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October 24, 2006

Will Internet Bypass Hurt Cable? Not Anytime Soon

Yesterday my colleagues at theStreet.com, Jim Cramer and Cody Willard wrote opposing opinions about the attractiveness of investing n cable stocks. I have been bullish on cable and Cramer even mentioned me as the lonely bull recently on his Mad Money show on CNBC. Cody is a good friend and we have debated this topic online and in person many times. In response to their comments, I wrote the following, which will appear on StreetInsight.com on October 25th. Unfortunately, Jim and Cody’s post are behind a firewall for paid subscribers only but I think you will understand my comments anyhow.

Jim Cramer had some bullish comments on AT&T (T) and Comcast (CMCSA/CMCSK) yesterday. Essentially, he argued that both companies are on a path for steady growth due to industry consolidation and a more benign pricing environment than expected.

On the other hand, Cody Willard says to sell cable because the internet and iTunes allow you to bypass cable altogether and watch and pay for just what you want. In other words, Cody believes the economic and pricing model of multichannel TV will breakdown.

For now, I agree with Jim. Cody may be right eventually but the time horizon where bypass is a real risk is many years down the line, well beyond what most investors should worry about.

As far as what matters now, I am with Cramer and this excerpt from my earnings coverage ofBellSouth (BLS) explains why....

The results from T and BLS indicate that the pricing environment in the battle with cable operators remains sanguine for all concerned. There is no doubt that the battle for subscribers is fierce but for now the battle is being fought on features, not price. Trends in average revenue per unit, especially for broadband, show that pricing has been stable this year. This is definitely better than most observers expected earlier this year.
How long the pricing remains benign will be the key to future performance of cable and telephone shares. I suspect that for the next several quarters all will be OK. T and VZ are benefiting from wireless growth and wireline cost cutting. These factors are overcoming the loss of access lines such that T and VZ can meet or beat their earnings growth targets. Additionally, penetration in high speed internet is still growing fast enough that DSL and cable can both achieve their subscriber goals without competing on price. BLS stated that its broadband subscriber growth is shifting in favor of higher speeds at higher price points. This is a strong indication that the broadband market is healthy enough to prevent a near-term price war.

Regarding Cody's bearish argument, I see several weak points, especially over the next year. To begin, most people that pay their cable or satellite bill are too lazy or not willing to go to the trouble of finding what they want on a variety of internet sites (ABC.com, CBS.com, NBC.com, etc.) and watching on their PC. As for iTunes, the interface and download process is a breeze but for now you are also watching on your PC or iPod. Watching TV is larger experience than just viewing the show. You want comfort and convenience. Right now, anything other than the living/family room TV and set top box meets neither need. Furthermore, there is no guarantee that the shows you will want to watch are available for download at iTunes or on the internet.

Cody says he wants to watch 100 hours per month of shows. How many different shows is he watching? When he cancels his cable he gives up 150 channels, how many of those is he watching to get his 100 hours? Entourage on HBO, 24 on Fox, Queer Eye on Bravo, etc. I like one show an Animal Planet and one on the History Channel and one on Versus and another on HGTV and a different one on Food Network. You get the idea. Guess what? Not all those shows are available for download. Guess again? You might have to pay individually for each of those shows if they aren’t streamed to the network’s website.

And then there is sports. No NFL games for Cody. Or NBA. Or college hoops. Or World Cup Soccer. Or Wimbledon and US Open tennis. Or the Masters. Or Yankees or Mets games. Maybe his beloved Lobos make the Final Four. No doubt he'll be paying a premium to see that game.

There is also value in the ability to channel surf and find shows accidentally. My daughter and I have found lots of great independent movies on IFC and Sundance. We were surfing the other night and came upon Ugly Betty, a new show that lots of our friends are talking about. I had a brief fling with Iron Chef, which I stumbled on while giving the remote a workout. Sure, I could just download or stream these shows but there is value is knowing they are part of the package in my monthly cable bill.

Either Cody watches the limited amount of content he can get for free by viewing an ad at one of the network websites (again, no guarantee the show he wants is available) or he goes to iTunes and downloads at $1.99 per show, probably more if sports ever goes to per event pricing. Let's say he finds half of his shows for free. That leaves 50 hours, maybe 35 shows for download or $70 per month. I don’t know about Cody but I get cable TV, high speed internet, and telephone for $111 per month from Comcast including all fees and taxes. Unbundling won't save many people much money and for now it is inconvenient. Media Center PCs and the upcoming iTV device from Apple Computer will improve the experience and eventually help to reduce the per show pricing. Those devices will also eventually help create enough demand that more shows will be available. For now, the value of my bundle of 150 channels is pretty good. And I think that goes for the overwhelming majority of couch potato households.

Cody has identified a risk but it is a risk that is miniscule now and will grow very slowly, likely not reaching critical mass in terms of financial performance and stock prices for many years. In the meantime, the story for T, CMCSA and the other cable and telephone companies will be whether the two industries continue to have enough growth opportunities that they don’t have to resort to a price war.

For the telephone companies, this means that DSL, data, and small and mid-size business revenues must continue to grow fast enough to offset continuing high levels of line losses, while cost cutting driven by merger synergies drives operating profit and cash flow growth. For cable, this means ongoing growth in telephony subscribers as part of triple play bundles where consumers buy more than the basic package.

Eventually, the battle for subscribers will focus on price. Broadband penetration will rise to levels where the absolute level of new subscribers won’t support the goals of the telephone and cable industries. Similarly, cable telephony will eventually steal more telephone subscribers than the telephone companies can offset through cost cutting and non-consumer revenues. And someday, though not in the next several years, telephone companies will have a widely deployed multichannel TV product. About that time, the bypass fears that Cody has discussed might be starting to bite as well.

I don’t see any of that occurring in 2007 so the coast is clear for continued strong relative performance from T, CMCSA, and the other major telephone and cable stocks.

Posted by Steve Birenberg at October 24, 2006 03:48 PM in Comcast/Cable TV