades NTL

Morgan Stanley (MWD) downgraded NTL Incorporated (NTLI) from buy to hold yesterday leading to a decline in the shares. Sitting out the market's big turnaround lifted my frustration with the NTLI position. However, it is worth noting that the downgrade comes along with a $75 target, up 15% from current prices. I remain bullish as further outlined below...

Morgan Prefers Telewest to NTL

Morgan's downgrade was mostly due to a corresponding upgrade of the U.K.'s #2 cable company, Telewest (TLWT). Morgan prefers the near-term fundamentals at TLWT and on its valuation measures TLWT is slightly cheaper. Morgan's model shows very similar revenue growth in the core cable business for both firms at around 5%. Where they prefer TLWT is on the balance of each company's business, on margin assumptions in the cable business and on 2005 subscriber growth. To his credit, Morgan's analyst is making it very clear to investors that he prefers TLWT over NTLI. Just what a good analyst should do.

Telewest's Diversification Is Accretive to Growth

TLWT has a content division that is growing at a double-digit rate, while NTLI has a wholesale carriers business that is likely to decline sharply as old contracts come up for renegotiation. I think that Morgan's assumptions on NTLI's carrier business in 2005 and beyond are overly conservative, but the point is well taken that TLWT's diversification is accretive to its growth rate, while NTLI's is dilutive.

High Churn Leads to Low Confidence in 2005 Guidance

On the margin front, Morgan is worried that NTLI's aggressive rationalization of its call centers, so far flawless, will encounter issues as the final steps are taken. Basically, Morgan appears to be worried that the low-hanging fruit has been eaten and the remaining work is a lot tougher. Call-center rationalization also relates to the above-average churn NTLI has experienced as it has tightened credit standards and cut back on promotions. The high churn leads Morgan to have low confidence in management guidance for 200,000 net subscriber additions in 2005.

I'm betting that NTLI 1Q05 trends confirm management's subscriber guidance and rebuild investor confidence in the company's fundamentals. If this occurs, I think the major share repurchase funded by the sale of the company's broadcast tower business (management has promised to buyback 15% of the shares within 6 months) and the pending sale of its Irish cable operations for a better-than expected 8 times cash flow (NTLI and TLWT both trade at 5.5 to 6 times cash flow), will move the stock back into the mid-$70s.

Merger Is Still Likely

One other consideration is that a long-rumored merger between NTLI and TLWT is still likely and could be announced this quarter. Investors are nervous that as the buyer, NTLI will pay a premium to TLWT and transfer a significant portion of the accretion in the merger to TLWT shareholders. These concerns were further inflamed when rumors that TLWT was shopping its content division emerged. Initial price talk was higher than expected. So in one sense, NTLI shares are trapped in that as they underperform TLWT shares, fears about the merger price go up.

I find this logic convoluted for two reasons. First, according to analyst estimates, NTLI's share of cost synergies in the merger could be over $20 per share. If so, that leaves a lot of premium to give away before this merger is anything but a major winner for NTLI shareholders. Second, the top four shareholders in both companies are identical. Any merger is likely to be mostly a share exchange so the better the terms for NTLI, the better the major shareholders make out.

Next Few Months Are Crucial

The bottom line is that the next couple of months are critical to the NTLI story. Good news on the Ireland sale, an aggressive share repurchase, signs of improved operating fundamentals, and a fairly priced merger with TLWT all can serve as potential catalysts. If things fall right, valuation of U.K. cable can expand toward its U.S. peers and NTLI shares can climb into the $80s. Despite my frustration, I'm hanging on as that is a darn good return with downside protection offered by the share buyback.

Posted by Steve Birenberg at April 13, 2005 10:51 AM