Selling Comcast. Buying News Corporation.

Partially driven by tax considerations, I sold Northlake's entire position in Comcast yesterday. I used the proceeds to purchase a full position in News Corporation. I completed this trade across Northlake's entire base of separately managed client accounts and in my two main personal accounts.

The Comcast long proved to be disastrous. My analysis of the company's fundamentals and the stock market's likely reaction proved wrong. I bought the position last July at more that $27. It was a 3% for most accounts position so it cost clients about 1% relative to the S&P 500 benchmark. Ouch. I’ve chronicled repeatedly why I was long Comcast and why I think the stock is undervalued at these prices. I still believe the shares are undervalued but barring a dramatic action by management I don’t see the potential for a significant rebound (>20%) in the next six months. Current fundamentals aren’t nearly as bad as the stock price implies but they are weak relative to Wall Street expectations and risk remains that there is one more disappointment in operating metric or capital spending guidance.

On the other hand, fundamentals at News Corporation are very positive. 1Q08 results are already in the books and strongly suggested that estimates are too low. When Rupert Murdoch refused to raise guidance due to concerns about the economy, the shares sold off as the implication is that estimates for the remainder of the year are too high. I think this reasoning will be proved wrong and we will find out within the next six weeks when News Corporation presents at a major sell side conference and then reports its 2Q08 results.

Simply put, I think News Corporation is similarly undervalued to Comcast but it has positive operating momentum and a recognizable catalyst. Add in the tax loss benefit against gains I’ve realized this year in my market cap and style rotation strategies and on position trimming in Apple and Central European Media Enterprises and the swap from Comcast to News Corporation makes sense.

I’d like to reiterate that I think Comcast remains cheap and oversold at current prices. My investment strategy limits the number of long positions I can maintain at any point in time. Something had to be sacrificed. No doubt it will prove to be a sacrifice to the trading deities as well so you can hold the emails noting that I threw in the towel at the low that are sure to come my way when Comcast is trading in the low $20s.

Morgan Stanley Upgrades Comcast

Morgan Stanley, which was early, aggressive, and correct with a bearish outlook for cable stocks upgraded its industry outlook yesterday to attractive. Comcast was raised from a sell to a buy. Here is a summary from the morning notes on Comcast: "We base our upgrade on three factors. First, concerns over a maturing product set have shifted to fears of an all-out price war, which we believe is unlikely, and multiples have compressed to historical lows. Second, consensus has moved to our camp of higher capital spending related to competing on high-def with satellite, and we see lower risk of capex misses going forward. Finally, voice share gains, HD/DVR deployments, and increasing data speeds should all help support 15-20% normalized EPS/FCF growth – compelling growth at this historical low multiple."

Morgan's upgrade is consistent with my post from yesterday: fundamentals for cable are actually pretty good with double upper single digit to low double digit revenue and EBITDA growth and a probable resumption of free cash flow growth in 2008....

....At current valuation levels, the problem for the stocks is sentiment is terrible and investors will be in "show me" mode for at least five or six months. Assuming Morgan Stanley is right that capital spending misses are now unlikely, the bottom should be right around here. But you'll have to have a lot of patience if you expect to make good money on new positions or make a meaningful portion of losses back.

One last point on cable before I shut up. Comcast does not count a customer who upgrades to an HD DVR as a revenue generating unit even though this customer pays a bigger monthly bill. Thus, when Comcast raised capex and lowered RGU guidance, it was overlooked that a major portion of the capex increase was generating incremental revenues. Management stated that the bulk of the capex increase came from HD DVRs and claims the return on this capex is very good.

This raises the final issue as to what might turn the stocks around. Investors are going to have to shift their focus from subscriber metrics to overall trends in revenue per household and total revenue, EBITDA, EPS, and free cash flow growth. This is not as much of a reach as you might expect. After all, AT&T and Verizon shares have overcome the fact that access line losses remain at all-time high levels. I still fail to see how AT&T losing a wireline telephony household (and all the add on triple play services they can sell that household) is different from Comcast losing a basic cable TV subscriber (and all the add on triple play services they can sell that household). Nevertheless, as the bear to bull view transition on AT&T and Verizon proves, it takes time for a shift in investor analysis focus for an industry to take hold.

I Was Wrong On Comcast

I enjoyed going on TV with my buddy Cody Willard. Unfortunately, since I debated Comcast with Cody and took the bull side, I'll probably never get invited back!

Not much I can say at this point other than admit the bullish stance I took in July when the stock was $27 was wrong. Nevertheless, I still think that the penalty the stock is paying is far worse than the reality of the company's fundamentals.

However, revenue and EBITDA growth are decelerating and, at least for 2007, free cash flow is down. Competition is rising, and cable bills are more sensitive to the economy than was previously thought. Against this backdrop, investor sentiment toward cable is not likely to improve. As a result, I don't expect much of a recovery in the shares even though I see them as oversold.

What will it take to for the shares to make a meaningful comeback? The first step is decent guidance for 2008. Management needs to guide revenue growth to at least 9%-10% with margin expansion pushing EBITDA growth to 11%-12%. More importantly, capital spending must be no worse than flat with the new elevated 2007 level. The most devastating part of company's new guidance is that they brought down the number of revenue generating units they will install (an RGU is a subscription to video, broadband or telephony) in 2007 while increasing capital spending. Comcast had assured us that as growth gradually slowed, capital spending would stabilize or fall, thus providing a big boost to free cash flow....

....Look, Comcast is still going to grow revenue 11% this year. EBITDA will grow 13%. The company will add 6 million RGUs, up from 5 million a year ago. Those fundamentals are only slightly worse than originally expected and worth a much higher stock price. The problem is that capital spending this year will be just 80% of the 2006 level. So you got growth but no payoff. Not good enough with competition and economic sensitivity on the rise.

Therefore, I don't think decent guidance will be good enough to really get the stock moving. Investors won't trust the guidance, particularly on capital spending and free cash flow, after having been burned badly in 2007 by a couple of capex budget increases and decelerating revenue and EBITDA growth as the year moved along. As a result, it will probably take decent guidance and an in-line 1Q08 report to begin to rebuild confidence. Comcast won't report 1Q08 until the end of April, so we are probably looking at five months more in the doghouse at a minimum.

I will probably be selling client positions in Comcast before year end. Taxable accounts can use the loss and I can always buy the stock back if the gloom lifts. I plan to give it a few more days though to see if the stock can bounce closer to $20.

Verizon Raises Prices

Dow Jones ran a news story on Tuesday noting that Verizon was raising the price of its FiOS TV service purchased outside the bundle by 12% for 2008. This is the second consecutive year that Verizon has raised FiOS TV prices.

Wait a second. I thought that FiOS TV was going to set off a price war with cable. At least that is what you might think if you looked at a chart of Comcast's stock price. The reality is that pricing for all parts of the triple play bundle has been very stable. Verizon is just facing its own reality - it can't buy programming at the same price as Comcast, DirecTV, et al because it doesn't qualify for subscriber discounts while it faces the same programming price hikes from cable network providers. And just in case he missed it, here's a shout out to FCC Chairman Martin. It isn't just the cable industry that is raising prices of multichannel video subscriptions. Lack of competition is not the issue. Multichannel video distributors are just passing through the annual increases charged to them by the likes of CNN, ESPN, and HGTV.

Cable still has serious issues with investors (though not nearly so serious with fundamentals) but after a summer and fall of discontent and bad news this is the first positive datapoint. Now if Brian Roberts would just step up his share buyback and show the same confidence with his actions that he expresses with his words.

AT&T-Echostar Has Implications For Comcast

With an AT&T acquisition of Echostar apparently imminent, I want to reiterate that while in the short-term investors will see the deal as negative for cable, in the long run the outcome may not be nearly as dire feared.

On its most recent conference call, Comcast specifically pointed to AT&T discounting using the satellite bundle (Dish or DirecTV + AT&T wireline + AT&T DSL) as a cause of lower than expected subscriber additions. In fact, Comcast said that the wireline TV offerings form AT&T (U-Verse) and Verizon (FiOS) had not had a material impact. If this is to be believed, then in the short-term an acquisition of Echostar by AT&T looks ominous for cable. AT&T has shown a willingness to discount aggressively and with Echostar in house will be able to more easily execute the strategy nationally. Cable stocks were down 2-3% yesterday and I suspect that this is the reasoning.

While I can't argue with this near-term reaction, I think the long-term is a little trickier. By using Echostar as its primary multichannel TV offering, AT&T is foregoing massive cost synergies available to cable and Verizon which are able to offer the triple play across a single network. Maintenance, billing, and customer service will al be less efficient for AT&T than its peers. This should mean that AT&T's discounting strategy has a limited life. The high cost producer can not maintain the lowest price for long.

An AT&T-Echostar tie-up will surely sour the mood of potential cable investors even further. But if it hastens the day when a stable oligopoly re-emerges it might not be as bad a thing as feared.

More Bad News On Comcast

Comcast reported disappointing 3Q07 results. More importantly, the tone of management comments about a number of issues was quite cautious and does not support their words supporting sustained double digit growth in revenue, EBITDA, and free cash flow. This quarter will further collapse the multiple and the shares are lower. Given the likely path of company's financial performance over the next three to five years the stock is way too cheap. However, management is not providing investors with the confidence necessary for them to pay for the growth. This situation will not be resolved in the short-term. I am re-evaluating the position. Essentially the decision is whether to show patience since upside of 30% exists in the shares. But we probably will be waiting several months at least for that to get started and Comcast is very widely owned so there could be more downside near-term as everyone throws in the towel.

Comcast reported cable segment revenue and EBITDA of $7.4 billion and $2.983 billion, respectively. These figures matched estimates as did margin expansion to 40.2%. Unfortunately, all the underlying metrics slightly missed targets. Comcast lost 65,000 basic subs vs. expectations of 30,000-40,000. Digital subs of 489,000 were about 15,000 light. High speed data adds of 450,000 were as much as 50,000 light. Of notable concern, telephony subs of 662,000 missed estimates of 700,000 to 725,000 and were down sequentially for the first time.

Management noted increased competition and marginal impacts from a slowing economy. They indicated they would respond by sharpening price points and introducing new product offerings beyond the focus on the triple play. Satellite and Telcos are using more aggressive pricing on one and two product offerings as well as tiering of high speed data. Comcast has not responded until now....

Guidance was maintained with a qualifier that competition and the economy "may have a slight impact." For free cash flow, guidance was changed from flat vs. 2006 to flat to down 10% vs. 2006. Investors are increasingly focused on free cash flow for cable companies and I believe this change is having a meaningful impact on the stock today.

The company announced a large new buyback program of $7 billion. That could buy about 10% of the stock at current prices. You would think this would be good news but cautious comments about the pace and funding of the buyback are adding to invest concerns. Management refuses to commit to an accelerated share buyback which signals a lack of confidence to investors.

Management stated that the 1.4 million addition RGUs would produce $600 million in new revenue next year. With revenue of $31 billion this year, obviously adding these subs is going to drive growth. I can’t see any scenarios where Comcast does not grow by at least 10% next year followed by a gradual deceleration toward mid single digit growth by 2011. Management is very firm is stating that it will have double digit growth for a few more years even with the increased competition.

If that is the case they need to more aggressive defend the stock and promote the good at the company. Instead they speak and act sheepish and cautious. Investors are taking this conflict as a lack of confidence in the long-term outlook. Until management does something to change the tone, the shares aren’t going to rebound. Producing decent numbers isn’t good enough. The street won't believe and won’t pay up.

More Debate on Comcast

Following my post yesterday on Comcast, my buddy, hedge fund manager and soon to be anchor on the Fox Business Channel, Cody Willard, replied with a bearish view of the stock. Among Cody's objections to my ongoing bullish stance on Comcast is, "$14 billion of market cap losses for wasting tens of billions of shareholder dollars building centrally-controlling systems is still just the beginning, IMHO. The point is that the company is in a secular declining industry since its entire model remains centered on controlling what and how and where and why people consume video."

I am sorry Cody but I would hardly call it a waste of money to build a network that supplies cable TV to 24 million homes, broadband internet to 13 million homes, and telephone service to 3 million homes. These homes pay Comcast an average of $96 per month on which the company earns an EBITDA margin of 40%. Even with the high level of capital spending required to install new customers for each service and maintain the competitiveness of the network, Comcast is presently generating $2-3 billion of free cash flow....

....As for that secular decline, Comcast will add about 2 million broadband customers this year and another 7 million over the next four years. Telephony subs will grow by more than 3 million this year and for the foreseeable future. Those telephone customers produce the highest operating margins of any Comcast revenue stream. Small and mid-size business is a new opportunity that Comcast is just beginning to target and most observers think it can grow to a multibillion revenue opportunity over the next several years.

Sorry again Cody, but Comcast didn’t waste billions of dollars on a video system. They built the most advanced network available to US households (OK, Verizon might cover one-third of the homes Comcast does in five years), a network that is easy to upgrade, a network that has allowed the company to reduce its reliance on video subscribers to 60% of total revenue. It is that very network that allows the empowerment that you are so fond of. There is no empowerment without paying to get on a broadband network. Sure the video revenue stream faces challenges but not so many that loss of a moderate number of subs will lead to a downward spiral in revenues and profits. Remember, even video has growth elements as more subscribers take digital packages, buy video on demand, and receive interactive advertisements.

The market is not valuing Comcast's business correctly. There may be a little less value than I thought a few months ago but there is a lot more value than exists in today's stock price.

Mea Culpa on Comcast

Mea culpa. Comcast made a new low for this latest down move yesterday, falling more than 3% on what looks like its highest volume day ever before recovering slightly to lose 2.7%. This action occurred after the stock rose a whopping 11 cents in Tuesday's 335 point advance in the Dow. I feel your pain. As with all the individual stock and ETFs held in client accounts, I am long the stock in my own account.

The latest downdraft came after Comcast present at two Wall Street conferences over the last few days. This is secondhand but I am told that management was quite subdued in both presentations. They did not deny that recent hints they had provided that estimates for basic and broadband subscriber growth had to come down were real. The odds of a loss in basic subscribers in the seasonally strong 3Q now appear to be high....

If there is one thing besides higher capital spending that cable investors hate it is the loss of basic subscribers. If subs are leaving it means either that the competitive environment is such that eventually pricing will have to be used as a weapon and/or that capital spending must go up to improve the company's competitive position. Either outcome hurts free cash flow which is the ultimate value metric for this defensive, growing, underleveraged but capital intensive industry. In the current case, the flames are being whipped by positive comments from DirecTV about future sub growth and market share gains.

I can only hope that the bar has now been lowered ahead of 3Q earnings so that the actual results are greeted with relief. Alternatively, maybe management is being overly cautious after having been burned on 1Q and 2Q results following comments like the business is "on fire." Finally, I'd ask that you put this is perspective. If Comcast loses 50,000 basic cable subs this quarter, that works out to a whopping $15 million in lost revenue assuming systemwide average revenue per sub. Comcast has 24 million basic cable subscribers and is expected to generate $7.8 billion in revenue in 3Q. Yeah, I know multiple contraction because of the long-term implications and lower out year numbers in analyst DCF models. But we are talking a loss of $14 billion in market cap since mid-July. I'll take more of the value trap risk for now.

Will Consumer Slowdown Cut Into Comcast's Growth?

Cable stocks have been poor performers all year. Things started badly when Comcast raised it s capital spending forecast in conjunction with its 4Q06 earnings reported. The second hit came with 2Q07 results when basic and broadband subscriber growth disappointed pretty much across the board. Access line losses for AT&T and Verizon, basic subscriber losses for cable companies, and broadband subscriber growth for all players came in short of estimates. Now fears of a consumer spending slowdown are adding to worries about broadband growth.

I chalked the 2Q07 shortfalls up to a combination of the housing slowdown and a regulatory driven need for the cable companies to focus on getting digital set top boxes into subscribers' homes which distracted customer service from retention and new service sales. I strongly suspect that 3Q and 4Q results will improve sentiment as subscriber growth, revenue, and EBITDA growth targets are hit. Nevertheless, investors have been worried that broadband growth is going to mature more quickly than previously expected with a new push coming from a consumer spending slowdown.

On this front, Jessica Reif of Merrill Lynch had some interesting insights in a report she issued on Comcast earlier this week. In the report, Jessica slightly lowered her broadband growth estimates for Comcast while strongly reiterating her recommendation of the shares. Her key conclusions on broadband was that penetration rates are following a similar curve to cable and satellite TV which means that ultimately 90% of households will purchase broadband. With penetration at just 50% today, there should be plenty of growth left. Jessica also noted that while 2Q subscriber counts fell short if looked at from an incremental penetration perspective, the results were on the low end of historical 2Q results.

Most interesting though was a look back at 1990-1992 cable subscriber additions and 2001-2002 wireless subscriber additions. Both periods saw penetration levels begin close to where broadband is today. Both periods saw a sharp slowdown or recession in consumer spending. So what happened to subscriber growth? It slowed significantly but it remained positive. In fact, you can make a pretty strong case that cable fundamentals were "defensive" in 1990-1992 as downside sensitivity to consumer spending was not as great as for other industries.

I think this is likely to repeat if consumer spending slows now. Broadband and especially cable telephony are still early in their growth cycles. Rising penetration should allow overall revenue and EBITDA growth to hold at good levels (10% or better) even if a consumer led recession occurs. Add in the likelihood that second half results should accelerate and the frustrating period of performance for cable stocks, and Comcast in particular will come to an end. Soon.

Cablevision Results Cause Comcast Pain

Comcast (CMCSA/CMCSK) took a serious dive yesterday, trailing the market action all day including a 3% drop when the DJIA was up close to 200 points, before recovering in the last half hour to close down 1%. I am certain that the poor quarter and reduced guidance from Cablevision (CVC) was at fault.

CVC missed expectations in its Telecom division pretty much across the board. The worst results were the 4% gain in EBITDA against expectations for a 13% gain and worse than expected subscriber additions in all four components: basic cable, digital cable, high speed internet, and telephony. The poor results from CVC cap a lousy quarter across the cable industry and a similarly poor quarter for AT&T (T) and Verizon (VZ) in terms of high speed data additions.

Cable bulls like me have little to fall back on in the short-term other than hope that the second half strength forecast by Comcast and Time Warner Cable (TWC) comes to fruition. If it does, there probably won’t have been a better time to buy cable since a similar nadir almost two years ago exactly. At that time, investors were convinced that the competitive battle between cable and telco was going to drive pricing for all services lower and crush margins right as capital spending would escalate to meet the worsening competitive landscape.

The bearishness in 2005 turned out to be way off base as cable financial and subscriber results accelerated throughout 2006 and cable stocks soared – Comcast was up over 70%. Now the bear case has been reinvigorated because estimates look too high in the face of slower subscriber growth.

CVC's results suggest a slightly different call for the bears. ...

Since this marked the second consecutive quarter where CVC's capital intensity fell along with slower subscriber growth, the fears of collapsing free cash flow seem less warranted. The risk now appears to be that EBITDA growth will be slower as less subscribers sign up for new services and as marketing spending rises to meet greater competition from telcos for TV subscriptions.

I suspect what is going on has as much to do with the housing downturn as it does with growing competition. Fewer houses being built and more vacancies means fewer addresses are signing up. If pricing holds, as it has done easily so far, then investors could quickly turn back to cable even if the top end of expectations for 10-14% revenue and EBITDA growth is not achieved.

That is what I am betting on and I look to accelerating financial and subscriber growth in the second half from Comcast as the catalyst.

Comcast Bidding for Virgin Media?

Big headline is something called City A.M. in the UK claims an inside source says that Comcast is considering a bid for Virgin Media. While Comcast may have requested info from the bankers running the auction I'll be shocked if they bid. I think the Comcast-Virgin Media rumors are being planted by the Virgin Media side to boost the pressure on private equity to bid higher. Comcast has a great groove going and won't mess it up by buying into the hyper-competitive, low growth UK market where cable is not leader as it is in the US. The same article mentions Time Warner as a potential bidder, another rumor I don't believe. Weakness in Comcast or Time Warner on this news should be bought.

Purchasing Comcast At Last

After writing positively about Comcast (CMCSA) for two years on Media Talk and in my contributions for theStreet.com, I finally decided it was time to buy the stock for Northlake clients. The main reason I had not bought Comcast previously was that I was very satisfied with the current portfolio of stocks held by clients. Northlake's equity management strategy imposes a strict discipline on individual stock holdings by limiting holdings to just 6 to 8 companies. So it wasn't that I did not think Comcast was a good investment but rather that it didn't make my top 8. With the shares up just 2% this year against a gain of 10% for the S&P 500, I think enough value has been created that Comcast now makes the top 8. Consequently, on Friday morning I purchased Comcast across the entire Northlake client base.

The investment thesis for Comcast is that the company will sustain growth of 12-15% for several more years in revenue and earnings on the back of its triple offering of cable TV, high speed internet, and telephony to consumers and businesses. Furthermore, Comcast will maintain this growth without any significant increases in capital spending beyond the equipment at customers' premises that is required to activate the services. This should lead to growing free cash flow enhancing an already extremely strong financial position. Comcast will use its growing financial strength to enhance shareholder value through acquisitions, share buybacks, initiation of a meaningful annual dividend, and capital investment to protect its competitive position.

The shares are presently trading below their recent average multiple of operating cash flow despite this excellent outlook. As Comcast meets its financial targets over the next few quarters, investor concern about competition from Verizon and AT&T should moderate leading to an expansion in Comcast's valuation at the same time that growth is above street expectations. This is usually a recipe for big gains in the stock price....

I am very confident in the path to significantly higher stock prices of $35-40. The reason for my confidence is two fold. First, Comcast shares went through a similar slump in 2005 before exploding to a gain of 80% in 2006. In 2005, there were the same worries about competition as well as concerns whether Comcast would rollout the triple play in a timely fashion. Throughout 2006 and so far in 2007, subscriber growth and gains in revenue and cash flow have put the initial worries to bed. Second, Cablevision, another major cable company which provides service in the New York City metropolitan area, is about two years ahead of Comcast in rolling out triple play services. Cable TV, high speed internet, and cable telephony are the same product everywhere – same technology, same marketing, same pricing. Comcast is expanding the reach of its triple play services across the country dramatically expanding its potential customer base. If you plot Cablevision's customer growth into Comcast's current profile, you can see where Comcast is headed in terms of subscriber and financial performance over the next two years. The outlook is very bright.

I'll leave the explanation of Comcast's attractiveness there for now rather than bore you with details and numbers. If you want to know more, here is a link to an archive of my postings on Comcast and the cable industry that have appeared on Media Talk.