Cogeco Incorporated (TSX: CGO) is a diversified communications company that provides cable distribution and radio broadcasting. Cogeco’s publicly-traded cable subsidiary, Cogeco Cable Incorporated (TSX: CCA), offers analogue and digital cable, high speed internet and telephony services to residential and commercial customers. It is the second largest cable telecommunications Company in Ontario, Quebec and Portugal with approximately 2.7 million revenue-generating units from over 2.4 million homes that are passed by its network.

During recessions, people generally look for small comforts and little “pick-me-ups” as we cut back on more expensive luxuries.  Cable TV, internet access and services such as video-on-demand are now substitutes for an expensive night out for dinner.  In the current environment, we think that cable and internet providers offer a nice mix of defensiveness and growth.  In the sector we prefer both Cogeco and Cogeco Cable.  To clarify, we own both the parent and the subsidiary because they are relatively thinly traded stocks.  To get full positions for our funds we had to purchase both CGO and the more liquid CCA.
 
We view the parent entity, Cogeco, as a net asset value play that trades at a discount to its sum of the parts.  Cogeco holds approximately 15.7 million shares of Cogeco Cable, or 32% of the outstanding shares, in addition to some radio assets.  The radio division includes the Rythme FM Network, which has four stations throughout the province of Quebec and Station 93 in Quebec City.  Using the current price of Cogeco Cable, we believe that Cogeco trades at more than a 20% discount to its net asset value.  Historically, the discount has ranged from approximately 20% to only 5% so we could see some upside in CGO should this discount narrow.

Further, we think that Cogeco Cable is itself a cheap stock.  Management recently updated financial guidance for fiscal 2009 and forecasted $500 million in operating income and $80 million of free cash flow for the cable division.  Today, Cogeco Cable trades at a discount to Rogers Communications (EV/EBITDA of 5.5x compared to 6.3x trailing and 5.9x compared to 6.4x forward) despite a higher consensus EBITDA growth rate (12.5% compared to 5.1% in 2009).  Narrowing the valuation discount relative to Rogers should be a two pronged-approach for management.

First, there is plenty of room for Cogeco Cable to improve its penetration rates relative to its peers.  Penetration rates are used to measure and compare the number of subscribers relative to homes passed by the Company’s installed network.  Currently, Cogeco Cable lags Rogers Communications in several key categories:  basic video at 56% compared to 65%, digital video at 31% compared to 44% and internet at 32% compared to 45%, respectively.  Increased penetration will come over time, as marketing initiatives and service bundling gain traction.

Second, the resolution of Cogeco Cable’s difficulties with its Portuguese cable operations, known as Cabovisao, could be a major catalyst for trading-multiple expansion.  Cogeco Cable originally bought Cabovisao in 2006 for approximately EUR465.7 million or roughly $660 million.  Although lower cable and internet penetration rates in Portugal originally presented a growth opportunity, competition from the two largest incumbents has intensified.  In the first half of fiscal 2009 the segment lost almost 35,000 revenue generating units.  In response, management wrote down their investment in Cabovisao by $399.6 million.  Tellingly, although Portugal accounted for only 14% of Cogeco Cable’s EBITDA in the second quarter of fiscal 2009, an inordinate number of questions on the quarterly conference call had to do with Cabovisao.  We believe that turning around these operations or even selling them entirely would provide a lift to CCA.

In summary, we bought Cogeco Inc. because it trades at a historically large discount to its sum of the parts.  The largest component of Cogeco’s net asset value is its holding of Cogeco Cable, which is itself a cheap stock.  We think that upside to the story comes from narrowing the penetration rates relative to Rogers and either turning around or selling Cabovisao.  One other potential catalyst exists, but whether this ultimate scenario actually plays out is unknown.  Rogers actually owns approximately 23% of Cogeco and 20% of Cogeco Cable.  Perhaps one day Roger’s management will pull the trigger and buy the balance of Cogeco and Cogeco Cable that they don’t already own.   In any event, we believe that both Cogeco Inc. and Cogeco Cable are relatively undervalued and that, over time, investors will be rewarded.

ABC Funds
May 1, 2009