Description

                                    SHARES      VALUE

True Position

(Wholly owned Asset)                   $150

Cash                                                  $763

Total CHTR Shares       28.8           $5,343

TWC Shares                     2.4           $452

Margin Loans & Other

Revolving Facility Draws               ($412)

NAV                                                   $6,297

LBRDA Shares                  26

LBRDB  Shares                    2

LBRDK  Shares                  75

Total Shares                   103

NAV Per Share                                 $61.03

Current LBRDK Price                       $54.54

LBRDK/NAV                         89%

CHTR:  Move Towards Horizontal Acquisition Machine

For those who are less familiar with CHTR, we provide a brief history and a quick summary of recent events.  Charter was founded in 1993 and later purchased by Microsoft co-founder Paul Allen in 1998.  The company aggressively invested in its own cable systems while executing further acquisitions over the coming decade.  When credit markets tightened in 2007/2008, Charter’s extended balance sheet became unsustainable and the company filed for bankruptcy in early 2009.  Emerging from bankruptcy in late 2009 and relisting in September of 2010 with a strengthened balance sheet, Charter’s momentum continued to build when the company tapped Tom Rutledge, Chief Operating Officer of New York based Cablevision Systems Coporation, to be its CEO in February of 2012.  Rutledge has spent nearly 40 years in the cable industry, and under his leadership, Cablevision was a pioneer in offering so- called “triple play” product offerings (TV, Internet, and Voice), increasing penetration rates and monthly subscriber fees to the highest levels in the cable industry.  Many consider Rutledge to be among the best operators in the entire cable industry.   Believing in Rutledge’s operating abilities and seeing an opportunity for further cable consolidation, John Malone reentered the cable industry with a $2.6 billion investment in Charter during March of 2013.  Liberty holds four seats on Charter’s Board, with two of the seats occupied by John Malone and Liberty Broadband CEO Greg Maffei.  

Following Liberty’s investment in standalone CHTR, Dr. Malone publicly discussed over the next two years the benefits of scale in the cable business and announced that he wanted CHTR to be a “horizontal acquisition machine.”   Malone also publicly discussed the crazy debt markets and proclaimed that debt was so cheap that one almost had to look for ways to increase leverage in order to take advantage of the relaxed terms.  Liberty, Charter, and Malone all discussed the benefits of a possible deal with TWC.  While TWC rejected various overtures from 2013-2014, CHTR believed that TWC had few viable options besides CHTR and therefore it would just be a matter of time before a deal was consummated.  CHTR was caught flatfooted, however, when Comcast (CMCSA) announced a merger in early 2014 for approximately $160 per share.  While CHTR seemingly negotiated favorable divestiture deals with CMCSA, as CMCSA needed to sell systems in order to receive regulatory approval, CMCSA had appeared to outmaneuver CHTR to land the largest viable acquisition target.  With the benefit of hindsight, one can question:  was CHTR penny wise/pound foolish with its offers of $114-$133?  Clearly, CHTR’s stock previously traded at lower levels, but TWC executives consistently expressed concern regarding CHTR’s valuation multiple and debt level.  Based on conversations with CHTR and Liberty, CHTR believed that CMCSA would not submit a solo bid due to regulatory risk.  These statements, however, contradict others made by Liberty executives following CMCSA’s bid for TWC, as the Liberty team (along with most analysts) expressed confidence that a CMCSA/TWC deal would be consummated.  Regardless, regulators surprised investors by pushing back against CMCSA’s deal and lobbying efforts, and Comcast ultimately abandoned its bid in May of this year.  Predictably, CHTR immediately began negotiating with TWC and ultimately struck a deal to buy not only TWC but also Bright House Networks (which CHTR originally announced it would acquire should the CMCSA/TWC deal be consummated).  While the TWC deal was not a surprise, the price was, as CHTR ultimately paid nearly $195 per share or just over 9x EBITDA prior to synergies.  As this write-up will discuss later, the higher bid reflected a late push from French telecom Altice, controlled by Malone disciple/admirer Patrick Drahi.  

Drahi’s late push likely took some of the future returns away from CHTR shareholders, but Dr. Malone has predicted that the deal will ultimately deliver high teen’s, low 20’s internal rates of returns.  An examination of pro-forma numbers suggests these returns are not only possible but potentially conservative.  Returns should benefit from greater than anticipated synergies, further broadband subscriber and average revenue per user (ARPU) gains, and continued share repurchases.  The bulk of the benefits, however, will likely occur in 2017 and later, and this elongated time frame could prove challenging for holders looking for shorter-term advances.  Clearly, the biggest near-term risk is that the deal might be blocked by regulators.  By most metrics, odds would appear to favor the deal moving forward, but investors were surprised about the CMCSA rejection and TWC’s 6-8% discount to CHTR’s offer suggests continued investor angst (spread has moved towards lower end of range).  This write-up will argue that the odds of approval are quite high, but absent a deal we believe that standalone CHTR would likely trade around $150, roughly 10% below current levels, with total standalone upside of roughly $240 within five years.  

Cable:  New Challenges…But Still a Fantastic Business

Before diving into CHTR pro-forma assumptions, it is worth reviewing the underlying cable business.  While cable certainly faces its share of negative headlines, including relatively new challenges in its video product, we believe the core business is still very attractive and a quasi-monopoly for large parts of its broadband offering.   Verizon’s FioS product offers broadband speeds equivalent to or faster than cable speeds and is therefore considered the greater competitive thread to cable operators than AT&T’s U-Verse offering.  Charter’s more rural locations have partially insulated the company from the broadband completion as it only overlaps with FioS and AT&T on 4% and 30% of its passings, with the same percentages jumping to 17% and 26% if the deal closes.  Additionally, Verizon and AT&T both require meaningful capital spending for their core wireless business, including payments for increased spectrum needs.  Despite the relatively heavy capital expenditure burden, the two companies’ shareholder bases remain focused on dividend maintenance and growth, and therefore will be less tolerant of new capital expenditure projects.  While less discussed, Liberty entities, unburdened by a “coupon clipping” shareholder base, likely have an advantage when competing in a business that  requires meaningful capital spending, carries higher debt levels, and often sports economics that are meaningfully different from reported GAAP earnings.  

Certainly, Google has made headlines by rolling out its fiber offering to 34 cities within the last couple of years.  While one cannot dismiss such a well-capitalized competitor (and potentially one with less concern about achieving minimum return thresholds), many of its offerings have avoided more costly rollouts to all homes in a given city, instead cherry picking selected household rollouts.  Politically, this strategy could become more difficult should Google embark on a more expanded rollout.  Furthermore, the increased talk of Title 2² regulation could also serve to protect cable’s position.  Fiber-to-the-home rollouts were never an inexpensive proposition.  But this rollout becomes more difficult if a builder begins to have concerns about regulators interfering with broadband pricing.    

In some ways, the threat of the Google rollout could prove beneficial to CHTR as it attempts to get regulatory approval for its proposed deal.  When questioned, CHTR can point to Google, possible mobile competition, and an expanded AT&T rollout as evidence of competitive threads.  Rutledge has publicly dismissed AT&T’s U-Verse offering as something more akin to a minor league offering, given its limited download speeds (<25 megabits per second) versus CHTR’s minimum 60 megabits per second (Mbps) offering.  Therefore, Rutledge will need to pull a regulatory rope-a-dope to warn about the dangers of an expanded AT&T offering.  But the fact remains that large portions of the country face limited competition for faster broadband offerings, especially if one assumes that speeds above 25 Mbps will become increasingly necessary for future offerings.  As just one example, Netflix says that users of 4K TV should have broadband speeds of at least 25 Mbps.  Even in cases with fiber overlap, cable has still shown an ability to compete effectively.  Within the US, Cablevision boasts penetration rates nearly 10 percentage points above Comcast despite much higher competitor overlap, and Altice has talked about broadband penetration rates in Europe ultimately reaching up to 70% despite higher competitor overlap than US peers.  Clearly, cable may face more competition than historical levels, but, even with this increase, the industry still remains far closer to a monopoly than most businesses.  

In addition to limited competition, the cable industry benefits from its resiliency during economic downturns.  Cable provider margin strength during the 2008-2009 recession demonstrates that broadband connections are among the last items cut by consumers during difficult times and the industry will likely perform superior to most during the next downturn.  While many investors are likely uncomfortable with the debt levels at certain cable companies, including CHTR, the performance during recessions does suggest that the business can safely support leverage higher than most businesses.  

As a testament to cable’s business strengths, consumers often have very negative views of cable companies yet continue to use their products.  According to a Harris Poll measuring the reputations of the 100 most visible companies among the general public, Charter and Comcast ranked a less than stellar 92 and 93, respectively.  Tom Rutledge has talked about improving customer service and pledged to bring all customer service functions back to the US, while greatly investing in further improvements for BH and TWC once the merger closes.  We did manage to call various cable companies to inquire about pricing strategies as well as to gain a basic sense of customer service experience.  We will describe the broadband only versus triple-play offerings later in this write-up. As a general observation, we would submit that cable’s customer service reputation is often well deserved.  We had Excel worksheets ready to inquire about all permutations of pricings and we still found the experience painful, but TWC particularly distinguished itself as truly horrible, with the call lasting 29 minutes (it took 9 minutes to just plug in our targeted address) versus 20-minute calls to CMCSA and a 12-minute call to CHTR.  We would suggest that the companies offer more consistent price points:  any particular reason that TWC’s double-play products second year price is $159.04 vs. say $158.99 or $159.99?  The savings from less customer confusion might be compelling.  We would also note that the simplicity of CHTR’s offerings stood out among our customer calls (the minimum speed of 60 Mbps pleasantly gives fewer options for customers).  Additionally, both triple play offerings had the same prices in years 1 and 2, which again makes for a simpler experience for customers.  We suspect that future dealings with cable companies will never be pleasant experiences and we do not expect CHTR to crack the top ten of Harris’ survey any time soon.  We would submit, however, that if the overall customer interaction experience can improve from something akin to a root canal towards something closer to a routine teeth cleaning, it would represent substantial progress.   

Deal Details:  $2 billion if Deal Fails but Smart Money Wants CHTR Equity

Before jumping into the specific assumptions of our pro-forma financial model, it is worth noting a couple of different specific aspects of CHTR’s offer for TWC and BH.  Standalone CHTR, unlike Comcast, did agree to a $2 billion break-up fee if the deal does not close.  Liberty Broadband and Liberty Ventures (LVNTA) will both only take CHTR stock for their TWC holdings versus the cash³ option offered to other shareholders.  Additionally, Liberty Broadband will invest a total of $5 billion into additional shares of CHTR, with $4.3 billion invested at $176.95 and $700 million invested at $173.  Furthermore, the Newhouse family, who currently controls approximately 25% of Discovery Communications’ voting shares, will accept roughly 25% of its total payment for Bright House in the form of a preferred stock with a 40 percent conversion premium.  Clearly, the noted cable investors prefer CHTR stock.

Malone vs. Malone:  LBRDK Funding Decision Has Impact on Multiple Liberty Entities

Liberty Broadband funded its additional investments in CHTR by selling $2.4 billion in LBRDK shares to another Liberty entity (LVNTA)⁴ as well as $2 billion to outside investors (Coatue, Jana Partners, and Soroban Capital).  Somewhat controversially, these investments were funded at par value ($56.13 at time of investment) even though LBRDK has traded at roughly 7-11% since it started trading in 2014.  The obvious question is why would LVNTA and smart outside investors agree to pay a higher price for LBRDK stock when both parties could simply acquire shares in LBRDK, CHTR, or TWC at a discount?  After speaking with multiple parties (including Liberty and CHTR), the answer appears twofold.  First, LVNTA and outside investors do not have to fund the investment if the deal doesn’t close, in effect allowing both groups to escape the regulatory risk of a failed deal.  Many believe CHTR shares will trade higher ($190-$200) should the deal close, but obviously regulators are capable of surprises.  Additionally, the investments were fueled by a desire to put larger amounts of capital behind a larger CHTR.  With a market capitalization of roughly $5 billion, it would be difficult for investors to acquire a meaningful stake in LBRDK without moving the price.  Obviously, buyers of LBRDK are still exposed to regulatory risk as the deal could be blocked, but they are compensated by buying shares roughly 10% cheaper should the deal be consummated as we expect. It is also worth noting that Liberty filed a 13-D on June 1 of this year which stated that LBRDK could potentially cut back all equity investments in LBRDK by 25% should it find alternate ways to fund the CHTR investment.  It appears that the only real possibility would be some kind of exchangeable note backed by CHTR shares.  This possibility, while remote, would potentially allow further upside for LBRDK as fewer shares would need to be issued to fund its CHTR investment.  

LBRDK’s decision to involve an outside Liberty entity in funding its CHTR investment has other knock-off effects on the various parts of the Liberty empire beyond the offering price of LBRDA shares.  While a full discussion of the potential dominos is beyond the scope of this write-up, we will highlight a couple of items that LBRDA shareholders should consider.  Normally, interrelationships among various investor controlled entities would be a red flag, as investors would rightly wonder about one entity receiving preferential treatment over another.  This concern is primarily mitigated by the overwhelming success of nearly all Liberty entities over time.  That said, LVNTA’s investment decision does leave some unanswered questions and leaves open the possibility of future asset maneuvering.  LVNTA’s decision to invest the bulk of its cash balance into LBRDK does call into question what the tracker will do with its existing EXPE stake as well as the cash payments it receives from its tax advantaged exchangeable securities.  Clearly, some kind of spin of the EXPE stake (along with all or most of the e-commerce retailers) appears to be the more likely path versus trying to tender for some/all additional EXPE shares or trying to acquire Barry Diller’s super-voting EXPE stock.  If a spinoff were to occur, then LVNTA would be left with LBRDK shares and a stream of cash payments that QVC pays LVNTA to utilize the tax shield from LVNTA’s attributed exchangeable debt.  While LVNTA has been examining its options for the EXPE stake for some time, our sense is that LVNTA’s investment in LBRDA might accelerate a decision.  

As we previously noted, it appears logical that the LBRDK stake will ultimately be merged with CHTR.  As a general rule, tracking stocks and other entities backed primarily by public holdings often prove to be temporary investment vehicles.  Usually, trackers become asset-backed companies and passive equity stakes are consolidated with the mother ship in a tax efficient manner.  A LBRDK/CHTR merger would follow a similar playbook used by Liberty Entertainment in 2008/2009, when Liberty created a tracking stock whose primary asset was a 40%+ position in DirectTV.  Ultimately, the tracker was merged into DTV and the discount was eliminated.  We believe it is reasonable to assume that LBRDK’s discount will ultimately disappear.  But, given the intermingling of Liberty entities, it is possible that some assets of the various Liberty entities could be combined prior to the CHTR merger.  LVNTA could ultimately be merged with LBRDK, especially if there were a way to move the valuable exchangeable debt tax shield to CHTR.  Alternatively, the exchangeable debt could be moved directly to QVC and potentially allow a hard spin of QVCA, as a larger investor base might flock to an asset backed QVCA, should it be separated.  Obviously, all of this is highly speculative, but we think it is important for investors to monitor all of the Liberty assets connected with the CHTR investment as there will likely be future maneuvering of the various pieces.  

When thinking about the pro-forma financials for CHTR, we believe there are a couple of key assumptions to discuss:

• Synergies:  CHTR Management sandbagging

• Video losses moderate/Programming costs rise (or vice versa) and Broadband takes share

• 4.0x or greater leverage/NOL exhausted by 2018

• Management projections suggest upside

Synergies:  CHTR Management Sandbagging/What to Make of European Cable Cowboy

We estimate that CHTR’s programming rate card is approximately $13 higher than Time Warner Cable (Bright House paid a separate fee to receive TWC’s rate card, so there is no programming synergy benefit for acquiring BH).  Assuming the deal closes December 31, 2015, (actual approval could easily be delayed, but for simplicity purposes, we make this assumption) CHTR would immediately pay TWC’s programming rates starting January 1, 2016, resulting in an immediate $600 million synergy.  This saving would increase annually versus what standalone CHTR would achieve, assuming programming costs continue to rise at 7-9% annually.  While many content owners were likely not thrilled about receiving lower programming rates, they believed this was the lesser evil than trying to negotiate a new contract with an enlarged company controlling approximately 17 million subscribers.  Clearly, once programming contracts come up for renewal, CHTR will likely get additional synergy benefits as the company attempts to move its rate card closer to CMCSA’s level.  As we will shortly argue, we would also expect an even more confrontational approach with content providers as cable companies try to moderate programming expenses.  In short, it is highly possible that Charter will exceed its synergy estimate exclusively on programming costs.  

But, of course, programming costs are not the only source of savings.  Excluding programming costs, New Charter will have nearly $15 billion in total operating costs.  We assume that CHTR ultimately eliminates 5% of this total by 2019 (we assume 1% in 2016 with 1-1.5% rises annually), resulting in nearly $800 million of savings.  Obviously, there will be some low-hanging corporate costs that can eliminated and some synergies within sales and marketing, information technology, and customer care.  The cuts will not be even, and spending will likely initially rise as CHTR tries to improve some of TWC’s neglected customer service spending.  But by most reports, TWC was far from the most efficient operator and we suspect that the combined company will have multiple opportunities to find savings.  We do not assume specific capex synergies per se but instead assume gradual reductions in total spending as a percentage of revenue (but generally flattish absolute dollar spending) even though increased purchasing power, cheaper security technology and cloud software updates offer substantial opportunity for savings.  CHTR’s internal forecasts suggest a substantial opportunity for further capital savings, as do comments from a certain European holding company (more on both below).  We would finally note that Liberty Global has exceeded synergy guidance following its acquisition of UK cable firm Virgin Media (deal closed in mid-2013), with EBITDA margins up nearly 600 basis points since the end of 2013.  Liberty Global has already increased its synergy estimate for Netherlands cable operator Ziggo by 50% (with the deal closing in November of 2014).  

And then there is Altice, a multinational cable and telecommunications company, led by the new European cable cowboy, Patrick Drahi.  Drahi is a long-time Malone follower and fellow billionaire who has executed multiple acquisitions, using a combination of highly valued equity, aggressive borrowing, and aggressive cost cuts to create substantial value.  Altice is actually a holding company registered in Luxembourg, quoted in Amsterdam and 57% owned by Mr. Drahi through another holding company called Next LP.  Even the company’s holding structure suggests a close following of Dr. Malone’s organization charts.  Altice announced the acquisition of 70% of US cable company Suddenlink in May of this year and the company provided a synergy target of $215 million (with another $65 million of separate capex synergies).  Since the deal was Suddenlink’s first foray into the US market, the synergy estimate was ostensibly coming from non-programming operating expenses, with the projected number amounting to an estimated 25-30% of all non-programming operating expenses.  Altice management noted that adjusting for programming expenses (which are much lower in Europe than the US), US cable operators were paying 2-3x more than their European brethren.  Is it possible that that the telecom equivalent of 3G has now invaded the sleepy cable space?  CHTR and Liberty management teams think these projected levels of cuts are untenable, and CHTR has noted that its team has experience running cable systems in Europe (Obviously Dr. Malone knows something about European cable as well) and therefore is acutely aware of where the bodies are hidden across continents.  Dr. Malone has called Drahi a fantastic entrepreneur who is smartly exploiting the company’s high stock multiple and low interest rate environment.  But, he also expressed skepticism at the degree of cost cuts.  Clearly, more dense population centers and the absence of DISH and DTV likely were key factors in the spending differences between European and US cable operators.  

But, before completely dismissing the European cowboy, it is worth nothing that Altice has had substantial prior success in slashing expenses.  Drahi has managed multiple international cable acquisitions, and Altice has shown success with larger deals.  Altice’s Numericable has already raised total synergy estimates after only one full quarter after buying mobile operator SFR from Vivendi in a multi-billion dollar deal.  Following the SFR merger, a mediator was actually appointed to arbitrate between Numericable-SFR and its suppliers after the operator demanded 20-40 percent lower prices on contracts.  While the US market is certainly different from Europe, it is harder to dismiss all of Altice’s claims about elevated capital spending (which is also believed to be 2-3x times European levels) when the company says it sees Suddenlink invoices showing substantially higher equipment prices versus those from the same supplier Altice uses.  Furthermore, Altice would be leveraged at over 7x following Suddenlink transaction (not taking into account the proposed Bouygues deal), but only 5.5-6x following the proposed synergies from the Suddenlink deal.  As Altice expects to sell debt for the deal at 5-6% (similar levels to what we assume for CHTR/TWC financing), some parties clearly believe the targets are achievable.   Time will tell whether Drahi’s aggressive cutting proves to be a viable strategy, but his guidance suggests that CHTR cutting 5% of combined costs is not only doable, but conceivably conservative.  

Video losses moderate/Programming costs continue (or vice versa)

Certainly, cable investors are very familiar with the cacophony of predictions regarding cable’s video offerings.  Consumer Reports has shown that the number of 26-35 year olds with streaming services almost exceeds those with video cable offerings, and many expect the trend to either continue or to actually accelerate.  Despite the pressure on its video offering, cable companies have continued to endure rising programming costs of anywhere from 9-12% annually.   SNL Kagan estimates that cable costs have risen nearly 9% annually over the past 10 years (sports programming increasing 11% and non-sports rising nearly 9%).  Over the next 3 years, SNL projects rises of nearly 7%, with 10.5% and 5% increases for sports and non-sports programming.  Clearly, these trends have taken their toll on video margins and conceivably made the offering more challenging, especially for smaller cable operators.  Prior to its IPO, Graham Holding Company  spinoff Cable One placed a slide in its investor presentation suggesting that after indirect costs and video specific capital expenditures are considered, video free cash flow margins could be negative.  CHTR has disputed Cable One’s analysis and cable margins and noted that CHTR and TWC contribution margins are far higher given the lower programming costs.  

While there are endless permutations of assumptions one can make, we assume that video penetration rates stabilize near current levels for standalone CHTR and decline for TWC and BH, resulting in declines for all three cable systems (but higher declines for TWC and BH).  On the broadband side, we assume penetration rates rising from nearly 40% to 50% for standalone CHTR territories while TWC levels increase to only around 45%, given the higher fiber overlap in TWC territories.  (For what it is worth, the European cowboy foresees broadband penetration rates approaching 60% in the US, albeit with pressure on ARPU growth).  We assume ARPU increases of 3-5% annually.  Visibility is clearly higher on the broadband penetration, but regulatory risks do exist on the degree of pricing that can be taken.  

                                                               2013      2014     2015E     2016E     2017E    2018E    2019E

CHTR Broadband Penetration Rate    37%       40%       42%        44%         46%       48%         50%

TWC Broadband Penetration Rate     37%       38%       39%        41%         42%       43%         44%

CHTR Video Subscribers                         4.2         4.2         4.2          4.1            4.1        4.1            4.1

TWC Video Subscribers                        11.2       10.8       10.6       10.4         10.3       10.3         10.4            

CHTR Video Penetration Rate              34%       33%       33%       33%         32%       32%          32%

TWC Video Penetration Rate               37%       35%       34%       33%         32%       32%         32%

On the programming front, we assume standalone programming costs increase 9% in 2015 and 2016 and then 8% annually from 2017-2019.  Again, we assume standalone programming costs and then make a synergy estimate based upon TWC’s assumed rate card (which is assumed to increase at the above levels).  Clearly, video losses could be far greater than these estimates, but, if that proves to be the case, we believe our programming cost estimate is likely inflated.  As a sensitivity, if we assume video losses from 2017-2019 end up approximately 2 million more than anticipated, but we simultaneously assume that programming costs only increase 5% instead of 8% annually during these years, the combined company’s EBITDA would be roughly $400 million greater in 2019.  

After comparing CMCSA, TWC, and CHTR prices for standalone broadband, we would note that it still could be challenging to replicate favorite programming offerings cheaper a la carte versus a discounted bundle.  Based upon the earlier described calls to CMCSA, TWC, and CHTR, high-speed broadband (25-50 Mbps or greater) ranged in price from $39.99-$44.99 for the first year with prices jumping to around $65 for the second year (quoted prices generally require 2 year contracts).  These prices compared with triple play prices in years 1 and 2 of $89.99/$89.99 for TWC New York, $99.97/$99.97 for Charter Athens, GA, and a particularly egregious $99/$144.95 for CMCSA Napa, CA.  Perhaps this broadband connection and a $7.99-$11.99 Netflix subscription will be sufficient for most subscribers, but we suspect many customers will still want other offerings, and the cost savings for broadband/multiple content offerings will be far less than many consumers wish.   

There have been more public disputes over content costs and we believe more protracted blackouts are likely.  As we previously noted, an enlarged CHTR will certainly have an opportunity as new programming contracts come up for renewal.  There is also reason to think that further programming cost savings could appear, should the bundle break.  A recent survey from Digitalsmiths asked consumers which programming they would want included in their primary cable tier without giving an estimate of each channel’s cost.  Surprisingly, Discovery Channel (number 2), History Channel (number 5), and National Geographic Channel (number 6) were among the top seven along with the four broadcasters.  Sports focused programmers TNT (number 17) and ESPN (number 20) faired far lower than anticipated, before customers saw price tags likely far higher than ESPN’s $6.00+ wholesale rate.  Certainly, one survey doesn’t make a trend, but we think an unbundled world could force sports enthusiasts, rather than all cable subscribers, to foot more of the bill for multi-year contracts and potentially offer some release on total programming cost increases.  

CHTR and Dr. Malone have both talked about how a consolidated cable industry would be better positioned to offer the elusive cable anywhere offerings, whereby a more consistent product could be offered on a video on demand (VOD) basis – a complete season of Mad Men for example available on Comcast and New Charter.  A more enhanced and consistent video on-demand experience available on any device could theoretically offer something closer to a competitive product to Netflix type offerings, especially given the higher cost for standalone broadband that we previously described.  At the very least, cable’s internet product and expanded VOD offering will give it a better chance of either keeping existing video customers or picking off those from satellite competitors.  It is conceivable that total video losses continue to accelerate across the entire telecom industry, but cable providers actually take additional share.  For what is worth, Rutledge predicted that New Charter will actually have more video subscribers five years from now than at present.  

Putting it all together, our video, broadband, and telephone projections previously outlined imply top-line growth of roughly 5% annually for the next 4 years.  These growth rates include continued double digit growth in commercial revenue for TWC and standalone CHTR, but down from the recent torrent 20%+ rates of recent years.  Total commercial revenue would account for over 15% of total pro-forma revenue in 2019 versus 13% of 2016 pro-forma revenue.  Again, programming costs are assumed to increase 9% for the following two years and 8% afterwards.  We assume no margin improvement in standalone TWC’s non-programming operating expenses (but some improvement at standalone CHTR).  Prior to the previously discussed synergies, we assume that the combined companies’ EBITDA actually increases at rates (roughly 4%) lower than top-line due to the continued programming cost pressure.  After factoring in the previously discussed synergies (which rise to nearly $1.6 billion by 2019), we derive EBITDA growth rates of roughly 6%.

Assuming the deal closes at year end, we estimate that net leverage will be approximately 4.7x and will fall to 4.0x before the end of 2017.  In fact, we assume that the company will start issuing additional debt sometime in 2017 and then raise nearly $10 billion more to maintain its ~4x target.  We actually wouldn’t be surprised if debt levels move towards 5x if New Charter finds new acquisition targets, but we suspect the company will likely not raise debt much beyond 4x just for share repurchases.  We assume the debt taken on to fund the deal will cost 5.5%-6.5% and buyback funded debt will rise to 7-8% with excess cash flow used to fund share repurchases.

On the tax side, we estimate that the combined company will have over $11 billion ($1.6B tax assets at TWC in addition to CHTR NOLs) of NOLs that will shield the combined company from meaningful tax payments until 2018, at which point the combined company will become a meaningful cash tax payer (and full payer by 2019).  This assumption could prove too conservative as higher depreciation costs might push the tax burden out until 2019/2020. For simplicity’s sake, we ignore Bright House’s step-up tax benefit upon the conversion of its preferred investment and simply assume a fully converted basis throughout the model.  We think our tax assumptions will prove conservative as it has always paid to take the “under” when estimating future Liberty tax burdens.

The above assumptions lead to leveraged free cash flows per share of over $21 by 2019.  Assuming an Enterprise Value/EBITDA multiple of 8x, roughly equal to Comcast’s current year multiple, Charter would trade at over $308, while LBRDA would be worth approximately $100.  Over 4.5 years this would represent IRRs of nearly 16% from current LBRDA levels.  Clearly, those are not horrible numbers, especially in the current market environment, but Altice’s bidding did eat away some of the upside.  That said, this model was built prior to CHTR’s release of its preliminary proxy statement.  Before talking about a possible upside scenario, we thought it would be more helpful to compare the above numbers with management’s internal forecasts released with the preliminary proxy.

CHTR Internal Forecast                     2015E        2016E          2017E           2018E           2019E

Revenue                                          $37,507      $39,503       $42,209       $45,690        $49,283

EBITDA                                             $13,328      $14,556       $15,974       $17,811        $19,541

Capex                                              ($6,516)      ($6,463)       ($6,916)       ($6,479)       ($5,829)

Capex/Revenue                               17.4%         16.4%            16.4%           14.2%           11.8%

Our Pro-Forma Forecast

Revenue                                          $37,558       $39,437       $41,359       $43,327        $45,490

EBITDA  (including synergies)      $13,409       $14,992       $15,912       $16,707        $17,734

Capex                                              ($6,542)       ($6,579)       ($6,399)       ($6,293)       ($6,217)

Capex/Revenue                               17.4%           16.7%           15.5%            14.5%           13.7%

If we simplistically use CHTR’s projections for EBITDA and capex and keep our other assumptions constant (depreciation levels, which could be understated, working capital spend, etc.), CHTR would actually generate over $28 of free cash flow per share by 2019 with a share price of over $380 at the same 8x target.  Our upside case actually had EBITDA levels approximately $1 billion above management levels, primarily driven by higher broadband penetration rates at CHTR (mid 50’s) and TWC (high 40’s), but we were still meaningfully above CHTR’s projected capex spend.  Again, using an 8x EBITDA multiple, these assumptions lead to a share price closer to $450.  Obviously, there are layers of assumptions and many will prove inaccurate, but we would simply note that it doesn’t take huge amounts of imagination to envision IRRs of above 20%.  

We would finally note that the model assumes no mobile revenue.  Following the merger announcement, Dr. Malone noted at Liberty’s shareholder meetings that one of the great opportunities for the combined company could be in the wireless space.  Malone noted that cable consortium SpectrumCo received an option in 2012 to participate in a wireless Mobile Virtual Network Operator (MVNO), essentially a wholesale wireless offering using another company’s infrastructure, with Verizon after the company bought $3.9 billion in frequencies.  SpectrumCo did not include CHTR but did include merger partners TWC and Bright House.  Malone hypothesized that a MVNO offering from Charter and say cable company Cox Communications (with a default to Verizon) could be an interesting product offering.  As Liberty has long discussed, large portions of customers data usage is actually done via various broadband networks versus on the wireless companies’ own spectrum.  Liberty Global has successfully employed MVNO businesses in several of its European markets, and the company has noted how so-called quad-play subscribers have among the highest retention levels.  Larger geographic areas make wireless only mobile offerings more challenging than Europe and an actual offering palatable to consumers could be years away.  But, clearly this possibility does have potential even if it is impossible to model at current time.  

Deal Risk

So what could go wrong?  Obviously the deal could be rejected.  Merger approval is far from assured, especially considering that many investors had previously assumed that Comcast’s attempted merger with Time Warner Cable would receive regulators’ blessing.  Currently, Time Warner Cable trades roughly 6-8% (the discount has been narrowing) below Charter’s proposed offering, suggesting some investor concern about the deal’s approval.  We believe, however, that the odds of approval are high for multiple reasons including:

• A combined Charter, Time Warner Cable, and Bright House would still be roughly 52 percent and 29 percent smaller than AT&T/DirecTV and CMCSA in terms of total video subscribers.  Denying Charter would amount to regulators’ tacitly admitting that prior approval for previous CMCSA mergers was a mistake, a landmine that we believe regulatory officials want to avoid.  AT&T/DirecTV is anticipated to be approved within the next month, and there has been little evidence suggesting that the deal has faced major scrutiny.

• CMCSA/TWC faced problems as government officials believed the combined company’s roughly 56% share of broadband subscribers above 25 Mbps constituted a monopoly.  While this arbitrary metric had never been previously discussed by regulators, a combined CHTR/TWC/BH actually would only have just under a 30% share, a level significantly below CMCSA/TWC levels.  

• Unlike CMCSA, which owns broadcaster NBC and various other cable channels, CHTR has no meaningful content assets.  Based on conversations with both Liberty and CHTR, regulators were highly concerned about the possibility of a combined CMCSA/TWC withholding its NBC/cable content from other distributors while continuing to distribute on CMCSA systems and via Hulu.  While these concerns were likely overdone, it appears they became one of the more contentious points when the merger was reviewed.  Again, CHTR avoids these concerns entirely.  

• While the Federal Communication Commission’s February 2015 decision to more heavily regulate cable companies using Title 2 of the Communications Act of 1934 will be challenged for a considerable period of time in courts, CHTR has nevertheless agreed to continue policies of not blocking or throttling traffic or enabling paid prioritization.  We suspect that the Federal Communication Commission (FCC) will ultimately force CHTR to adopt language that recognizes the FCC’s authority to regulate broadband providers, but we do not believe that the agency wants another merger rejection following the contentious debate over Title 2.  In fact, numerous articles reported that FCC Chairman Tom Wheeler personally called cable CEOs, including CHTR’s Tom Rutledge and TWC’s Rob Marcus, in May of this year following the CMCSA rejection to assure executives that he was not opposed to further consolidation within the cable industry.  

• We do not believe that public outcry over CHTR’s proposed merger has reached levels remotely close to those at the time of the Comcast announcement.  Additionally, CHTR has made several commitments that increase the probability of approval.  Major content companies have spoken out far less frequently against the CHTR/TWC/BH merger and Netflix has now blessed the deal. Based on conversations with CHTR and Liberty, most content companies have agreed to recognize Time Warner Cable’s rate card, rather than Charter’s more expensive one, immediately after the CHTR/TWC/BH deal closes.  Meanwhile, CHTR has promised that all combined company subscribers will be upgraded to a minimum speed of 60 Mbps, the slowest speed that CHTR currently offers.

• CHTR has tried to put a positive political spin on the deal.  It has emphasized the investments it will make in the merged company, with pledges to add thousands of jobs as the company moves all customer service back to the United States.  And importantly, CHTR has extended an olive branch to regulators by hinting that the combined CHTR/TWC/BH company could serve as a meaningful wireless competitor, with the combined entity pledging to create over 300,000 out-of-home WiFi access points.  

And if we are wrong?  Then the downside case immediately turns to standalone CHTR’s projected value.  We would estimate that CHTR might immediately fall to somewhere around $150, should the deal be rejected.  TWC might fall less as investors anticipate another bid from Altice, but we assume an initial drop to around $150.  Assuming discounts of 8% to 10%, Liberty Broadband might trade for $45-$46 (versus a Net Asset Value of $50), should regulators reject the deal.  We would emphasize that we firmly believe that the discount for LBRDK will completely disappear, and therefore investors should assume they will ultimately receive net asset value for their shares.  Further CHTR downside is possible as investors view the company as a stranded cable asset with an acquisition subset limited to only smaller cable players.  Our standalone broadband, video, and internet penetration levels and ARPUs would not change, as CHTR would continue to operate  in geographies generally free from major competition, but CHTR would likely not pay any meaningful taxes through 2020 (and likely longer) and the company would likely be even more aggressive with leverage and share repurchases.  Again, assuming only an 8x multiple, CHTR would be worth $240-$250 by the end of 2019 and LBRDA Net Asset Value of approximately $75 (assuming $150 for TWC), suggesting annual IRRs of 7-9% from current levels.  We would certainly not expect CHTR to sit idly, should regulators reject its merger, and therefore standalone CHTR would likely find additional acquisition targets. For longer-term holders, 7-9% IRRs are not exciting, but they are likely not the worst imaginable outcome.  

Summary:  Favorable Risk/Reward

To summarize, cable remains a fantastic business.  CHTR offers investors an opportunity for better operators to improve TWC’s core business and for outstanding capital allocators to execute other bolt-on acquisitions and meaningful share repurchases.  High teen/low 20 percent IRRs may be less exciting to some investors, but we have come across fewer opportunities with this type of upside with downside likely limited to high single digit IRRs.  We are convinced that there is substantial synergy upside relative to management projections.  While Mr. Drahi’s projections strike us as aggressive, we do wonder if cable’s monopoly position in many markets has likely made some operators a bit complacent.  We continue to believe that LRBDK will ultimately merge with CHTR thus eliminating any discount between LBRDK and CHTR.  We also suspect that further Liberty asset rearrangements will occur prior to this deal.  At age 74, we think Dr. Malone has another 10 plus years of value creation in front of him, and we believe investors will again be well rewarded for hitching their wagon to one of the greatest investors of all time.

  SHARES      VALUE

True Position

(Wholly owned Asset)                   $150

Cash                                                  $163

Total CHTR Shares       59.8           $18,431

Margin Loans & Other

Revolving Facility Draws               ($412)

NAV                                                   $18,332

LBRDA Shares                  26

LBRDB Shares                     2

LBRDK Shares                153

Total Shares                   181

NAV Per Share                                 $101.04

Current LBRDK Price                       $54.54

[1] As is the case with other Liberty entities. Liberty Broadband’s A class of shares (LBRDA) is entitled to one vote while the C class of shares (LBRDC) does not have any votes.  Given Dr. Malone’s substantial voting interest, we ascribe little value to the single vote, even though many Liberty entities’ A shares trade at 3-7% premiums over the no vote class of shares.  As an outlier, Liberty Broadband’s A shares have recently traded at a discount to the K shares, partially as a result of slightly higher trading volume.  We would simply buy whichever class of shares trades cheaper.

[2] Following a multi-month period of intensive debate, in February of 2015, the Federal Communications Commission voted to reclassify broadband as a utility under Title 2 of 1934 Communications Act.  Under FCC rules, broadband operators cannot block access to any lawful content, cannot impair connectivity on the basis of content, and cannot establish fast lanes that offer higher speeds in return for compensation of any kind.  The FCC has promised forbearance from many Title II regulations (namely rate setting or network unbundling) but there are questions about whether this stance could be reversed.  Telecom providers along with cable and wireless industry lobbyists have sued the FCC over the Title 2 regulation. 

[3] TWC shareholders can either receive $100 in cash and 0.5409 shares of CHTR stock or $115 in cash and 0.4562 shares of CHTR stock.

[4] Liberty Ventures and QVC are two tracking stocks of Liberty Interactive.  Liberty Ventures’ assets include stakes in various public entities (with Expedia by far the largest at approximately $2.5 billion), a collection of e-commerce retailers, multiple tax-advantage exchangeable rate securities with larger tax deductions versus cash coupons, and, post the CHTR investment, $2.4 billion of LBRDA shares.  QVC Group’s primary asset is online retailers QVC but also includes a nearly 38% stake in HSN.   

Catalyst

-Successful deal closing

-Possible equity linked note lowering the total number of Liberty Broadband shares offered to fund CHTR investment

-Increased CHTR synergy estimates

-CHTR programming cost moderation

-Traction with CHTR MVNO offering