Debt Puts Strain on Cable Stocks

In the wake of the WorldCom Inc. scandal, cable TV stocks have been battered by Wall Street more than any sector other than telecommunications.

At the core of the cable meltdown is the industry’s heavy debt.

Debt has always been an issue for investors, but it’s become a red flag after several high-profile bankruptcies. Last week, Adelphia Communications Corp., the nation’s sixth-largest cable operator, which is under a tower of debt, filed for Chapter 11 bankruptcy protection. And with $30 billion in debt, WorldCom appears to be headed for bankruptcy as well.

Heavy debt made these companies vulnerable. But what toppled both were accounting practices that some executives and analysts said raise suspicions about the accuracy of financial reports in all capital-intensive businesses in which there is so much leeway in how to book operating expenses.

“Both cable and telecommunications march to the same metrics, and these metrics are subject to abuse,� said Leo Hindery Jr., chairman of Yankee Entertainment and Sports Network and former president of AT&T; Broadband, the nation’s largest cable operator. “The cable industry is getting crushed because investors know the companies fudge their numbers. There needs to be standards that are commonly defined and unimpeachable.�

Cable stocks already were down because of an accounting scandal at Adelphia, and they fell further last week. The hardest hit were firms with the most debt: Cablevision Systems Corp. shares fell 26% last week and are down 80% this year, while shares of Charter Communications Inc., which fell 12% last week, are down 75% this year.

The bonds of Cablevision and Charter were trading last week as if the companies were on the verge of bankruptcy. Some bonds of Charter were trading at 70 cents on the dollar.

“They both need capital but don’t have access to the equity markets, and Charter already has too much debt,� said Oren Cohen, a principal at hedge fund Trilogy Capital.

Charter Chairman Paul Allen could draw on his billions of dollars to reduce the company’s debt, according to sources close to the Microsoft Corp. co-founder.

Earnings Not a Measure

Like telecommunications companies, cable operators are judged on Wall Street by three main criteria--subscriber, revenue and cash flow growth. Earnings, the gold standard by which most companies are measured, are not used as a ruler in the cable industry because the profits come and go, depending on capital investments.

Charter posted a $1.2-billion operating loss last year, while that of Comcast Corp. was $746 million.

Though cable companies enjoy steady streams of cash, they spend even more to keep their networks up to date. Since Congress deregulated the phone and cable industries in 1996 to ignite competition, cable companies have spent $60 billion to upgrade their networks with digital technologies for high-speed Internet access and telephone service.

“They’ve become cash alligators rather than cash cows,� Hindery said. “It takes a lot of money--a lot of debt--to be in this business.�

Because of this, Wall Street has deemed cash flow a better measure of a cable company’s health than earnings. Media analysts use a gauge of cash flow known as EBITDA, or earnings before interest, taxes, depreciation and amortization. This tool is used to give a picture of how much cash a company generates from ongoing operations to pay debt, interest and capital expenditures.

But the measurement is not foolproof. Companies can book some expenses as capital expenditures, treating them as assets that can be depreciated over time. Doing so improves EBITDA and in the case of WorldCom was the difference between a profit and a loss.

Improper Accounting

WorldCom originally reported a profit in 2001 of $1.4 billion instead of a loss by improperly accounting for $3.9 billion in operating costs over the last five quarters. Instead of recording fees paid to local telephone firms for connecting its long-distance calls as operating expenses immediately, WorldCom accounted for them as capital expenditures--or assets--and depreciated those costs over several years.

Adelphia did much the same thing. The cable firm took certain marketing, labor and programming costs that should have been recognized immediately and spread those costs over many years. As a result, Adelphia overstated its fiscal 2001 cash flow by $210 million.

“There are a zillion things you can do to fool with the numbers,� said Frank Biondi, an investment advisor and former chief executive of Universal Studios and Viacom Inc. “The problem is, there are guidelines but no standard rules for fixed-asset accounting.�

UBS Warburg media analyst Christopher Dixon said, “Companies [that use] EBITDA are coming under pressure. This is part of the WorldCom meltdown.�

Some analysts said investors are overreacting to the accounting scandals and are unfairly punishing entire industries for the abuses of a few companies.

“It’s irrational that cable stocks are off by 60%,� Dixon said. “This is a great business with very stable revenue and cash flows. This is panic behavior. People are running scared.�

Dixon said it is widely known on Wall Street which companies most aggressively use EBITDA. Cohen and Dixon said Cablevision and Charter fit into this category.

Shares of Comcast and rival Cox Communications Inc., considered to be the most conservatively run cable operators, fell only 3% and 5%, respectively, last week.

One debate within the cable industry is how to account for labor costs to install new services.

“Ask seven cable companies how they do it and you’ll get seven different answers,� Biondi said.

Another area prone to manipulation is accounting for fees collected by cable operators for launching new channels.

Industry executives said these fees must be booked over the life of the contract, but some cable operators account for them immediately by booking them as advertising income, thus propping up sales.

A firm’s number of subscribers, which is used by Wall Street to value cable, phone and Internet business, also is subject to interpretation. America Online Inc. has long been suspected of giving free Internet service to customers who ask to be disconnected to continue counting them as subscribers. Adelphia, DirecTV and AT&T; Broadband recently have revised their subscriber counts downward.