Hysteria, says Webster, is ?any outbreak of wild, uncontrollable feeling.? That's a proper description for the treatment of cable stocks in recent months. But now I have a new definition of investor paranoia: fear of everyone's cash flow valuations when one company cooks its books.
Cable stocks were dumped wholesale on June 26-27 when it was revealed that WorldCom fabricated its cash flow (better known as EBITDA, for earnings before interest, taxes, depreciation and amortization). This broke new ground in the field of guilt-by-association. Much as cable MSOs would like to have the long-distance lucre WorldCom has (or was supposed to have), the only thing they share with that reviled carrier is the EBITDA valuation model. So they quickly became racially profiled.
Amazingly, it took only minutes for analysts to give last rites to the time-tested theory that some companies deserve to be valued on the basis of their cash flow, rather than their earnings. Especially when they don't have earnings in the first place.
Return with me now to yesteryear, when, as an analyst at E.F. Hutton, I wasn't allowed to write about cable companies. I left, and by January, 1970, in my own newsletter, I was comparing the public cable MSOs by cash flow and value per subscriber (VPS is, in fact, a shorthand way of expressing a cash flow multiple). I didn't invent the theory, but I was the first to articulate the methodology cable operators (and broadcasters, for that matter) were using in their private negotiations to buy and sell properties. And still use.
Eventually, all of Wall Street came to understand that a real estate mentality (cash in vs. cash out) was a more reliable way to analyze capital-intensive industries with long-term growth horizons, high cash flow, low earnings and no taxes. Cable was (and is) the best of that breed. The Street named it EBITDA in the 1980s.
WorldCom shocked the world by inflating its EBITDA, capitalizing more than $4 bil. of certain operating expenses. The quick, and unbelievable, conclusion drawn by many of the offended investors and analysts is that, since one company figured out how to manipulate its EBITDA, the underlying theory as a base for valuation must be suspect.
Right, like bottom-line earnings are as pure as the driven snow.
The very reason EBITDA valuation has thrived for decades is that it is a truer measure of a company's operating performance, and is far more useful for comparing one company with another. If EBITDA is dead, long live cash flow!
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This is the sixth time in their public market history that it has looked like ?curtains? for cable stocks: 1974, 1982, 1987, 1990-92 and 1997. The last time, Fox and its ?Death Star? told MSOs to call in Dr. Kevorkian. The Kagan MSO Average was 885 then and proceeded to rise 7-fold to the 2000 top of 6095. Now, due to contagion from Adelphia and WorldCom, the average fell to 1421 on June 27, a 77% decline from the peak.
It's the second-biggest correction in industry history, worse than the 58% decline in the Gulf War crash of 1990 and almost as bad as the 95% wipeout in the Credit Crunch of 1974. The latter, though, hit a very young industry that had little cash flow. Now the group is running at an annual rate of $15 bil., and, at their lows June 27, were valued at 8x.
(Note: This column was written on July 1, 2002.)
Analyst Paul Kagan writes exclusively for Cable World. He is an active investor and money manager and often owns securities mentioned in his columns. He may buy or sell before and after the columns are published, and his positions may change at any time. Information in his columns does not represent a recommendation to buy or sell securities, nor is it a solicitation of any securities transactions. Kagan is vice chairman of Primedia Ventures, an affiliate of the owner of Cable World.
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