undervalued opportunities for patient investors
By Ann M. Miletti and Thomas D. Wooden, CFA—Portfolio Managers
Opportunity Fund
Our team continuously looks for stocks that we believe are selling below our estimate of private market value (PMV), or what we believe a private equity investor would pay to acquire the entire business. We have found several such investments within the cable industry and believe that the PMVs of certain stocks in the sector continue to offer compelling value for patient investors. In our assessment, investors are overestimating the effect that the recent stagnation in video subscriptions will have on cable company earnings just as cable companies are strongly benefiting from growth in higher-margin broadband internet services. Because of investors’ focus on near-term negative trends in the video space, we have been able to uncover several companies that we believe have stronger fundamentals than their equity prices would suggest.
The increased importance of broadband internet services
Growth in cable subscriptions has dwindled, with total subscribers to the top 14 multichannel video program distributors (MVPDs)—including cable, satellite, and telecommunication companies—rising only by approximately 383,000 subscribers in 2011.1 By comparison, during the industry’s higher-growth period in the 1990s, MVPD subscribers grew from a total of 60.3 million households as of year-end 1993 to 94.1 million households as of June 2003, an average of more than 3 million a year.2 However, in our view, the markets have underestimated the effect of the growth in broadband internet services, leading them to undervalue some cable stocks.
Growing interest in online content and games has made internet subscribers more willing to pay for high-speed broadband internet services, and in most locations the fastest service comes from the cable company. Broadband internet subscriptions generate substantially higher profit margins than video subscriptions because the cable company doesn’t have to share revenue with channel providers. According to industry researcher Strategy Analytics, the margins on cable broadband services are 70% to 110% higher than those on video services (depending on whether or not advertising revenues are included in the calculation).3 Those margins can rise if subscribers pay extra for faster service tiers. In an August 2011 interview with The Wall Street Journal, the chief executive of Time Warner Cable Inc. (the nation’s second-largest cable operator) said that broadband is becoming the operator’s “anchor service,4” implying that the foundation of the company’s profits are increasingly coming from broadband internet subscriptions.
TABLE 1: Growing revenue from broadband internet services hasled to positive earnings surprises
Some of the stocks that we have found particularly attractive include Time Warner Cable, Cablevision Systems Corporation, Comcast Corporation, and Liberty Global Incorporated.* Aside from attractive industry trends, we believe that the underlying fundamentals of each of these firms need to be continuously assessed for their own unique benefits and risks.
TABLE 2: Price valuations within the cable and satellite industryremain attractive
For example, despite Cablevision’s slower growth rate relative to peers in the industry, its dominant position within the lucrative New York City and surrounding market makes the company’s assets quite valuable. We estimate that the stock has recently been trading near the lower end of its PMV range and that it has the potential for significant upside in the longer term. Likewise, Comcast has not only increased revenues through its sale of broadband internet services, but we believe the company can create further value from its 2011 acquisition of a majority stake in NBC Universal Media, LLC, which owns not only the NBC television network, but also such cable channels as USA Network and CNBC. Comcast’s stock has begun to approach the top of its PMV range, though we still believe that it could continue to rise as it reaps benefits from last year’s acquisition and sees potential increases in homeownership.
Concluding observations
Through our PMV process, we identified cable company stocks that demonstrated the potential for long-term appreciation. Even though the number of video subscribers has stagnated, cable companies have been able to generate growth largely by focusing on their broadband internet services, which have higher margins than their video services. We believe that investors may still be able to find value in specific stocks within the cable industry as companies increase their customer base of both businesses and general consumers, add new service offerings, and continue to leverage the potential of internet broadband.
Ann M. Miletti is also the portfolio manager for the Wells Fargo Advantage Common Stock Fund.
Stock fund values fluctuate in response to the activities of individual companies and general market and economic conditions. Smaller company stocks tend to be more volatile and less liquid than those of larger companies. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk. Consult the fund’s prospectus for additional information on these and other risks.
