Investing in the Shrinking Cable TV Business

Merger plans between the two largest U.S. cable television service providers Comcast (NASDAQ: CMCSA) and Time Warner Cable (NYSE: TWC) have investors and customers sitting on opposite sides of the fence.

What makes the potential marriage a topic for much debate is the size of each company’s share of the cable television market. Where Comcast holds the number one spot with 21.7 million subscribers, Time Warner comes in at number two with 11.4 million customers.

Out of a very rough estimate of some 100 million U.S. households subscribed to cable television services, the combined conglomerate would be the gatekeeper to a full third – some 33.1 million – leaving a huge gap between itself and its closest competitors Cox and AT&T who barely have 4.5 million subscribers each.

Will such a merger really benefit customers as Comcast proclaims? What about shareholders? Will investors be better off or worse? You might be surprised at the results.

Mergers Usually Benefit All

Whether a merger is beneficial or not depends on the type of meld.

For instance, a merger between two companies that directly depend on each other – say a furniture retailer and a furniture manufacturer – would clearly have positive benefits for both consumer and investor alike. The costs saved in manufacturing could be used to lower furniture sale prices (benefitting consumers), retained to increase stock value (benefitting investors), or a combination of both to benefit all.

Another type of merger exists between businesses that don’t deal with each other directly, but would complement each other if joined – such as an auto dealer and an auto insurer or auto lender. Although each business can carry on independently of the others, they may as well come together since they cater to the same customer.

Once they get that customer in the door, it’s as simple as just passing that client down the assembly line from auto loan, to auto purchase, to auto insurance, and essentially milk the cattle for all their worth. This merger type, too, would be beneficial to consumers, who now enjoy the convenience of one-stop shopping, as well as investors, who enjoy profits from multiple sources, and lower expenses from lighter overhead and labor costs.

Yet another merger type involves businesses from completely unrelated industries, where one of the companies might be having a hard time expanding in an already saturated market. Since its present market offers no room for growth, the board of directors will jump the fence into an entirely different field that offers plenty of room for expansion.

This type of cross-industry merger might not necessarily offer many benefits to consumers, since the industries are too diverse to offer much in the way of synergy at lower company levels. But the blend would benefit shareholders who would now be exposed to growth potential.

But then we have mergers like the one between Comcast and Time Warner. This one is a little more complicated than the others, with any perceived benefits left up to intense debate.

A Match Made in Heaven or Hell?

It must be noted that both Comcast and Time Warner offer services across multiple industries. Comcast, for instance, provides cable-based access to television and internet, online advertising, cable networks, broadcast television programming, filmed entertainment, even theme parks.

Time Warner Cable, for its part, offers cable access to television programming and high-speed internet, online radio, cloud computing, web hosting, computer security, local and long distance telephone services, even home automation and monitoring services.

Does it sound like a potential monopoly? It does come close, according to the government’s own HHI (Herfindahl-Hirschman Index) which rates a market’s concentration on a scale of 0 to 10,000.

Simply put, a market with no dominant companies has the lowest concentration rating of 0, while a complete monopoly with just one company controlling 100% of the market share is rated the highest concentration rating of 10,000. A market is considered moderately concentrated if its HHI measures between 1,500 and 2,500, and is considered highly concentrated if it measures above 2,500.

How would the Comcast / Time Warner merger change the cable television market’s HHI? As it stands today, before the proposed merger, some estimates put the cable tv market’s HHI at around 1,800, or moderately concentrated across numerous small and mid-sized providers.

But after the merger, the cable tv market’s HHI would soar to around 2,450. That’s pretty close to the 2,500 threshold into highly concentrated, isn’t it?

This is probably the reason why Comcast promised to downsize its client base by 3 million subscribers, bringing the merged subscriber base down from 33.1 million to 30.1. Without this downsizing, the cable tv market’s HHI would definitely be well above 2,500, and would likely be blocked by antitrust law.

So it looks like Comcast knows how to get around the restrictions, and will probably succeed with its merger plans. But will it be good or bad for customers and investors?

Great For Investors, But So-So For Customers

For cable tv and internet customers, one very important stat can make the proposed merger less harmful than it appears.

The fear has always been that mergers stifle competition by taking out rivals and limiting customer choices. But Comcast argues that “Time Warner Cable and Comcast don’t compete against each other in any given market”.

They pretty much have their own regions of service, as noted in the map below.

Source: Mosaik Solutions

If Comcast’s and TW’s service areas did overlap each other, then customers would suffer from a reduction of providers to choose from. But as it stands now, customers don’t have a choice between the two providers; it’s one or the other at it is. Customers, therefore, would not be experiencing the elimination of one of their choices as a result of the merger, since they are already living in one-choice regions even now.

However, apart from cable access, the merger would limit customer choices in online services. The two companies may not overlap in physical space, but they do overlap in cyber space, and the merger would concentrate the two companies’ online profiles into one.

But while the merger would be restrictive to some consumers, its impact on shareholders would be nothing but beneficial. Synergy at the upper levels of management and executive staff would save millions in annual salaries, while the expansion of the client base would increase revenues dramatically.

Time Warner’s revenues are clearly better than Comcast’s relative to market cap. While Comcast’s revenues of $64.66 billion measure 49.8 percent of its $129.78 billion market cap, TW’s revenues of $22.1 billion measure some 57.5 percent of its $38.38 billion market cap. TW also generates better returns on assets and equity (6 percent and 27.46 percent) than does Comcast (5.24 percent and 12.01 percent).

Then there’s Time Warner’s substantial operating cash flow of $5.75 billion, some 15 percent of its market cap, as compared to Comcast’s cash flow of $14.16 billion, or 10.9 percent of its market cap. And what Comcast shareholder would not be attracted to TW’s diluted earnings per share of 6.7 as compared to Comcast’s DEPS of 2.56? As a much leaner profit generator than Comcast, Timer Warner is more rewarding to shareholders, which would boost Comcast’s shareholder value and benefits.

So while customers may find the merger a little more restrictive in some services and inconsequential in basic access, investors will definitely come out of it in better shape than when going in.

Joseph Cafariello