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Morningstar | Comcast Posts Strong Results as Sky Strategy Unfolds; Maintain $42 FVE as Shares Still Undervalued

Comcast’s core cable business continues to perform well, gaining market share in the Internet access business and expanding margins during the third quarter despite ongoing pressure in the traditional television market. With the Sky acquisition complete, Sky CEO Jeremy Darroch presented the state of the business and Comcast provided its strategic rationale behind the deal, which primarily ties back to increased global scale. Comcast appears content to play nice with emerging online players like Netflix and other content owners, but we suspect it believes Sky adds strategic options should some of these relationships sour. To that end, we expect Comcast to increase investment in Sky’s original content production capabilities. While we believe Comcast paid a high price for Sky, we also think the strategic rationale makes sense. We are maintaining our $42 fair value estimate and wide moat rating.

Cable revenue growth held steady at 3% year over year, with a spike in political advertising offsetting lower pay-per-view sales during the quarter and the remainder of the business performing in line with recent trends. The firm added 363,000 net new Internet access customers, about 70% more than a year ago, and average revenue per customer increased 4.5% year over year, which we believe reflects Comcast’s shift in emphasis to favor this business rather than bundled services. The firm lost 106,000 net television customers during the quarter, but this figure improved year over year for the first time in eight quarters.

NBCUniversal posted solid growth, with revenue up 8%, but soft margins. Both the cable and broadcast networks produced strong subscription (affiliate and retransmission fees) and advertising growth, primarily driven by higher pricing. The studio business continues to face a tough comparison versus 2017’s heavy film slate, while theme park revenue was disappointing, declining 1% thanks to the storms and earthquakes in Japan.

The cable EBITDA margin expanded to 40.7% from 39.1% a year ago. The decline in television customers has limited programming cost growth, and efficiency gains in customer service kept other operating expenses flat. At NBCU, the EBITDA margin contracted sharply to 24.0% from 28.3%, pulling EBITDA down 8.5% year over year. Programming and production costs to support the networks continue to increase, with the World Cup adding pressure during the quarter. Similarly, the film studio continues to invest aggressively in content, but without a highly profitable blockbuster release in the quarter, studio profits declined 44%.

Tax reform, solid cable results, and modestly lower cable capital intensity have lifted free cash flow nicely. Thus far in 2018, free cash flow is up 34% to $10.5 billion, with $6.4 billion returned to shareholders via the dividend and repurchases. With the Sky deal closed, management said net leverage now stands at 3.5 times EBITDA, with management committed to return leverage to a level consistent with Comcast’s current credit ratings within 18-24 months. With share repurchases on hold, the firm should be able to meet that goal, assuming no major additional M&A activity or wireless spectrum purchases.