Consider this a prudent reminder in the aftermath of an annual cable conference where optimism runs rampant: The industry with the clearest shot at becoming the pre-eminent digital video and data gatekeeper has a future that is as fragile as it is promising.
That dichotomy was strikingly evident as executives of AOL Time Warner, the world’s largest media concern, and Comcast Corp., which will become the dominant U.S. cable operator when it pays $72 billion for AT&T Broadband, pondered their potential fortunes and pitfalls during last week’s National Cable & Telecommunications Association gathering.
Comcast President and CEO Brian Roberts generally focused on the robust rollout of digital services, while AOL Time Warner CEO-elect Richard Parsons insisted his company’s challenged merger vision remains viable. Both executives likely are right in the long term. But there was a general tendency to too easily dismiss the short-term difficulties that can be devastating, which AOL Time Warner is finding firsthand and Comcast is about to discover.
When AOL Time Warner’s new management team takes control this week following its annual board and shareholders meetings, it will be racing against the clock to revitalize its AOL online business, tap Time Warner to create more enterprising online content, better integrate company operations and cultures, settle debts and unhappy partnerships, create value through the public spinoff of its cable systems and use the new deal currency to selectively acquire more cable systems.
Mr. Parsons readily acknowledged his company’s past mistakes and current challenges without detailing solutions, although he was emphatic about not spinning off the bruised AOL online business anytime soon. But if the company’s stock is any barometer-hitting a new low of $17 per share and $75 billion in market capitalization after losing 40 percent of its value this year-Mr. Parsons and his team have months, not years, to show significant improvement.
Comcast’s challenges
Riding on the promise of creating another cable behemoth, Comcast is today where AOL Time Warner was 18 months ago: basking in the glow of visionary management, good operating track records and lots of projected synergy and earnings potential.
Back then AOL Time Warner’s stock was at $56 a share and its market cap was $200 billion. Today AOL Time Warner is a monument to overpromise and synergistic drag.
If the AOL Time Warner merger has taught us anything it is that synergies, cost cuts, integration of operations, the mesh of corporate cultures and management shakeout take longer to achieve than previously thought. Any significant growth in earnings or revenues could be delayed by an unexpected downturn in the economy, in ad spending or in global affairs.
The biggest challenges facing Comcast’s well-regarded management as it assumes command of a generally wanting AT&T Broadband are execution, cost cutting, halting AT&T’s basic cable subscriber decline and mining for deep, immediate synergies to generate incremental new revenues and boost cash flow. They are many of the same challenges still faced by AOL Time Warner.
Although it does not have the same unpredictable, unproven online component that AOL does, Comcast has its own potential albatross: It is acquiring a cable system base, much of which is substandard to its own and far from the ideal launchpad for new digital services.
The success of the new AT&T-Comcast hinges on normalizing and improving AT&T’s cable system margins, primarily by investing $6 billion in long-overdue system upgrades through 2004. In the meantime, the company hopes to realize enough synergies and cost savings to generate $250 million annually in incremental earnings before interest, taxes, depreciation and amortization.
The upside also includes monetizing an estimated $10 billion investment in Time Warner Entertainment, which could be pushed back to mid-2003.
But part of the future value of a combined AT&T-Comcast will depend on its ability to launch new channels, even as it creates digital subsets of its existing QVC, E! Entertainment, Golf Channel, Outdoor and Spectator networks.
Aches and pains
It will need another multiple-system-operator partner to provide a broader base beyond its own 22 million cable subscribers (or 35 percent of the U.S. cable market) over which to distribute its content. It also will need to buy a block of programming or form a joint venture with another content provider to supply alternative fare, since Comcast does not have its own library to mine for low-cost programming. Hence, the constant speculation about AT&T-Comcast’s interest in eventually acquiring The Walt Disney Co.
Without factoring in potential synergies from increased advertising revenues and decreased programming costs, the combined AT&T-Comcast will have an enterprise value of $107 billion and $38 billion in debt when the deal closes by the end of 2002, according to a new report by Morgan Stanley Dean Witter analyst Richard Bilotti.
Although Comcast already has acquired 1.4 million AT&T subscribers and has demonstrated its ability to improve margins, the massive upgrade of AT&T systems will push back the prospects for free cash flow to 2004 at the earliest. AT&T system earnings margins are 23 percent to 19.7 percent, which are below the 41 percent industry average that Comcast exceeds.
Mr. Bilotti said that launching new products, realizing synergies, improving ad sales and decreasing program costs will be difficult given the new company’s initial “operational complexity”-from which AOL Time Warner also suffers at the moment.
But the aches and pains of trying to create and manage a company of scale-the same scale that is supposed to be synonymous with earnings prosperity-don’t stop there. Consider these critical change-agents that were addressed at last week’s show:
The emerging phenomenon of cable operators clearing time-shifted programs from the broadcast networks the same week they originally air, as a freebie to build their video-on-demand business, is going to lead to some interesting carriage fee negotiations a year from now. Comcast has signed to carry NBC news and entertainment fare and is looking to do the same with other broadcast networks. Cablevision Systems will offer free VOD runs of Fox’s “24” and FX’s “The Shield.”
Broadcast networks’ becoming major content suppliers to cable’s digital tiers simply by time-shifting what they already produce is an intriguing notion that smacks of second-revenue-stream potential. It’s not clear whether eventual compensation would take the form of cash payments or shared subscription and user fees. But it clearly is a new revenue stream in the making.
Infrastructure improvements
The tug of war between cable operators and conglomerate content suppliers with lots of bargaining chips, such as Walt Disney with its ESPN, is about to intensify. Cable operators are more aggressively fighting another annual 20 percent rate hike just to preserve ESPN’s historically rich profit margins. Their negotiating weapon may be resisting Disney’s proposed doubling of carriage fees for its revamped ABC Family Channel. Five of ABC Family’s seven MSO carriage pacts have already expired. The battle could set new guidelines for future content licensing deals.
Even with dual subscription and advertising revenues as a safety net, highly leveraged cable companies may find it difficult to maneuver as quickly as they had hoped. They still are paying off an estimated $60 billion in broadband infrastructure improvements before realizing any substantive regular returns on their investment from new digital services.
Until that occurs, cable companies will continue to swap systems and investments in search of value.
During the cable show, AOL Time Warner filed a warning with the Securities and Exchange Commission indicating that it will reduce its stock buybacks and might incur “an additional significant noncash charge” due to the decline in the value of its Time Warner Telecom, for which it took a $571 million charge in the first quarter, even afte
r taking a record $54 billion first-quarter write-down for the loss of value in its overall company.
With $4.5 billion in available funding to cover more than that in acquisition, buyout and restructuring commitments, liquidity is an issue even for a company as large as AOL Time Warner.
And even AOL Time Warner is looking over its shoulder.
There were growing signs last week that EchoStar Communications’ proposed acquisition of Hughes Electronics’ DirecTV could be blocked by government regulators, immediately paving the way for Rupert Murdoch’s News Corp., and its ally John Malone to step in with a more aggressive takeover bid.
If that happens, and it very well could, the global satellite entity that is created would give new meaning to the word “scale” and new urgency to the cable industry’s call for digital maturity.