|Shares Out. (in M):||288||P/E||0||0|
|Market Cap (in $M):||97,600||P/FCF||20.5||0|
|Net Debt (in $M):||66,000||EBIT||0||0|
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Zero points for originality, but I believe Charter is a long with a decent risk-return profile.
I believe there is a high probability of earning a >15% IRR over the next 3 years if management can execute their plan. There is also positive optionality as there are many interested acquirers. It is reasonable to think Charter doesn´t want to sell now since there is a lot of runway in integrating and improving the acquired assets. Once this process is done and the operation reaches a more “mature” stage, I think they would be willing sellers at a premium. Now, on the downside, some of the major risks are an acceleration in video sub-losses, technological changes, aggressive FTTH rollouts and regulation. We will touch on the risks at the end of the write-up, but we believe the risk-return profile here is attractive after considering these.
Charter´s stock went on a run since early 2016. Starting with the closing and successful integration of the enormous Time Warner Cable acquisition. Then in early 2017, there were rumors (further confirmed by management) that Verizon was interested in acquiring Charter. Some months later, Softbank and Altice were mentioned as interested acquirers. The probability of any of these two acquiring the Company are low (at least in my opinion). Softbank might try to use Sprint stock as part of the deal, and it seems like this is not a currency that Charter´s board would be willing to take. In the case of Altice, they have another business model of basically pushing price, cutting costs and are comfortable with ~6x leverage. Charter has a completely different operating model and would prefer a more conservative financial profile. So while speculation has been high, the reality is that these two might not be viable buyers (unless they go all out with a huge premium or big cash consideration, which seems like a low probability). The major block so far (I believe) is that management and the board are confident they can drive value by executing their business model.
About 2 months ago, the stock started to decline after some of those m&a rumors receded. Last week, Charter reported earnings that didn´t meet expectations. The stock took a significant hit and we think this is a good opportunity to enter the name.
Why is this an attractive investment?
Tom Rutledge is considered the best operator in the industry. He did a great job as COO of Cablevision from 2004 to 2011, making it the most profitable cable company in the US. In December 2011 he joined Charter, which had recently emerged from bankruptcy. At the time, the strategy was clearly stated. He was going to invest in the infrastructure, insource jobs and improve the product and packaging in order to drive penetration. This process would translate into short term pain (higher capex, higher opex and lower revenue growth as new product packaging depressed ARPU). After some years, results started to show and the profitability of the company improved dramatically.
The process went as follows: in mid 2012 Charter introduced new product pricing and packaging. Later, they started moving all customers from legacy analog systems to digital and finished the process by the end of 2014. This strategy enabled the company to offer a better product since it released spectrum in the network which could be used for more HD channels, speed, etc. A better video product offering reversed video sub losses trend and in 2015 they had positive net video adds (this is remarkable given industry headwinds, i.e. cordcutting). Also, HSD net adds increased dramatically as the company was successful in their volume growth strategy over driving pricing and profitability in the short term.
We also show Comcast figures as proof that while the industry had some tailwinds, the results at Charter show a dramatic improvement above the industry performance. At Comcast we can appreciate a reduction in video sub losses and marginally increasing HSD net adds, but improvement is not as radical as in Charter.
This process at Charter caused a high level of capex intensity, mostly due to growth (CPE, line extensions, etc) and the all digital strategy (which was finalized in 2014). These investments took some time to show in the growth profile of the company but as the years went on, growth accelerated. This left the Company growing at a fast pace, with a reduced level of capital intensity and higher free cash flow per passing (from $82.91 in 2012 to $122.51 in 2015).
The reason why this background information is important is because Rutledge and his team are going over the same process in a much larger footprint: Time Warner Cable and Brighthouse.
It is also important to note that the process should be less dramatic since the acquired assets are in a better shape, given Charter went through a bankruptcy process and there was a long period of underinvestment. Also, Tom Rutledge used to be the President of Time Warner Cable and he knows the asset perfectly well.
Since Charter closed the acquisition, Rutledge has implemented a similar strategy: insourcing much of the labor force to improve customer service, going all-digital and improving/simplifying product packaging and pricing. So far, the integration is going according to plan.
So, the bet we are making while investing in Charter is that Rutledge can do something like what he did in Old Charter in a much larger footprint. I think there is a decent chance he will be able to accomplish this. In case he succeeds, what can we expect?
As part of the TWC & Brighthouse transaction, Charter released a proxy with some financial projections. Numbers looked like this:
Charter might not reach these goals in the stated time since the transaction closed later than originally expected. Having said that, if they are able to reach anything close to these figures in a reasonable amount of time, the stock should yield attractive returns in the medium term.
As expected, they project revenue growth to accelerate in the next year as they have already introduced new product packaging and service in 2016/17. Margins should expand over time given lower opex per customer as service quality improves, churn/transactions per customer go down and business migrates to HSD being the primary service. Finally, they expect capex to decrease radically from 18.5% of revenues in 2017 to 11.8% in 2019 as they complete the all-digital rollout and other network investments (we think this will be difficult to accomplish, but the trend is important). Also, lower spending on CPE due to a reduction in STBs prices and a cloud based offering that enables cable companies to service the devices remotely should help.
The logical question: is this plan achievable? Let´s start with comparing Charter to the 2 other largest players in the industry: Comcast and Altice USA.
*We include “purchase of intangible assets” in Comcast capex since a large portion of this line is investments in software for the cable business
Comcast serves as a good comparable given their scale and relatively similar levels of FiOS and U-Verse overlap. Having said that, Comcast is a much more profitable company. This can be observed in their higher margins and EBITDA per passing. We think over time Charter will be able to close this gap. New Charter has been an undermanaged asset for years. Now they have arguably the best management team in the industry and have reached a scale comparable to Comcast. There is no structural impediment to reaching, or even surpassing, Comcast in terms of profitability.
We also include Altice USA, given they are the third largest operator in US. They have an aggressive model of cost cutting that should push margins for the coming years. They have stated that margins in US cable are too low and that over time should move closer to 50%. They argue that in Europe there is more competition, so they have learned how to run a lean organization. We think this is ambitious and in some years we will know if their strategy is prudent. We don´t expect Charter to reach similar profitability metrics. In case Altice USA proves that this business model is sustainable, we should expect other larger operators to push towards achieving similar results. If they don´t, then Altice might acquire these assets in order to operate these assets more efficiently (similar to what 3G has done in the Consumer Staples sector).
Charter and the rest of the industry should benefit from sector tailwinds:
-Broadband Penetration: In the US, residential broadband penetration is between 75-80%. Penetration has grown slowly from the low 70s in the last couple of years and we expect that trend to continue. Over the next few years, broadband penetration might push towards 90%. Also, we expect an acceleration in household formation, after several years of depressed figures, to help growth as well.
S&P Global Market Intelligence
-Broadband Market Share: Cable companies have been taking share from telcos for years now. Cable is capable of offering higher speeds compared to telcos who rely mostly on a copper network. Their DSL offering in most of the cases is not able to deliver speeds of over 10 Mbps while Charter offers 100 Mbps in 75% of their footprint and 60 Mbps for the other 25%. Telcos have been investing on driving fiber deeper in their network but still they fall short of cable speeds. This is the case because signals degrade while going through the copper wire and this gets worse as the distance between the home and the DSL hub increases. The same market share dynamic is occurring in the SMB and Enterprise segment where telcos are losing share. Cable companies are able to offer a better product and more services, which have helped them take share. Cable has grown at an accelerated rate (over 15% CAGR for the last decade) in this segment for those reasons. Also, as the cable industry has consolidated, some of the largest players are able to offer services in many markets which is ideal for the Enterprise segment since they have needs in various locations. We expect that cable should continue to take share in the coming years as data consumption continues to increase exponentially and the need for higher broadband speeds is accentuated.
S&P Global Market Intelligence
-Video Market Share: Video is a segment that should continue to shrink at a moderate pace. Having said that, cable providers have done a good job at shrinking at a slower pace than the overall industry. We expect cable to accelerate share gains from Satellite video providers over the coming years and this should help in preventing a collapse in Charter video subs. Tom Rutledge expects that industry wide linear video subscribers should continue to decline, but Charter will have more subs in the medium term than current subs. We are not sure if that will happen, but the truth is that cable has improved its relative video proposition versus satellite, and this should help Charter to take share from these competitors.
S&P Global Market Intelligence
-Capex Intensity: We expect that cable operators’ capex intensity will decline over the following years. STBs are now mostly cloud based which means they can be accessed and serviced remotely. This will reduce the need to update these devices and the number of customer visits. At the same time, pricing for CPEs is declining due to technological advances. Also, as broadband becomes the primary service, over video, the need for STBs declines. It is also important to note that CPEs and installation are a significant driver of total cable capex. Most cable companies will be done with their all-digital and DOCSIS 3.1 rollout in the next few years which means lower network investment after this period. Finally, as penetration levels reach a “mature” stage in the coming years, the need for growth capex will decrease. All these tailwinds should enable the cable sector to reduce capex intensity over the next few years, which will drive free cash flow generation.
-Margins: Over the following years, EBITDA margins for the industry should improve. Broadband is becoming the primary service, which is close to a 100% gross margin business. In order to provide video, cable companies must pay for content costs which have increased at a very high rate for years. Cable industry video gross margins have compressed from ~60% in 2007 to ~35% at the moment. On top of that, there are associated service (a disproportionate amount of service calls come from video vs other services) and CPE costs with running a video offering, which further reduce profitability. Cable One (a small operator) has argued that video is no longer profitable and that running a HSD focused operation is a better bet. By doing this, Cable One has improved their EBITDA margins from 36% in 2013, to 46% at the moment. We expect that over time, broadband will become a more important contributor to the cable business and this should help drive margins. Also, in case video subs start declining, the impact on EBITDA-Capex shouldn´t be that dramatic for the reasons mentioned above. In case customers drop the bundle offering, cable companies will charge more for the standalone HSD. This reality serves as a tailwind to profitability and a hedge in case cord-cutting accelerates. Finally, we expect that if Altice is successful in sustainably raising the margins at their operation, this will pressure the rest of the companies. Altice achieved a level of opex (ex-programming) per customer per month of ~$43 at their newly acquired Suddenlink business, compared to ~$52 for Charter and Comcast. We can expect that the rest of the industry will copy some of the mechanisms or if they are not able to do it, there will be pressure to sell to Altice.
-Mobile: Cable companies have a dense, fiber-rich network that can be utilized to offer mobile services, especially in a 5g world. Comcast has already launched a mobile offering using an MVNO with Verizon. Comcast currently has more than 250k mobile customers and expects that once they reach 1 million customers or 5% of their HSD base, their mobile service will become profitable and NPV positive. Approximately 5 years ago, Comcast and Charter swapped valuable spectrum for capital and a special MVNO with Verizon. Comcast has mentioned that this MVNO permits them to build a profitable business without investing in a mobile network. Currently, more than 80% of data traffic goes through the wired cable network via wifi. Also, cable companies have been investing in wifi hotpsots that permit customers to access the network once they go outside their home. Charter has mentioned that they will launch their product through the MVNO with Verizon in 2018 and eventually the plan is to utilize their own mobile infrastructure of LTE small cells. We think cable Charter and Comcast will become major wireless operators and that this will become a profitable business by itself. Also, it will reduce churn as experienced by cable companies in European markets.
-ARPU growth: We believe that cable companies will be able to push pricing over the long term given their position as an advantaged operator, offering a superior product. Cable companies will also continue to improve their offering by increasing speeds, improving their video product (better guide, VOD, etc) and including other services (home security, mobile, etc), that will justify price increases. We think that it´s reasonable to expect ARPU growth for years to come, specially once Charter reaches high levels of HSD penetration in its footprint.
-New FCC: Since Ajit Pai took office, he has focused on reducing regulation. We think a more cable friendly FCC might help in M&A and enabling the industry to charge the large players for their service. On M&A, we think that Comcast and Altice USA are interested in acquiring Charter at a reasonable price. A Comcast-Charter transaction seems more “do-able” because we think the Charter board would be willing to take that currency over ATUS stock. It´s also reasonable to think that if Comcast wants to acquire Charter, they will try to do it under this FCC and government. Also, Verizon and Sprint have shown interest in acquiring Charter. We think that cable and wireless consolidation makes sense, given the success these operations have experienced in Europe. There are many possible acquirers and ways to speculate on this, but the reality is that the regulatory environment hasn´t been this favorable in years. We also think that there is a possibility that cable companies will eventually try to charge for the services they provide to large data players like Netflix, Facebook and Google. Most of the data that is “clogging the pipes” is coming from these players, and cable companies want to charge them for the service and infrastructure they provide. This is not built in to the financial projections, but would be a positive for the industry.
How will this story play out in the financials?
-Revenue: As experienced in Old Charter, revenue growth should accelerate in 2018 and further in 2019 as they integrate old Time Warner Cable and move these customers to the new packaging. As the promotional period rolls off, revenue growth should hit a positive inflection point in early 2018. Further penetration of HSD and B2B expansion will also help drive growth.
-Margin: As Charter continues to drive HSD penetration, we expect margins will expand due to the reason discussed previously. Also, further integration of the TWC & BH acquisitions will continue to drive synergies over the medium term. In 2020, the model has 40% EBITDA margins, which is close to where Comcast is at the moment. This number is conservative because in 3 years, the cable business will be more dependent on HSD compared to current levels. Also, we believe that Rutledge and his team are solid operators and there is no reason for this delta to persist after the integration period.
-Capex: As Charter ramps up the all-digital transition in 2018, we expect that capex will increase. The Company should be done with this process by 2018. Also, the company will be investing in transitioning to DOCSIS 3.1 (costs to deploy are moderate at less than ~$80 per home) in the following years. We expect that capital intensity will start to go down in 2019 and will hit 14% of revenues in 2020. This figure is conservative when compared to Charter´s proxy model. It is also important to note that the push into mobile will determine capex after 2019. Our model doesn´t incorporate mobile as a significant driver in any income or expense line since the product or the strategy are not yet clear (at the moment, the idea is to do it through an asset-lite MVNO).
-Valuation & Capital Allocation: We expect that Charter will maintain its financial leverage between its target of 4.0-4.5x and will use the proceeds to buyback shares. Also, all the FCF will be used for buybacks. By the end of 2020, we think that 15x FCF and 9.5x EBITDA is a reasonable multiple for an infrastructure company with stable, non-cyclical demand, growing EBITDA mid-single digits and moderate financial leverage. From current prices, the expected IRR using the mentioned assumptions is ~17%.
What are the risks and why is this asset mispriced?
-Cord-Cutting: There is major fear that video sub losses will accelerate as customers transition from a linear TV model to OTT offerings. We think that the linear video market will continue to shrink as customers needs change and the cable bundle price continues to increase. However, we believe that Charter will have better results than the industry as they take share from satellite. Rutledge even expects that Charter will have more video subs few years from now. Finally, video has become a marginally profitable service. If video sub losses accelerate we expect that Charter will increase HSD ARPU and margins will experience a rapid uplift. Also, customers that drop linear video might consume this service through an OTT offering. These OTT services require a high speed broadband connection to function properly and Charter is the best qualified to provide this service in most markets.
-Technological Risk: The idea of this new 5g era has unsettled investors. There is the fear that telcos might deploy small cells and use millimeter waves to improve speeds outside the home and that this might reduce the demand for fixed broadband. We think this technology is still in its early stages and it´s not clear if the model is profitable/reasonable to deploy. Also, it is important to note that these waves are not capable of traveling through walls and might get affected by rain. At the same time, cable companies might be the best fit to deploy these services given their fixed, dense and fiber-rich network. In a 5g world, telecom operators need this type of network in order to connect all the small cells and provide the backhaul service. Comcast and Charter might be able to take wireless share from telcos in a 5g world and at the moment we think cable is in a better position relative to wireless providers in a 5g future. These companies are already using its wifi hotspots as a way to provide this service to its customers outside of the home. Having said that, in this industry there are always technological risks and we must be aware of that (e.g. data compression). It is comforting that cable companies are in a healthier financial condition than telcos which in many cases have a declining business, coupled with high leverage and most of their FCF goes to cover the dividend. Telcos are not in a position to invest heavily for the long term benefit of their business.
-Competition & FTTH Deployment: Cable has been able to compete against the telcos given they have a better product offering and service. There is a risk that telcos, or other players, might push into FTTH in order to offer higher speeds, comparable to those offered by the cable companies. About a decade ago, Verizon spent close to $25 billion on building over 18 million FTTH premises and this project was eventually halted due to terrible returns. Currently, AT&T is building more than 6 million additional residential premises with FTTH, which will leave the company with close to ~13 million FTTH passings by 2019. Goggle Fiber has recently slowed down the deployment due to complications in deploying the infrastructure and providing the service. Small local fiber players and municipalities can also threaten certain markets. WideOpenWest is an example of a cable operator that has overbuilds and competes against Charter. Overall, we think competition will increase but Charter should be able to remain as an advantaged, scale operator in most of its footprint. We remain vigilant of new entrants and FTTH deployments, but at the moment the threats are not overly aggressive (this can change).
-Regulation: Title II regulation under the Tom Wheeler FCC raised concerns that in the future cable operators would be heavily regulated. Regulation has always been a risk for the sector, primarily if rates get set by the FCC and broadband gets categorized as a utility. Since Ajit Pai was named Chairman of the FCC, he has been working on reducing regulation. We believe that some of the regulatory risks have decreased under this new administration.
Charter should continue to increase its customer penetration, ARPU and profitability as the company executes on its plan. Eventually, we expect that this company will enter a mature stage of lower growth but lower capex, which will dramatically increase FCF generation. If Rutledge and his team are able to repeat what they have done at other cable assets, this stock should do well over the medium term. In a dream scenario, Charter is acquired in 18-24 months, once the integration is complete.
I will leave you with the following quote on buybacks during the last earnings call:
“We have a fundamental view on the value creation that's going to take place at Charter over time. We're not stock pickers. We don't understand the vagaries of the marketplace from day to day, and we have a fundamental view on what the long-term value creation of the company is going to be. It looked cheap then; it looks cheap now.”
Charter has reduced S/O by ~8% in the last 9 months.
Chris Winfrey, CFO bought $1.0 million of stock this week.
-Completing the TWC & BH integration
-Interest possible acquirers: Comcast, Altice, Softbank/Sprint & Verizon
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