Searching For Buried Treasure
In today's stalled economy, banks are more conservative when it comes to financing loans, venture capitalists have nearly disappeared and non-bank lenders are skeptical of companies that can't show legitimate earnings potential and cash flow. That's not news. But it's making access to capital for smaller cable operators nearly impossible.
Smaller, independent cable operators are used to facing adversity and challenges, especially when it comes to convincing lenders to finance an upgrade, a rebuild or a simple system tweak to remain competitive. Now they're being challenged more than ever.
That's not a pretty picture for smaller cable operators. It's a gloomy outlook that has remained relatively unchanged for years and has pushed smaller cable operators to creatively pursue much-needed financing to compete and survive.
Now, that picture may be brightening, albeit with several caveats.
"For any company, it's a challenging credit environment, but there are still media lenders doing business with small cable operators," says Tracy Smith, vice president of communications finance for Wells Fargo, a leading lender to smaller cable operators. "They have a better story to tell with current upgrades when seeking financing. It's a hard story to tell, but there is lendable cash out there."
Wells Fargo and a handful of other lending institutions remain relatively bullish on small cable systems, particularly those with an owner/operator structure. "An operator could pass every mark, but if management isn't there, the deal will probably blow up. It's always bad management that does it. It's not flawed business models, but flawed management. We would rather work with owners/operators. They live and breathe the business and listen. They're willing to do the right thing," Smith says.
Living and breathing as a small operator isn't for the faint of heart, however, and the recent spate of defunct dot-coms and growing anxieties among lenders over bad debts, along with the failure of some companies in the contract manufacturing sector to honor their contracts, aren't helping matters and are contributing to the virtual closing of vendor financing programs.
"Even when Cisco Systems designed a great financing program, they were burned by some of their vendors and contract manufacturers, so vendor financing isn't in the cards. Too many companies have been stung so they don't want to do it anymore," says Mark Bishop, senior VP of hardware for the National Cable Television Co-Op (NCTC).
Yet despite the crushing financial and operational concerns such as little or no economies of scale, antiquated cable plant and rising programming costs, there are faint signs that the small cable market may be redefining itself, albeit slowly and cautiously.
"There are sufficient numbers of purchasing opportunities from the big MSOs spinning off smaller pieces and smaller operators exiting the business, and there are a limited number of buyers for those properties," says Chip James, president of ICE Holdings, an operator who's now in the process of acquiring small systems in several states.
What's most appealing about small cable, James says, is the solid cash flow and operational efficiencies of cable systems, which have the added advantage of potential new revenues from digital and high-speed Internet services. Wall Street's new-found demand for solid earnings and smart management that comes as a result of the technology sector's breakdown is contributing as well.
"Interest rates are favorable, and capital markets have moved back to renewed appreciation of cash-flow businesses like cable, so the time is right to raise capital funds. Also, prices have moderated, and we're seeing customers paying $60 a month and more for cable and ancillary services, even in small towns. That's the appeal," James maintains.
Whether it's appealing enough to attract more lenders into the small cable market is questionable, however, especially for truly small operators that have fewer than 15,000 to 20,000 subscribers.
"Size is crucial. The cutoff point for loans is about 15,000 subscribers. It's not only lack of scale, but we just can't see a return because costs are the same as a larger loan. So, smaller operators, even with great systems, will have trouble getting financing for loans under a few million dollars. It's scary (for those) on the smallest end," Smith admits.
Wells Fargo, Smith says, rarely will loan under $8 million and focuses on four key lending principles. They are:
- How the company performed through various business cycles, preferably over a 10-year period;
- The accuracy of the forecasts and budgets;
- The strength of the management team and whether the company is owner-operated;
- The quality of customer service and whether there's room to raise rates.
"The weakness with many smaller operators is they have no CFO (chief financial officer). They play a huge role in the due-diligence process, and many smaller companies really don't know the numbers. They must surround themselves with financial people," Smith suggests.
For operators such as James, reducing the costs that surround smaller systems is another key to good financial health and adds another step to the painful process of securing capital to upgrade, rebuild or acquire smaller systems.
"We have to keep forcing the capital costs down to allow new services in smaller systems. They (systems) tend to be very remote, and headend consolidation becomes uneconomical. But the good news is there's help with HITS and a new service called QuickTake," James says.
QuickTake is a combination of HITS (Headend In The Sky) and other technologies and equipment that delivers satellite signals to a transcoder at the headend and then delivers them via the coaxial cable infrastructure to set-top convertors. The result is a low-cost (but only one-way) digital headend costing about $15,000 versus the $100,000 or more for traditional digital headends. (See story on page 16.)
Reducing capital costs, especially in the headend, translates to greater system value, experts say, and can make smaller systems more appealing to lenders such as Wells Fargo, Textron, Silicon Valley Bank, venture capitalists and others who have traditionally bank-rolled small operators.
One way to lower costs is to co-op purchases of big-ticket items. NCTC, Bishop explains, negotiates volume deals for equipment and programming for its members. For many smaller operators, the volume deals have been helpful. But for some, it remains a struggle. "Even if the playing field were level, some still can't afford to play. They'll have a difficult time paying $250 each for set-top boxes. That's about $65,000 for an average small system, and they can't afford that," Bishop admits.
Yet the small-system market is becoming more attractive, even to vendors of expensive gear (see "VOD: Coming ashore in a small city near you?," page 20). "In 1997, we had $4.5 million in volume. Last year, we did $130 million. Now, every vendor wants our business. They know there's $200 million in business potential with our members," Bishop says.
Programming costs muddy the financial waters as well. Adds Smith: "ESPN's 20 percent increase will affect small cable operators, and Fox Sports is raising prices, too. Programming costs are a major component of their cost structure, and we look very closely at that, as will most senior lenders."
Yet even as operators lower their cost structures, the small cable market is mercurial at best. Says James: "The 50,000 to 100,000 subscriber systems are mostly gone, so bigger regional banks have pulled out of that business and moved to larger MSOs and the $30 million deals. Clearly, there's very little acquisition funding for smaller operators. But, there is in the $5 million to $20 million range. There's financing out there for those systems."
Financing smaller loans through the Small Business Administration is a viable option, loan experts say. "SBA will guarantee 50 to 75 percent of a loan to smaller operators, so there are some advantages to being really small. We're now making SBA loans," says Kathy Marien, president of the media division for Textron Financial Corp., a leading lender to the small cable community.
Yet Marien has no illusions about the capital-challenged small cable market. "Most lenders won't lend under $10 million to systems smaller than 5,000 subs, and that's a big problem. Most of the very small systems have to deal with their local banks," she admits.
One option, she adds, might be for smaller cable operators to strike a partnership with a local satellite service provider. "They may want to find a satellite partner or face the prospect of continued customer erosion," Marien says. Yet Textron remains open to small cable loans. "We routinely look at smaller loan requests, and we've done some in the past through SBA and would do it again."
Silicon Valley Bank is another notable lender in the small cable category which has made loans smaller than the magical $5 million mark. "Our mandate is debt financing under $10 million, so we would do cable systems with less than 10,000 subscribers, but we just don't see many of them," says John Brooks, senior vice president and manager of media practice for Silicon Valley Bank.
That could be changing, however. Adds Brooks: "Big cable operators are ending their big capital investments and could generate tons of new cash flow with new services. To some degree that momentum will trickle down to smaller operators. For a small operator with 6,000 subs and 18 headends, that's about $1.8 million for headends, but if there are 15,000 subs, it looks much more interesting. I don't think rural cable is a business that's going away."
Staying in business may require some serious re-tooling, however. "What's lacking is a well thought-out business plan to grow their businesses to compete and (whether) they have the skill sets to execute the business plan. It takes the right combination of technical and financial skills," Brooks says.
It's that combination, he concludes, that will get the attention of lenders such as Silicon Valley Bank. "If a company shows us a finance package with projected growth of 15 percent in the next four years, even with declining revenues the previous few years, we would look at that very carefully."
With all of the consolidation in the banking industry, most banks are adopting an economies-of-scale mentality. Says James: "Banks have restrictions, too. Most only want to lend where they have a retail bank presence."
Retail presence or not, James and other small cable operators feel confident they can persuade banks and other lending sources to provide the capital needed to upgrade, rebuild and compete. "We're confident the business is out there for modems and digital services and capital costs keep coming down. With the QuickTake and HITS models, for a $20,000 headend, $22,000 for convertors and about $100 in installation costs, there's about a two-year payback, which is good at 18 percent penetration. People will buy the products," James insists.
That's the idea. But for many smaller operators faced with rising programming costs, growing competition and complex business decisions, the future remains overcast. For lenders such as Wells Fargo, however, the skies could be only partly cloudy. Concludes Smith: "There's no doom and gloom attitude. They're not set for huge growth potential, but they'll find a way to make it happen and stay in business. Many of the smaller operators are very passionate about their business."