Rate cut no tonic for cable stocks

Cable World, Feb 12, 2001 by Mavis Scanlon

The Federal Reserve's second rate cut Jan. 31 was supposed to provide the market -- and cable MSOs -- with the same euphoria that ensued after its early January reduction.

But instead of another 10%-plus pop in share prices, some cable stocks, such as Adelphia Communications and Charter Communications, fell slightly the day the most recent cut was announced.

Even now, MSO shares are roughly flat compared with the days before Fed Chairman Alan Greenspan made his interest rate announcement.

What gives?

One reason for the lack of momentum in recent weeks is that cable stocks saw large jumps in their prices throughout the fourth quarter, especially in December, when stocks rose in expectation the Fed would step in to spur the battered market. Investors fleeing from tech and Internet stocks helped bid up MSO shares because the group's steady cash flow and large asset base makes them a defensive investment.

Now, the $64,000 question is how much more can MSO shares run, even in a declining interest rate environment?

Cable has significantly outperformed the broader market in recent weeks and, as earnings season begins, operators are expected to post strong numbers -- usually a driver for stocks. Incremental revenue from cable's new service offerings is expected to kick in as upgrades are completed. Further, even in a slowing economy, consumers are more likely to cut large-ticket items out of their budgets before they turn off cable.

All that bodes well, but the payoff -- both in cash flow and stock valuations -- may be more long-term than short-term, say some analysts.

"We are maintaining a somewhat cautious stance on meaningful near-term valuation expansion," says John Martin, who follows the industry at ABN Amro.

Historically, cable stocks perform better in lower interest rate environments, he explains, in large part due to the lower cost of debt service that comes with lower rates.

"But in some respects we think a lot of that is already baked in to the stock prices," he says.

Two immediate benefits of lower rates are a greater access to capital markets and lower interest expense on variable-rated debt -- a lower cost of capital. Comcast, Charter Communications and Adelphia issued larger-than-expected debt offerings within days of the first rate cut.

Cable companies took advantage of lower rates to get better deals on refinancing debt and, consequently, will pay less interest expense going forward.

Charter, for example, as of Sept. 30 paid an average of 9% interest on its then-outstanding $12.2 billion in debt. Since 40% of its debt bore variable rates, even a cut of 1% would save the company about $50 million.

Here's the catch: While $50 million is a significant absolute number, it would barely make a dent in the bottom line of a company whose cash flow runs more than $1 billion, says Russ Solomon, senior media analyst at Moody's Investors Services. In essence, he says, interest rates would have to be dramatically lower to make any huge impact on the company's balance sheet.

Still, companies will jump to take advantage of lower rates -- after all, it's the treasurer or CFO's job to minimize the cost of capital.

From a stock perspective, however, cash flow increases will likely drive stocks more than rate cuts.

Jessice Reif-Cohen, who covers the industry at Merrill Lynch, wrote in a recent report she expects valuations to improve from current levels -- which are near historical highs -- as "revenue and EBITDA growth accelerate from new services (largely digital and high-speed data) and as `new' new services are introduced," such as video-on-demand, Web to TV and games.

Although it may prove easier said than done, that is exactly what operators are striving to do.