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Stock Strategist

Despite Mixed Earnings Report, This Cable Company May Still Have the Right Vision

Second-quarter results sent Cablevision's share price down, but we're holding on to our fair value estimate and moat rating.

 Cablevision's cable business serves more than 3 million customers in the New York-New Jersey-Connecticut metroplex area, as well as parts of Pennsylvania. Given the high level of wealth and population density of this technologically progressive market, Cablevision has been able to develop a well-entrenched competitive position by offering a stable of advanced service offerings. This approach has rewarded Cablevision with industry-leading market penetration rates.

The flip side to high penetration rates is a mature market, and we think Cablevision's easy growth is behind it. Annual subscriber growth for its Internet service has slowed to roughly 3% versus the 20% seen a few years ago. Growing competition is another headwind. During the past five years, telecom giant  Verizon (VZ) has invested heavily in its ambitious FiOS network in an effort to battle Cablevision for triple-play customers. We don't think Verizon will be overly promotional in rolling out FiOS, given the substantial investment required. However, we think FiOS' superior technology and delivery capability position Verizon to threaten Cablevision's dominance and capture market share.

We Think Shares Are Overvalued, but the Firm Is on the Right Track
Cablevision posted a mixed second-quarter earnings report, with revenue and EBITDA coming in ahead of expectations on weaker-than-expected subscriber numbers. We continue to believe the shares are overvalued due to the prospects of a merger or acquisition, and we do not plan to change our fair value estimate or moat rating at this time.

Second-quarter revenue rose 3.8% year over year to $1.63 billion--roughly 1.5% ahead of consensus. Both the core cable business (up 3.7%) and the other segment (Newsday, up 0.4%) were stronger than expected. The firm continues to keep pricing firm, evidenced by a 7.4% increase in the average monthly cable revenue per video customer (ARPU). That said, the ARPU jump was partly fueled by the further erosion of its subscriber base. Video customers fell by 3.3% to 2.77 million, and the firm lost high-speed customers and voice subscribers on both an annual and sequential basis. This dynamic underscores our negative view on the firm’s economic moat trend. Ultimately, Cablevision is being forced to choose between gaining share and losing ARPU. That said, given that the firm’s adjusted EBITDA margin expanded nearly 200 basis points to 29.9% (beating consensus by 2.1 percentage points), it seems to be heading down the right strategic road.

Financially, the firm continues to lighten its massive debt load. Net debt fell by more than 11% from the year-ago period, which cut its net leverage ratio by more than 1 turn to 4.1 times adjusted EBITDA. Free cash flow is on the rise given the lower capital expenditures (down 14.1% year to date), but the firm isn’t repurchasing any shares despite having $455 million available under its buyback authorization. Given that the shares are trading 12% ahead of our fair value estimate, we agree with management’s decision to hold off on buybacks.

A Focus on Its Core Businesses Points Cablevision's Operations in the Right Direction
While managerial missteps have plagued the firm in the past, we do agree with the firm's spin-offs of Madison Square Garden and Rainbow. These moves should boost free cash flow and allow the company to deleverage while opening the door for management to pour more resources into its cable empire. These moves, combined with the recent dividend increases and share buybacks (although the firm slowed down the pace in 2013), have gone a long way to make Cablevision a cleaner, clearer story. However, it also shines the spotlight exclusively back onto the operational performance of its core cable segment. Unfortunately for Cablevision, management's shying away from rate hikes while programming costs (and capital expenditures) continue to rise means the firm's margins, free cash flow, and share price might be stuck in neutral, barring major takeout speculation.

Our Fair Value Estimate Is $17 per Share
Our fair value estimate is $17 per share. With the lack of rate increases, coupled with the uptick in capital spending and the increase in programming costs, the firm's free cash flow will remain under pressure in the near term. A protracted retrenchment in consumer spending, coupled with increasing competition from the likes of Verizon, will make the headier growth rates of recent years more difficult to achieve. Our average annual organic revenue growth rate is 3.3% for 2013-17. The firm should be able to increase average revenue per user by penetrating the SME market and getting a recovery in advertising rates, but the pace of the ARPU expansion will continue to slow. That said, the firm still owns roughly 5 million high-ARPU customers, which, especially after its recent divestitures, makes it a prime takeout target.

Narrow Economic Moat Intact Amid Economic and Competitive Pressures
We think Cablevision has a narrow economic moat. The firm consistently has outmarketed its competitors, exemplified by its industry-leading penetration rates for digital cable, voice, and Internet. For example, the firm has been able to migrate an industry-leading 95% of its customers to digital cable, even though it was the last major operator in its market to offer the service. It also owns the highest-ARPU cable base in the sector, and the scale economics of the industry have allowed it to have lower programming costs on a per-subscriber basis.

Given the economic and competitive pressures in its industry, we have lowered our moat trend rating to negative from stable. The fundamental model on which the industry is predicated--paying X for content acquisitions and charging Y for distributing the content--is eroding. There is more competition from satellite TV providers (most notably  DISH  and  DirecTV ) as well as telcos such as Verizon and  AT&T (T), and now a majority of larger ILECs are rolling out their own IPTV products. Also, the continued proliferation of online content, both VOD and broadcast, is proving problematic. Ultimately, despite the rise in content costs, Cablevision has not been able to raise cable prices of late for fear of share erosion. This dynamic will continue to pressure the firm's margins and economic efficiency prospects.

Recent Spin-Offs Improve Our View of Management
Charles F. Dolan founded Cablevision in 1973 and has served as its chairman since 1985. Six sons and daughters currently serve in various executive and board capacities, including his son, James L. Dolan, who retains the president, director, and CEO titles. The Dolan family's tight-gripped control over the company is entrenched by a long-standing dual share-class structure, which gives the Dolan clan 70% of the voting power while retaining only a 21% economic interest. We think this shortchanges common shareholders. Total compensation packages for Charles and James Dolan are more than generous, but their base salaries only account for about 11% of their total compensation packages. Finally, we question the wisdom of the special one-time $10-per-share dividend issued in 2006. The company funded this dividend with borrowed money, adding $3 billion in debt to the balance sheet. We estimate that the dividend funneled as much as $650 million into the Dolan family coffers. Because the Dolans stood to benefit the most from the dividend, we think capital allocation decisions have been made in the family's best interests, to the detriment of new would-be shareholders. At the end of 2011, COO Tom Rutledge and President of Cable Communications John Bickham resigned. Ultimately, while we don't agree with many of management's previous decisions, we think the recent spin-offs of Rainbow Media and MSG made the Cablevision story more investable for the stock market and more digestible for potential suitors.

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