Description

Introduction

Most likely Altice USA (ATUS) is a name that is familiar to many on VIC having been written up a couple of times previously. Mwmg113’s excellent writeup from May 2019 is a great starting point for getting familiar with the company. Over the past couple of years, Altice has significantly underperformed Charter and even fared worse than Comcast after declining nearly 14% since earnings on July 28^th. Given the significant underperformance, Altice’s stock is much cheaper than its cable peers and the market overall. Despite recent disappointments, I think the market’s high level of pessimism is unwarranted and given the lowered expectations, the stock price can conservatively compound at a mid-teens rate going forward without much having to go right. With the stock trading near 9x EV/EBITDA and a levered free cash flow yield of somewhere between 10% and 12%, I think the key questions that must be answered to invest in ATUS are: will EBITDA grow and is the debt manageable. This writeup will attempt to provide some context surrounding these questions.

Recent Developments

Altice’s stock price plunged on July 29 as the market digested Q2 results. The company had an organic loss of 12,000 customers compared to a net gain of 35,000 last year, a loss of 1,000 in 2019 and a loss of 4,000 in Q2 2018. Excluding the Morris Broadband acquisition, broadband net ads were nil compared to 53,000 in Q2 2020. Overall revenue growth was 1.7% but this was mostly due to a big jump in ad revenue on an easy comparison. Residential revenue slightly declined and overall EBITDA was flat. Management attributed the loss of customers to migration trends as customers moved back to NYC from the outlying suburbs served by Altice’s Optimum. This was a reversal of trends in 2020 as people left the city for more space in surrounding areas due to the pandemic. Other than this reversal, management claimed that the competitive environment in the Optimum footprint was stable. Also, the resumption of disconnects in certain areas was a headwind to customer growth. Management also walked back expectations that broadband gains in 2021 would be equal or better than the 72,000 in 2018 and 2019. These results were especially disappointing compared to strong broadband subscriber growth for both Comcast and Charter. Prior to the Q2 results, the stock price was just over $34 compared to $29 currently.

Revenue Growth

Relative to its publicly traded cable peers, one of the biggest knocks on Altice is its lower revenue growth. While revenue growth has been below that of peers, it is likely that the company can still generate growing revenue and EBITDA going forward. The following discussion will focus primarily on broadband subscribers and revenue per subscriber as broadband is the company’s highest-margin revenue stream.

Broadband

Altice is comprised of two 2015 acquisitions, Cablevision and Suddenlink. Cablevision, now called Optimum, passes around 5.3 million homes in the metropolitan NYC area including Long Island, Connecticut, New York, and New Jersey. Optimum accounts for about 60% of Altice’s passings, and within the Optimum footprint there is overlap with Verizon’s FIOS in approximately 55% - 60% of passings. Despite having to compete with fiber in a majority of its footprint, Optimum has been able to hold broadband penetration relatively steady in the low to mid 50% range. Recognizing that as data usage continues to grow rapidly, to compete with FIOS over the longer-term, Altice has started building out fiber-to-the-home (FTTH) within Optimum. As of year-end 2020. FTTH has been built to over 1 million passings and it will take around 3 more years to complete the buildout.

Suddenlink offers services primarily in the mid-south including Texas, Oklahoma, Missouri, Arkansas, and Louisiana. It also has networks in North Carolina, West Virginia, Ohio, California, Arizona, and Idaho. Suddenlink passes between 3.6 and 3.7 million homes and faces significantly less fiber competition compared to Optimum. At the time of the acquisition, Suddenlink only had fiber competition in 8% of its footprint; however, that has likely increased in recent years as AT&T has built more fiber. Broadband penetration in Suddenlink was 40.3% at year-end 2018 when Altice last broke out Optimum and Suddenlink. For the years 2014 through 2018, broadband sub growth had increased at a CAGR of 4.4% and passings increased at a CAGR of 1.8%.

Altice has stated that it plans to increase total passings on an annual basis by at least 150,000 which equates to passings growth of about 1.75% based on year-end 2020. This is an increase from prior years in which passings increased by a CAGR of 1.5% from 2014 through 2020. Historically, broadband penetration in new passings reaches 40% within the first year and continues to increase thereafter. Assuming 40% penetration and 1.75% annual growth in passings results in annual broadband subscriber growth of nearly 1.5% across the entire footprint, or approximately 60,000 new subs. In addition to new passings, Altice will continue to add new broadband subscribers, especially in the Suddenlink footprint where it primarily competes with legacy telecom. Between 2014 and 2018, broadband penetration in the Suddenlink network increased by almost 400 bps. Assuming Suddenlink penetration slows to 50 bps. annually for the next few years, this adds another 15,000 to 20,000 broadband subs resulting in total subscriber growth of approximately 75,000 to 80,000 annually solely based on passings growth and increased Suddenlink penetration. This number is very similar to what the company gained in the years leading up to the pandemic with lower rates of passing growth. As far as Optimum, while penetration in the 40% - 45% of the footprint that doesn’t compete with FIOS should increase, for the sake of conservatism I assume growth in Optimum only offsets churn. However, as the FTTH rollout continues, share gains in the Optimum footprint are very likely, especially in areas with no FIOS competition. Collectively, the growth in passings and slight increases in Suddenlink broadband penetration results in annual growth in overall broadband subs of approximately 1.8% going forward. While this is quite a bit below consensus, I’m purposefully using very conservative assumptions to demonstrate what needs to happen to generate slight revenue growth.

From a pricing standpoint, revenue per broadband sub increased at a CAGR of just over 9% from 2016 through 2020. While it’s difficult to pinpoint the exact drivers, the company has said that the ARPU growth has resulted primarily from customers opting into higher-speed tiers as well as dropping video for higher -ARPU stand-alone broadband rather than explicit price increases. Broadband ARPU per month in 2020 was $70 and I conservatively project that to increase by 4% annually over the next five years. This is significantly lower than past years and driven by continued migration to higher-speed tiers, especially in Suddenlink but also in Optimum as the FTTH buildout continues. Currently just less than 10% of Altice’s broadband customers take speeds of 1 gig despite its availability in 92% of its footprint leaving plenty of room for capacity upgrades moving forward. These assumptions for broadband subscriber growth and 4% ARPU growth result in a broadband revenue CAGR of 5.8% through 2025 which compares to 12% from 2016 through 2020.

Video

The second largest revenue category behind broadband is video, which has been declining rapidly as consumers have cut cable or migrated to skinnier bundles. From 2014 to 2020, video subscribers and video penetration have fallen from 3.54 million and 41.5% to 2.96 million and 32.8% respectively. This trend combined with growth in broadband has resulted in broadband residential revenue surpassing video revenue for the first time in 2020. Currently residential broadband and residential video revenue are both just over 37% of total company revenue. Going forward, declining video revenue will be a significant headwind to overall revenue growth but video revenue will also decline as a percentage of total revenue as it shrinks and broadband revenue grows. I’ve assumed video penetration declines 200 bps annually going forward (i.e similar to past levels) while video ARPU increases by 2% annually to partially offset increasing programing costs. These assumptions lead to ongoing video revenue declines in the mid-single-digit range.

Total Revenue and EBITDA

With the previously discussed assumptions plus continued sharp declines in voice, 3% growth in SMB (2% price, 1% psu), assuming the wireless attachment rate to broadband reaches 7% in 2025 (with 2% annual pricing), and 3% average annual growth in ad revenue (which is significantly lower than previous years), I can get to slight revenue growth for Altice over the next five years (1% CAGR from 2020). Again, I realize this level of revenue is quite a bit below consensus expectations as I purposely make conservative projections in order to demonstrate what needs to happen for revenue to remain flattish/grow slightly.

On the other hand, over that same time frame I believe it’s highly likely that EBITDA can compound at a rate of between 2% and 3%, even with flattish revenue. This is due primarily to the fact that video is the company’s lowest margin product (by far) and it will continue to decline going forward. The cable companies have faced significant cost pressures as programming and retrans fees have increased ahead of inflation for years. For the past three years, programming expense per video sub has compounded at 6.8% while video ARPU has been flattish. Given low levels of customer satisfaction with the product, the rise of streaming alternatives, and the already high price point, cable companies, not wanting to further alienate their customers, have not priced the product to match cost increases which have resulted in declining margins. As a result, the shifting mix of revenue to higher-margin broadband away from video will have a positive impact on the overall EBITDA margin and this impact is magnified as customers move from a bundled video/broadband price to stand-alone broadband. Simply based on declining video subs and increasing broadband subs and broadband ARPU’s growing at 4% over the next five years, the EBITDA margin will be positively impacted by 200 to 300 bps.

Another significant factor which should boost margins over the next several years is the FTTH build in Optimum. While it is difficult to place a number on the cost savings due to fiber, Altice expects a FTTH network to result in higher customer satisfaction, fewer service center calls, fewer truck rolls, and lower operating and maintenance costs. Operating expenses excluding programming, mobile, marketing, and franchise fees total $2.26 billion in 2020. This includes staffing and benefits, network maintenance and field costs, call centers and other operating costs, etc. Given the enormous costs of running and maintaining the network, even small savings will result in improving margins. Fiber will increase customer satisfaction due to higher speeds and greater reliability and lower customer service costs. The network itself is more durable, less costly to maintain, and requires less spending on networking hardware. Again, in order to have conservative projects, I don’t model any specific margin improvement due to the FTTH upgrade. However, it isn’t difficult to imagine a high-single-digit reduction in Optimum’s other operating costs which would save well over $150 million annually post the FTTH buildout which would represent 1.5% of revenue.

Debt

In addition to minimal revenue growth, I think one of the biggest concerns surrounding Altice is the debt level. The company currently has just under $27 billion in net debt compared to 2020 adjusted EBITDA of $4.4 billion for net leverage of 6.1x. EBITDA less cap ex covers interest by 2.5x. Given Altice’s stalling revenue and potential concerns over the ability to expand already high margins, the headline debt level may give investors pause. However, I think the debt load is manageable and the company could delever relatively quickly if it wanted to. As detailed in earlier sections of the writeup, I think it is highly likely that EBITDA will expand over the next five years despite revenue potentially being flattish due to growth in high margin broadband and operating cost savings from the FTTH buildout in Optimum. Also, completing the FTTH buildout will result in falling capital after 2023. The company estimates that capital expenditures could decline to nearly $1 billion compared to $1.4 billion once FTTH is completed.

The following chart reflects debt maturities as of June 30.

While not a thing of beauty like Charter’s debt maturity schedule, Altice doesn’t face a maturity that it couldn’t repay with free cash flow until 2025. Free cash flow was around $1.3 billion in 2018 and 2019 and over $1.9 billion last year as capital expenditures fell. Free cash flow over the next couple of years, even with capital expenditures running between 14% and 15% of revenue and fully taxing earnings, will likely be around $1.5 billion. For purposes of modeling how Altice could reduce its debt if it chose to do so, I’ve modeled the company paying off all maturities as they come due over the next five years and using excess cash flow to retire stock. Simply by paying off maturing debt through 2025, pre-tax interest expense would decline by nearly $300 million and net leverage would decline to 4x. This assumes EBITDA in 2025 is approximately $4.96 billion compared to $4.4 billion in 2020 and consensus expectations for $4.7 billion in 2023. As interest declines, free cash flow grows thus increasing the ability to delever.

Using the assumptions laid out previously, revenue and EBITDA growing at CAGRs of 1% and 3% through 2025, capital expenditures declining from 14.5% of revenue to 12%, paying off debt maturities as they come due, using excess cash to retire stock, and assuming a 2025 exit multiple of 9x EV/EBITDA, I can get the equity to compound at 15% to 16%. Total debt paydown and stock repurchases through 2025 are $6.2 billion and $2 billion, respectively. In other words, the company could delever by two turns and also retire 15% of the market cap. If it directed 100% of free cash flow to debt paydown, net leverage would be even lower. Based on the current stock price, the levered free cash flow yield per share is over 17% in 2025 using these conservative assumptions.

It is also important to note that even if all debt maturities are refinanced, the company will save on interest by refinancing at lower rates. Earlier this year Altice issued $1.5 billion of 10-year debt at 4.5%. Nearly all of Altice’s existing notes have coupon rates higher than 4.5%. For example, a $1 billion note maturing in November of 2021 has a coupon rate of 6.75% so interest most likely will decline even if total debt is unchanged.

Risk

I know that Altice has stated its intentions of buying back $1.5 billion of stock this year and it won’t pay down debt. While I don’t think the debt is too worrisome, I do worry somewhat about the decision making of controlling shareholder Patrick Drahi and his potential willingness to empire build and/or take advantage of minority shareholders. There have been enough instances in the past where Drahi has tried to squeeze out minority shareholders at insufficient premiums (e.g., SFR in 2016 and taking Altice Europe private earlier this year) to question if he may try the same thing at Altice USA. While this is possible, protections for minority shareholders are generally stronger in the US and given the strong appetite for infrastructure assets, I think there would be interest in Altice from other investors. On a related note, Altice trades at significantly lower multiples than public cable peers as well as recent transaction multiples in the space. While the purpose of this writeup is to look at Altice from an absolute perspective, it is also very cheap from a relative standpoint. The excellent "Yet Another Value Blog" on Substack had a post in July highlighting how recent cable deals for inferior assets (e.g. the overbuilder WOW) took place at a higher multiple than the current valuation of Altice. I would recommend reading this.

Another risk is acquisitions away from the core cable business. Drahi built his empire on debt-fueled acquisitions, some which have worked better than others. Thus far this hasn’t happened at Altice USA but that doesn’t mean it won’t. The media recently reported that Altice has expressed interest in Mint Mobile and, in an interview with CNBC earlier this year, the CEO, Dexter Goei, mentioned an interest in wireless assets in the context of fixed/mobile convergence in the coming years. In my opinion, this is the most significant risk an investor in Altice faces.

Like other highly levered businesses, rising interest rates could pose a problem for Altice if it had to refinance at rate higher than it currently pays. This would be especially problematic if it coincided with unexpected weakness in profitability making natural deleveraging impossible. Obviously rising rates and declining EBITDA would be a toxic mix. However, for the reasons outlined previously, I think it is highly unlikely that EBITDA declines. Plus, I think the company could delever fairly quickly given its strong free cash flow and mostly fixed-rate debt thus increasing the likelihood of being able to roll debt, even if at higher rates.

 Conclusion

The purpose of this writeup has been to look at two of the primary issues facing Altice, low growth and high debt. I think the customer migration issues raised in the most recent results will prove to be short-lived and I think it is very likely the company can continue to grow revenue and EBITDA in the coming years. Growth of high-margin broadband revenue (due to growth in passings, broadband ARPU, and penetration in Suddenlink), declining video revenue, and lower operating costs post FTTH will lead to higher margins/growth in EBITDA. While I’m not suggesting that Altice will resort to debt paydown, I think it could delever quickly through cash generation, interest savings, and refinancing higher-cost debt if it wanted to. If Altice continues down the current path of $1.5 billion in annual buybacks and EBITDA grows and leverage falls slightly to 5x or 5.5x range, the equity returns could be 20%+ annually over the next few years. Returns could be higher if the EV/EBITDA multiple rerates higher. In other words, I think the potential upside is tremendous. Altice certainly has risks and given the management wildcard and leverage, things could work out poorly, but given the steadiness of the cable business and the potential upside, I like the risk/reward setup, appropriately sized.

Catalyst

Return to growth in broadband in coming quarters

Continued execution of the buyback

Declining capital expenditures and operating costs when the FTTH buildout is completed