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Scientific-Atlanta's Box of Goodies

By Ari Bensinger As one of the two primary cable set-top box suppliers, Scientific-Atlanta (SFA

: $37.50) should benefit from an industry transition towards higher-end boxes that incorporate digital video recording (DVR) and high-definition TV (HDTV) capabilities, in Standard & Poor's view.

In addition, we expect the company to benefit from an improving cable spending environment, as the proliferation of bandwidth intensive applications like HDTV and video on demand (VOD) necessitate network equipment upgrades. We also think the company is making inroads in the emerging telecom video market, as evidenced by its recent Internet Protocol TV (IPTV) equipment win with SBC Communications (SBC

: S&P investment opinion, 3 STARS, hold; recent price, $24).

SOLID NUMBERS. We believe that a set-top product upgrade cycle towards next-generation cable services and the emergence of telecom video initiatives will provide the company with a strong underlying growth driver for the next several years. Scientific-Atlanta has done an admirable job over the past couple of years, performing well despite the cyclical spending habits of the cable operators, translating core strengths of manufacturing scale and efficiency into good profitability, in our opinion.

We view the company's balance sheet as strong, with a large cash position and minimal long-term debt. On both a relative and intrinsic basis, we believe the stock's valuation is compelling. Given our view of the company's improving operating fundamentals and attractive valuation metrics, our recommendation is 5 STARS (strong buy).

Scientific-Atlanta produces a variety of broadband equipment for the cable-TV and telecom industry. Products are categorized under two general segments: customer premises equipment, which generally resides in consumers' homes; and network infrastructure products, which generally are deployed at a facility or outside the plant of the broadcaster.

HOT BOXES. Under the customer premises segment, the company's primary product is the Explorer digital set-top box (63% of total fiscal 2005 revenue), which is designed to enable subscribers to access new services such as e-mail over TV, VOD, Web browsing, IP services, DVR, and electronic commerce. Scientific-Atlanta shipped 4.2 million Explorer set-tops in fiscal 2005, up from 3.9 million in fiscal 2004.

The company ships a variety of digital set-top models in order to meet the various entertainment needs of consumers. During fiscal 2002, the company began shipping high-definition digital set-tops, devices that enable subscribers to access the enhanced picture quality and sound of high-definition content.

In fiscal 2003, Scientific-Atlanta began shipping digital video recorder set-tops, which enable subscribers to pause, stop, rewind, fast forward, record and replay live analog and digital TV content using a built-in hard drive. In the following year, it began shipping HD-DVR set-tops, combining the functionality of HD and DVR set-tops in a single device. Initial demand for these higher-end set-top boxes has been met with great success, in our view, with HD-enabled and DVR-enabled unit volume increasing 145% and 67%, respectively, during fiscal 2005. We expect this strong growth to continue, and forecast higher-end set-top boxes to represent 65% of total sales in fiscal 2006.

OPTIMIZING BROADBAND. Product introductions remain an important part of the growth story. During fiscal 2005, Scientific-Atlanta introduced multi-room DVR set-tops, which allow consumers to access their recorded content on as many as three additional TV sets within their home, using existing in-home wiring and existing non-DVR interactive digital set-tops. For fiscal 2006, the outfit plans to introduce a DVR with a built-in DVD burner, as well as IP TV set-tops designed to deliver video over digital service line networks.

The company also sells modem products to the consumer and small office under the brand name WebSTAR. During fiscal 2004, the company introduced voice modems that enable operators to offer advanced telephone services and high-speed data from one device. Using the voice modem, subscribers are able to communicate via telephone using new Voice over Internet protocol (VoIP) technology. Voice modems account for roughly 40% of total modem unit shipments.

Network infrastructure products include a wide range of signal processing and headend capabilities featuring encoding, multiplexing, ad insertion, switching and modulation. A key element of the company's transmission strategy is switched digital broadcast, which enables cable operators to delete unwatched channels from the broadcast stream and then automatically switch a channel back on when a subscriber selects it. This technique frees unused bandwidth for other services.

CONSISTENT PERFORMANCE. We believe that international expansion represents a significant growth opportunity. During fiscal 2005, international sales increased to 23% of the total, up from 20% in fiscal 2004. In January, 2005, Scientific-Atlanta signed a two-year exclusive deal to provide DVR set-top boxes to Britain's Telewest. The company also has shipped material set-top units in Japan, although sales recognition has been delayed to a major customer due to a lengthy acceptance process.

The company's largest customers in fiscal 2005 included Time Warner (TWX

; 4 STARS, buy; $18) (21% of total), Cablevision Systems (17%) (CVC

; 3 STARS; $30) and Comcast (18%) (CMCSA

: 3 STARS; $29). During fiscal 2005, Time Warner and Comcast announced plans to acquire the assets of a third customer, Adelphia Communications, which has operated under bankruptcy protection since 2002.

Operationally, the company has demonstrated, in our opinion, its ability to perform well despite the cyclical spending habits of the cable operators, translating core strengths of manufacturing scale and efficiency into good profitability. We view the company's business model and balance sheet as attractive, with a net margin of 13%, over double the peer average, nearly $10 a share in cash, and a debt-to-equity ratio well below the peer average.The company recently halted all stock repurchasing activity due to the knowledge of undisclosed material information.

We believe Scientific-Atlanta will dramatically increase its share repurchase commitment once the material information passes or becomes known in the public marketplace.

EXCLUSIVE SUPPLIER. Furthermore, in our view, there are some positive developments on the horizon related to industry consolidation that can act as a potential catalyst for the stock. Specifically, the Britain's leading cable operator, NTL, is expected to merge with rival Telewest sometime in the fall of 2005, while Time Warner is expected to complete its asset purchase of Adelphia in the beginning of 2006. Both proposed transactions are subject to necessary approvals. Being the exclusive set-top supplier to both Telewest and Time Warner, we estimate that the aforementioned developments could expand SFA's target market by nearly 5 million subscribers.

Following a 12% increase in fiscal 2005, we expect sales to advance 11% in fiscal 2006, reflecting our outlook for improved spending by the company's cable operator customers, particularly for digital video recording and high-definition TV set-top boxes. We foresee strong transmission product sales, on improved network spending by cable and telecom operators.

We forecast that overall digital set-top shipments will break through the 4.6 million-unit level during fiscal 2006, up from 4.2 million in the prior year. The gross margin should remain steady at about 37%, as higher sales volume and material cost reductions from engineering re-design will likely offset the lower set-top box selling prices that we forecast. Overall, we see fiscal 2006 EPS of $1.85, vs. the $1.64 posted for fiscal 2005.

PLACED TO PROFIT. While overall cable capital expenditures are weakening with the recent completion of large network upgrades, we believe that operators are materially shifting spending priorities toward success-based enhanced services like HDTV, VOD, and cable telephony. Meanwhile, telecom operators have begun to offer video services through the deployment of fiber to home and digital service lines. We believe that these industry developments play directly into Scientific-Atlanta's strengths in integrating video distribution and transport equipment.

Following the joint acquisition of Adelphia by Time Warner and Comcast, which is expected to close in the first quarter of 2006, pending approvals, the top four cable companies would represent more than two-thirds of the industry's total subscribers. Accordingly, we view established operator relationships as a material competitive advantage. In the set-top arena, Scientific-Atlanta enjoys 100% market share with Time Warner and Cablevision, while Motorola has 100% share with Comcast. The vendors have split accounts at Adelphia, Charter Communications (CHTR

; 3 STARS; $1.50), and Cox.

In the transmission market, with cable networks largely upgraded from one-way broadcasting to two-way interactive services, capital spending has been largely standard maintenance and network extensions. However, given the increasing competitive pressures from both satellite and telecom providers, we believe cable operators are aiming to accelerate the conversion of their subscriber base from analog to digital to better enable the introduction of new service applications.

THE STOCK-OPTION FACTOR. Cable operators would be able to bundle these new services with broadcast TV in a single package, potentially reducing customer churn and increasing average revenue per subscriber. Looking forward, we believe the proliferation of next-generation services will force cable operators to increase available network bandwidth.

On a Standard & Poor's Core Earnings basis, we estimate Scientific-Atlanta stock option expense of 20 cents during fiscal 2006 and 22 cents during fiscal 2007. While the absolute per-share amount is rising, we expect option expense to grow more slowly than earnings and, therefore, the negative impact of options under S&P Core Earnings methodology is expected to decline in both fiscal years. The negative impact of options on our fiscal 2006 operating estimates under S&P Core Earnings methodology is 11%. In our view, this compares favorable to that of the company's peers.

Adjusting for $9.80 a share in cash, the stock recently traded at about 17 times our fiscal 2006 EPS estimate (without 19 cents of interest income), below the industry average. On a price-to-sales basis, the stock was trading at about a 30% premium to the industry average. We believe that this premium is justified by the company's strong gross margin, currently near the 40% level, well above the peer mean.

GOOD GOVERNANCE, MOSTLY. Our discounted cash flow (DCF) model indicates intrinsic value of about $42. Based on a blend of our intrinsic value, as determined by our DCF model, and our relative analysis, we arrive at our 12-month target price of $44.

We view several of Scientific-Atlanta's corporate governance practices positively. The board of directors is controlled by a supermajority of outsiders, and the compensation committee is entirely outsiders. We also think that the company's executive compensation philosophy appropriately balances the business environment with the need to effectively attract and retain a high-caliber management team. However, we have some concern that shareholders do not have cumulative voting rights for directors and that the positions of chairman and CEO are combined.

In addition to general market and macroeconomic risks, we see the following risks to our recommendation and target price: lower capital spending by cable operators, delays in the widespread deployment of HDTV and DVR technologies, the potential loss of a major customer, and a loss of market share as the industry migrates toward open access technologies.

Analyst Bensinger follows shares of telecommunications equipment companies for Standard & Poor's Equity Research Services

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