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February 05, 2007

Comcast: Capital Spending Should Not Be Penalized

Comcast (CMCSA/CMCSK) reported 4Q06 results that were very close to extremely high expectations. Guidance for 2007 is also very close to current analyst expectations with the notable exception that 2007 free cash flow is forecast the same as 2006 due to an increase in projected capital expenditures as Comcast expects to sign up more customers than anticipated. The lack of upside in the numbers and the debate likely to be triggered by the free cash flow and capital spending guidance will probably lead short-term traders to push Comcast stock lower today. However, I see nothing to that significantly concerns me about the 2007/2008 outlook for the shares and think they will be comfortably higher than current prices by the end of 2007.

On a pro forma basis, 4Q cable revenue and EBITDA growth were 14% and 17%, respectively. These growth rates represent the highest level of any quarter in 2006. As mentioned, the numbers tracked very closely to analyst estimates. At the subscriber level, basic video additions were the highest in years at 110,000. I think this is attributable to the success of the triple play which not only gives households a reason to add or switch ot Comcast but also lowers churn. High speed data additions were 488,000. Growth here remains very storgn with stable ARPU. Penetration stands at 25% leaving plenty of upside for continued growth as broadband becomes more pervasive due to the inceasingly data and video intensive content on the web. Digital TV susbscirbers were also storng, up 613,000. Unlike some prior quarters in 2006, more of these additions were taking higher end digital packages. VOIP telephony sign-ups were a little bewlo some estimates at 508,000 but this is a booming business with quarterly revenue up 77%, a level that should proved sustainable thorugout 2007.

The free cash flow and capital spending forecast is sure to re-ignite the criticism that the cable industry never rewards shareholders.....

because it must constantly invest in a high cost infrastructure to support growth. In this case, I don’t buy it. Capital spending is expected to rise by $1.1 billion in 2007 to $5.7 billion. $250 million is dedicated to preparing for Comcast's assault on the small and mid-size business market, a multibillion revenue opportunity. Another $150 million is for upgrades to newly acquired systems as part of the Adelphia deal and unwinding of partnerships with Time Warner (TWX). Neither of those items was in analyst forecasts. I don’t see the big concern about a $700 million increase in capital spending, up 15%, when the company has forecasted 30% in revenue generating units (each digital TV, high speed data, or VOIP addition is an RGU). RGUs are actually up 40% given the planned loss of 500,000 traditional phone subscribers acquired from AT&T years ago.

Furthermore, management pointed out that 50-60% of the incremental $700 million is due to equipment installed at households to enable the triple play services. This is mostly modems and advanced set top boxes. If the RGU's average $30 per unit per month, Comcast is adding an annual revenue base of $2.5 billion. If margins just match the corporate average, this equates to incremental $1 billion in annual EBITDA. Management calculates a 25% ROI on this capital spending. And that doesn’t; give the company any credit for building new and/or stronger relationships with historically low churn customers ahead of a more substantive entry into TV services by Verizon (VZ) and AT&T (T).

The bottom line is that not all capital spending is bad and sometime the correct decision is to invest in your business. When that investment is merely incremental cash flow and can be invested at a return of 25%, the justification for increased capital spending is even greater.

Oh yeah, Comcast is still going to produce over $2.6 billion in free cash flow in 2007.

Here's hoping that knee-jerk traders knock the shares back into the $40s…that would be a good place to enter the shares for upside of 20-25% over the balance of 2007.

Posted by Steve Birenberg at February 5, 2007 08:11 AM in Comcast/Cable TV