Banc of America analyst Doug Shapiro sees opportunity in Comcast for headline-conscious investors. By Steve Goldstein In his Media Outlook 2006 report released earlier this year, analyst Doug Shapiro named Comcast his top cable pick, and reiterated his assessment in this month’s report, Comcast Corp.: All Systems Are Go on VoIP. In an interview, Shapiro, Banc of America Securities’ managing director and senior research analyst, discusses how Comcast can convince investors to wake up to its true value. Why did you pick Comcast as your top pick for cable operators in your Media Outlook for 2006? Shapiro: Cable is a pretty homogeneous group. Typically either all the stocks will work or all the stocks won’t work. Either the sector works or the sector doesn’t work. When you get down to the actual brass tacks of which one to pick it becomes, I’ll concede, a little subjective. If you’re positive or negative on the cable industry then the next step is to figure out which stock offers the best risk and reward combination. So for Comcast my argument would be that it offers a pretty good risk profile because it’s at a historically low valuation and has a very healthy balance sheet. If you looked at the historical valuations you’d see that the only time in the past that it’s even approached the level it trades at currently was during credit crises. When you go through the process of elimination you have a Charter, for instance, which is really not an equity story, it’s a debt story, in the sense that there’s such a small equity component in the company and there’s so much debt. Because it has such high debt leverage it would be the most expensive cable company in the sector even if the stock went to zero. When you’re talking about a top pick in cable you’re going to be debating whether it’s Comcast of Cablevision. Obviously with Cablevision it’s been somewhat volatile over the last year and a half. I actually think Cablevision is cheaper than Comcast, but from a risk/rewards standpoint I think Comcast is probably more attractive. But there’s clearly subjectivity involved when you get to that level of specificity. Can you characterize investors’ perceptions of that MSO? Shapiro: For investors’ perceptions of Comcast you first start with investor perceptions of cable and then you could even broaden that out to investor perceptions about the TV distribution business. Clearly there is a lot of concern among investors about the ability of cable to derive the kinds of returns that we’ve been expecting all these years. There’s just fear about competition—competition of any form. Right now the most focus is on facilities-based competition from the Bells. Ranking a close second is concern about competition through virtual video providers, whether that’s a Google or a Yahoo or somebody who’s disaggregating the application from the infrastructure and just selling you the application on somebody else’s infrastructure. Clearly DBS is the only one of [cable’s competitors] that’s actually offering any real competition in the immediate term. The perception is that that’s a relatively healthy environment in the sense that there’s always been rational pricing. Cable and DBS have been a relatively rational oligopoly. That’s the history of it, and it’s become even more so in recent months as you have both DirecTV and EchoStar, to a lesser degree, sending the message that they’re focusing on profitability and not unit growth. From an investor’s standpoint they don’t see a lot of change. There’s some question in the market about what would happen in the market if they put their money behind some kind of wireless broadband solution. Most of the focus is on the Bells and the Googles and Yahoos of the world. Obviously it varies who you’re talking about. Verizon is different from AT&T is different from BellSouth is different from Qwest. But Verizon and, to a lesser degree AT&T, are investing in an on-net video solution. And there’s a lot of uncertainty about what will then play out. In general there’s the fear of the unknown. And there’s also what I’d call holder fatigue. For some of the people who’ve owned these cable stocks for a long time, the stocks have not performed and you’re continually being buffeted by negative news flow and this article in the Journal and that article in the Journal and everyone proclaiming the death of distribution. At a certain point you just get tired of defending the stocks. If you think about the mentality of an analyst who works at a big mutual fund and has told his portfolio managers to buy stock X or stock Y and then he’s being continually called on the carpet to answer why the stocks are down or why the Journal wrote this or that, at a certain point you just get sick of it. The stocks have become a bit too labor intensive, in the sense that you have to always be doing work to understand the latest perceived competitive threat. This circles back to valuation. If you look at the relative value of cable stocks in the market, they’re really at unprecedented levels of discounts. The only time you’ve ever come close to these kinds of discounts was in the past during credit crises in September ’02 and post-Adelphia and Enron and in ’96-’97 when TCI was supposed to be on the verge of bankruptcy. You say, well, Comcast has the healthiest balance sheet it’s ever had, it’s been using excess capital to buy back stock. How could the market value the stock lower today than it did when it was on the precipice of its credit crisis? And I think the answer is that there’s this holder fatigue, and you have a market where there’s not a lot of rotation, there’s not a lot people moving around money very aggressively and there’s so much uncertainty in the market. There’s more safety in numbers than usual. It’s been more of a fear-driven than a greed-driven market. And because of that people tend to congregate in packs, and it exacerbates trends. Stocks that are going up keep going up because everyone piles into them, and stocks that are going down keep going down because everybody gets out of them. I’ll talk to investors who say that they’re not so much worried about whether the article in the paper is right; they just worry about whether there’s going to be another like it the next day. In a market where people are being graded on very short time frames, whether those perceptions turn out to be correct in the long term or not are almost irrelevant. There’s a shrinking pool of capital that has the luxury of having a long-term time horizon. And this is a group that requires a long-term time horizon. Getting back to Comcast, those are the concerns they’ve had in the market about the group generally. For Comcast specifically the concern has been more about the pace of their VoIP rollout. What role will VoIP play in perceptions of Comcast this year? Shapiro: VoIP is probably the single most important factor. Comcast suffers in comparison every quarter because Cablevision and Time Warner are so far ahead. I think investors have overlooked a couple of things. Comcast has a different set of circumstances. They probably had more heavy lifting to do at some of these old AT&T markets. And then the big thing is that they were doing everything in-house because they want to control the network end to end. And you have Cablevision and Time Warner that chose to outsource a fair degree of the nuts and bolts of telephony. The other thing that people are forgetting is that for Cablevision and Time Warner, it took them each about four or five quarters to really hit critical mass on the VoIP deployment. If you were to graph Comcast net adds per homes marketed on the same timeline, to normalize it for the first quarter of launch, you’d see that Comcast was actually right on track with where Cablevision and Time Warner were at this point in their deployment. But every quarter you’ve got Cablevision and Time Warner shooting the lights out, and then you look at the Comcast numbers and they haven’t been there. So there’s some skepticism about that and concerns that maybe they have some structural problem that nobody else has. We don’t think that’s the case. If you simply extrapolate what these other guys have done and you take into account the delay that Comcast is having in the launch you’ll see that they’re really on track to at least meet, if not beat, the expectations for VoIP adds this year. If you look at Cablevision and Time Warner, what’s interesting is that they’ve been putting up very strong sub adds, but VoIP has up to this point been a bit of a drag on margins because they’re bringing on revenue that has low margin or no margin. They’re spending a lot money and they’re both just starting to get to the point where that starts to reverse, and you actually start to see the benefits of voice in the EBITDA growth too. If you look at the numbers that Cablevision put up this quarter they’re very impressive. The second most important thing for Comcast is they need to hit their guidance for capex and EBITDA growth. The third thing is to continue to do what they have been doing, which is using all of their excess cash to buy back stock. If they do all those things, when you couple that with a historical low valuation, I don’t think that it would take a lot to move the needle and get people excited. What pending legislative issues might affect your outlook on Comcast? Shapiro: There is the whole a la carte, indecency question, and whether there’s going to be legislation that would be a backdoor to giving the FCC the jurisdiction to enforce a la carte. Other than that the other chief issue is some kind of national franchising legislation. Those are the two things we’d be the most focused on in terms of risks. In terms of the national franchising legislation, the jury is out on exactly what that would mean. There are a number of pretty substantial business impediments to these on-net video efforts really working. And the difficulty of securing franchises is a part of the problem, but it is not at all the heart of the worst part of the problem for the Bells. If the Bells were to be given some kind of national franchising relief that made it very simple for them to get franchises I think that there’s little question that that would damage the psychology on all the video distribution stocks further. It seems to me that it’s going to be tough to get that kind of legislation passed in the next 60 days. The other thing is that when you start messing around with states’ rights or municipality rights it’s going to get kind of contentious. So No. 1, it sounds like that legislation is still a bit of a long shot this year and, No. 2, the devil will be in the details. And on a la carte, it’s hard to see, given how tumultuous that would be and the fact that there’s just absolutely no regulatory framework associated with that, it seem that that’s also a long shot. You start to ask questions like, OK so now we’re going to impose a la carte, how do we determine how much each channel costs. Are you then going to go to the point of actually legislating or regulating on a channel-by-channel basis what each channel is worth? That’s a Pandora’s box too, and enough legislators have come out and said that they think a la carte has the potential to have negative impact on the public interest. To what extent does Comcast’s performance influence investors’ perceptions of all cable operators? Shapiro: Comcast is the proxy. When it does well there’s a perception that cable’s doing well, when it doesn’t then there’s a perception that the cable industry is not. I would say that’s a little overly simplistic. Comcast has had in the last couple of quarters mixed results. Yet Cablevision has continued to put up very impressive numbers. I don’t think that there’s such a direct linkage that if Comcast doesn’t go up that Cablevision couldn’t go up. But certainly from a portfolio manager’s perspective they are definitely linked.