Beyond Bulls & Bears

Equity

Communications breakdown: The broadband wasteland

In the second of a two-part series on the communications services sector, Mandana Hormozi of Franklin Mutual Series maps out cable companies’ rocky traverse to new territory and reveals areas where she sees opportunities abound.

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Some companies are so integral to the way we live our lives that we hardly notice them. This includes our internet service providers, many of which are cable companies. These stocks have come under pressure in the first part of 2022. The turbulence within the industry represents big changes in the way many of these companies run their businesses, manage the competitive landscape and provide value for shareholders.

The before times

Back when dial-up was the only option for accessing the internet and set-top boxes brought a whopping 50 channels into homes, consumers primarily purchased video packages, or bundles, from their cable providers. Fees were paid according to a contract. The cost of providing more expensive programming within the bundle, like live sports, was subsidized by viewers of less expensive programming, like sitcoms. This helped to balance out the cable provider’s costs. The companies also paid for trucks, maintenance staff, and all the equipment required to maintain connectivity.

Few cable subscribers still utilize a set-top box or require in-person setup to begin service. Many consumers who pay monthly fees do not even receive video service. Several factors have contributed to a shift in the way cable companies do business. The advent of faster, more widely available internet gave birth to streaming services, which battle with cable providers for video subscribers. Consumers now want unbundled programming, or a more a-la-carte experience, which has put cable companies in direct competition with streaming service providers for the video portion of their business. However, video delivery is no longer the primary focus.

Extinction-level events

Cable companies are pivoting toward becoming connectivity companies, delivering high-speed internet through coaxial cable, fiber optics, Wi-Fi and mobile. Connectivity is a higher-margin business than traditional video delivery, with lower capital intensity and the potential for higher penetration of households as the service is an essential utility. Recently, this attractive business model has attracted competition.

The number of broadband providers is growing. Telecommunications companies, which offer fiber optic cable—a superior product for delivering broadband service—are working on expanding their footprints, aided by $40 billion in infrastructure spending that is earmarked to bring these cables to untouched rural areas. In addition, some companies are upgrading their existing networks to fiber optic cable to become more competitive broadband providers. Lastly, mobile operators are using spare capacity on their networks to offer fixed wireless access, a less competitive product, but often good enough for many consumers. While cable companies have not lost any market share yet, they are starting to feel the heat from the increase in competition.

Spam and twinkies

Cable companies have a market advantage due to robust networks that can be upgraded incrementally to meet consumer demands. Their ability to bundle in mobile and video services differentiates them from most of their competition. Their knowledge of and relationships with municipalities and history of delivering on capital plans positions them well to be beneficiaries of stimulus funds. While they will have to weather this latest appetite for infrastructure investment, we believe that the staying power of these franchises, exemplified by their high free cashflow generation, will long outlive the current fad among new entrants.

As industries evolve, an intimate understanding of the environment in which they operate becomes increasingly important. Within cable companies, we think those shifting to more margin accretive, broadband-based models can offer opportunity. The industry still has room to evolve, in our opinion, and companies that can generate free cashflow and grow their market share can unlock additional value for investors.

 

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