Description

GCI Liberty is a way to create an investment in Charter Communications at a very low multiple of its medium-term earnings power.  Through GCI Liberty, you may be acquiring CHTR at just over 6x 2020E Fully-Taxed FCF/Share.

I’m nervous recommending an investment reliant upon a security with such widespread hedge fund ownership, so I’ll strap on the protective armor of the first person plural.  In a base case, we think the shares could potentially double over the next 18-24 months.

Background of the Transaction

The combination of Liberty Ventures and General Communications, Inc. (“GCI”, the largest communication provider in Alaska) was a way for Liberty Ventures to 1) become an independent, asset-backed company versus a tracking stock, 2) separate its interests in Liberty Broadband and Charter Communications to potentially close the NAV discount and 3) set up a potential tax-free combination with Charter down the road.  The transaction structure involved Liberty acquiring GCI through a reorganization where certain Liberty Ventures Group assets and liabilities were contributed to GCI Liberty in exchange for a controlling interest in GCI Liberty. Liberty then pursued a tax-free separation of GCI Liberty through a split-off. The original transaction was announced on April 4, 2017, and was completed on March 9, 2018.

GCI Liberty’s primary assets include GCI, shares of Liberty Broadband and shares of Charter Communications.

Liberty Broadband

For a quick summary of Liberty Broadband, you can view jon64’s write-up from March 3, 2018, which conveniently also references MarAzul’s November 2, 2017 write-up of Charter Communications

GCI

For a quick background on GCI, you can see greenshoes93’s timely June 2016 write-up.  GCI is an integrated, facilities-based, quad-play operator in Alaska, passing 253k homes, with 125k residential broadband subs, 94k residential basic video subs, and 197k consumer wireless lines in service.

Despite having the best network in the state, GCI’s margins are below cable peers.  While some of this is due to scale, the management team has put in place a four-point plan to drive EBITDA Margins higher from the current low-30%s level:

• Implement a new billing system in 2018 (company eliminated 4 billing systems in 2016, implemented a rate plan simplification in 2017)

• Simplify the network (eliminated old technologies, faster turn up of new products)

• Reduce reliance on Local Exchange Carrier facilities (expect to reduce spend by $10m/year through network build-outs)

• Procurement Savings (over $500m in addressable spend, first company-wide procurement initiative)

GCI’s earnings to date have disappointed initial merger proxy estimates.  While Liberty’s initial $2.68bn Transaction Value may not look as attractive (now represents 8.9x current LTM EBITDA), I think this component of the GCI Liberty’s asset value is protected.  Based on Maffei’s comments, I think it’s highly likely that GCI will ultimately become a part of Charter. Recent cable transactions have seen announced/realized OpEx and CapEx synergies ranging from 7-15% of revenue.  For GCI, at 9% of Revenue, this would translate into over $90m of synergies (on $301m of LTM EBITDA). Stepping into Charter’s rate card alone could account for a decent chunk of this value. Even applying only a 7x synergized EV/EBITDA multiple to GCI on their LTM EBITDA would get you to a transaction value above where I’m carrying the asset.

Charter Communications

CHTR shares sold off significantly on heavy volume on April 27th after reporting modestly disappointing Q1 sub metrics.  The share price move (down 12%) seemed overdone (subsequent to the quarter a few large hedge funds that were large shareholders of CHTR announced they are shutting down), but was reflective of the worsening sentiment around cable providers.  I think there are a number of fears in the market around the go-forward prospects for cable companies in the U.S. I’m comfortable with most of these risks, particularly considering the FCF generation I expect to see out of CHTR over the next 5-6 years.  I’ll list the risks below and hopefully we can bring in the broader VIC community to share viewpoints in the messages.

• Fears that cord-cutting will accelerate given superior value proposition of OTT video offerings vs. traditional linear TV

• Fears that Comcast’s bids for Fox/Sky are an attempt to diversify away from its core cable business perceived to be in decline

• Comcast’s shares went through a long, slow re-rating process from 2011 to 2017 (from 11x NTM EPS to 21x), followed by a much sharper decline back down (from 21x NTM EPS in mid-2017 to just over 12x today)

• Lower valuation multiples for Telecom in general due to rise in long-term interest rates (cable has seen funds flow from Teleco names over the past 5 years given better competitive dynamics and financial results)

• Fears around slowing broadband market share gains from the cable players (and AT&T’s roll-out of fiber to satisfy FCC conditions associated with DTV deal)

• Fears around Verizon’s 5G Fixed Wireless rollout starting this year

• Fears around 5G Mobile networks getting constructed by the early 2020s

• Fears around 4G wireless substitution (unlimited data plans)

• Worsening Voice PSU trends (new as of 1Q18)

• AT&T and DISH aggressively pushing uneconomic skinny bundles

• Legacy CHTR video sub growth has turned negative

While I don’t have the effort to address all these concerns in depth at the moment, I will say a few things.  I expect facilities-based video losses to continue at the ~4% rate per annum, but expect cable in general to outperform this number, and expect Charter to outperform cable given its footprint (more broadband-only customers, greater satellite share) and operating strategy (simple packaging, low prices, better customer service).  Charts from Goldman on cord-cutting are below. Despite the fears around Charter’s results, in Q1 video PSUs were only down 0.7% y/y, residential customer relationships were up 2.9% y/y, video revenue was still up 5% y/y and programming costs stepped down at both Comcast and Charter. Internet PSUs were up 4.9% y/y with Residential Internet ARPU up 3.7% y/y.  Currently only 48.3% of CHTR’s Homes Passed take Internet and Maffei thinks this can reasonably get to 60% over the next 5 years (4.3% p.a. sub growth). 60-70% of CHTR’s customers already take Netflix as well.

A lot has been written on the poor standalone vide unit economics (poor Gross Margins from high programming expenses, and poor FCF Margins due to CPE).  While this is true, a video offering also provides for a stickier customer and maintaining video subs is key to Rutledge’s operating strategy, so linear video is still important.

Around 5G, all of our industry diligence has suggested Verizon’s Fixed Wireless plans are more bark than bite (rolling out in only the best markets for millimeter wave and long-term economics that ultimately don’t look too dissimilar to overbuilding with FTTH).  And we tend to agree with Rutledge and Malone that cable has the best infrastructure in place today to capitalize on a 5G world (“Charter has 26 million ‘small cells’ today”).

Net, net, constructing our model assuming conservative video sub losses (~2.5%+ video PSU declines across legacy CHTR/TWC/BHN) we still get to $35+ in fully-taxed FCF by 2020 (with the lower share price since MarAzul’s November write-up making buybacks more accretive).  At a 14x FCF/share multiple, this would lead to a $490 CHTR share price by the end of 2019 (87% upside). There’s the possibility that it make take a little longer for CHTR’s CapEx to normalize down to the 12-14% of Revenue level appropriate for a cable company of CHTR’s scale.  But even then we’d be looking at FCF/Share of well above $40 by 2021.

The M&A bid premium has clearly come out of CHTR’s shares, but it is worth recalling that the WSJ and NY Post reported Verizon made an informal bid for CHTR in the first quarter of 2017.  The rumored price was in the $350-$400/share range, which would imply a $359-$416/share range on today’s share count and debt levels. Some of Verizon’s competitors have been dismissive of Verizon’s 5G technology roadmap, which may suggest that a CHTR bid isn’t off the table.

Share Repurchases

Given the Free Cash Flow generated at GCI and the borrowing capacity stemming from equity ownership stakes, GCI Liberty is planning on repurchasing shares going forward.  This should help to close the NAV gap while also being a very high-return deployment of capital. There’s also the possibility that Liberty Broadband takes on margin loans to pursue buybacks as well.  You could have a situation where you benefit from the coveted triple buyback (buybacks at CHTR, LBRDA, GLIBA).

Net Asset Value

While not a huge component of the NAV, I don’t have a strong view on LendingTree shares.

Preferred Shares

As an aside, we think the 7.0% Series A Cumulative Redeemable Preferred shares- issued to legacy GCI shareholders as part of the transaction consideration- are attractive as well.  $25 liquidation price and currently trading at $23.50 (Ticker: GLIBP).

Quick Comment on CHTR’s 1Q18 Results

Charter management explained the soft Q1 sub trends as a self-inflicted problem that should be fully corrected by Q3.  As the company integrated TWC and Bright House, they went from 13 different billing systems down to 4. As they did this, they inadvertently allowed in certain sales channels lower credit quality customers to be accepted that didn’t go through the intended qualification and prepayment process typically required.  So customers that would have been required to prepay did not prepay. As a result, churn ticked up as those customers in Q1 became “nonpay disconnects”. The issue was mostly corrected during Q1, and April was supposedly the last month where any of those lower credit quality customers broke through. This issue is guided to be less of a headwind in Q2 vs. Q1 and is guided to be completely resolved by the beginning of Q3.

Cord-Cutting Charts

Risks

·         Accelerated video sub losses

·         Mobile 5G Competition (2024?)

·         Rising interest rates (floating rate debt), tightening credit markets

Catalyst

• Q3 Earnings
• Buybacks
• Merger into CHTR