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3 Major Threats Could Send This Huge Industry off a Cliff

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You have to hand it to cable companies. For years, they continually boosted prices and still managed to retain customers. Only recently has their customer base begun to shrink modestly. But thanks to several recent developments, the pace of customer defections looks set to accelerate. This implies that sales and profits may soon peak (if they haven't already), and with some pretty hefty debt loads, certain companies may see their shares plunge.

Rising costs, sinking value

Cable companies such as Time Warner ( TWC ) , Conmcast (Nasdaq: CMCSA) , Cablevision ( CVC ) and Charter Communications (Nasdaq: CHTR) aren't fully to blame for their current predicament. Key cable network operators such as Disney ( DIS ) , which owns ESPN and others, have forced the cable companies to pay ever-higher fees, and those costs needed to be passed on to the consumers. Trouble is, consumers are no longer mesmerized by theoption of more than 100 channels, realizing that they watch only a handful of broadcast and cable networks.

This created an opening for the likes of Netflix ( NFLX ) and to start winning converts, some of whom have "cut the cord" with cable companies. Yet it is three recent moves that really threaten to make consumers flee in droves.

Threat No. 1

The first threat comes from (Nasdaq: AMZN) , Sony ( SNE ) and Apple (Nasdaq: AAPL) , which announced in 2011 that they plan to develop a robust video offering for consumers, presumably at monthly fees far below that of a cable bill. This threat has been widely considered by Wall Street in recent months, though its impact has yet to be really felt. Amazon is expected to be the first to launch a service, which is not only a threat to Netflix ( as I noted here ), but also to traditional cable service as well, at least for consumers that are willing to time-shift their viewing habits away from real-time.

Threat No. 2

New York-based Aereo, a little-known holding of Barry Diller's media empire (IAC Interactive (Nasdaq: IACI) owns a partial stake) is set to roll out a $12-per-month service that lets consumers watch local broadcast stations on mobile devices and their TVs through a specialized box that pulls in digital signals far more effectively than rabbit ears. The move is being contested by firms like Disney, but could ramp up later this year. This could lead to defections from cable subscribers who don't watch a lot of TV.

Threat No. 3

Enter mighty Intel (Nasdaq: INTC) .

News reports circulated this week that the giant chip maker plans tooffer an Internet-based cable service, selling various bundles of cable networks that better target specific demographics. For consumers who only watch reality shows or sports programming or high-brow dramas from networks like FX or AMC (Nasdaq: AMCX) , this could be just what they've been waiting for.

Why Intel? Because the company appears to have realized that further robust sales gains from chip-making may be hard to achieve, despite an $8 billion annual expenditure on research and development. With roughly $15 billion in gross cash and $6 billion to $8 billion in annual free cash flow , Intel can afford to make a major bet on this initiative.

How will this play out? Either Intel will fail to move beyond the thought stage of this initiative, realizing that odds of major success are long, or it will plow ahead anyway, likely creating a lose-lose for itself and the cable companies and a win-win for consumers that get more choice and lower prices.

For the cable companies, the prospect of a shrinking customer base is a real concern. These companies carry huge debt loads, and an increasing portion of their operating cash flow may simply fund interest expenses (as operating income falls and interest expense stays constant). This means their shares will be worth less and less if current operating and free cash flow multiples stay in place. In a worst case scenario, cable operators would be forced to pay higher interest rates when it comes time to roll debt over, as interest coverage weakens.

Risks to Consider: A rebounding U.S. consumer may feel less stressed and more willing to tolerate high cable bills.

Action to Take --> For many investors, cable stocks have been a core long-term holding. The time has come to rethink this strategy. The four cable companies I mentioned have seen their subscriber base modestly shrink in recent quarters, though that process looks set to accelerate. By 2013, as these threats really start to bite, analysts will begin to identify the real risk in these business models as falling cash flow and still-high debt loads look like an increasingly mismatched pair. Aggressive investors may feel the urge to short these stocks, but investors should steer clear of buying these stocks at the very least.

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-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of INTC in one or more if its "real money" portfolios.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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