Description

WideOpenWest

NYSE: WOW | $8.90/shr | $773M MV | $3.1B EV | HQ: Denver, CO

WideOpenWest is a highly levered cable company that we believe is on the verge of becoming a high-margin, data-centric broadband provider. If we are correct, the potential IRR from the current price is extremely high. We see fair value between $25 and $40 per share three or so years from now.

WideOpenWest is a cable overbuilder with corporate offices in Denver. Its primary cable markets are in the Midwest and Southeast US: Detroit, Columbus, Chicago, Huntsville (AL), Tampa, etc. It IPOed out of private equity ownership in 2017, at $17 per share. Since then the stock has suffered mightily as the company has struggled with two major issues: video profit losses due to cord-cutting and rising content costs, and a corporate infrastructure that was cut to the bone by the previous private equity owners. We believe that both of these problems are about to be resolved, leaving investors with levered exposure (5.5x net debt/EBITDA) to the powerful secular wave that is broadband.

WOW was previously written up on VIC by madler934 in April 2018 when the stock was at $6.90. Valuations across the cable sector have gone up since then but WOW’s financial performance has been uninspiring, with revenue and EBITDA below 2017 levels every year since.

This downward trend is set to reverse in short order. We expect significant positive change in the company’s business from: (1) continued strong growth in high-speed data profits, which represent an ever-increasing share of WOW’s total business, (2) the end of years of declining profits in WOW’s traditional television service, driven by a new willingness to raise video prices rapidly while pulling spending away from video OpEx and CapEx, and (3) the end of the inflated SG&A growth that was required to rebuild corporate functions after they were hollowed out by the private equity owners.

We’ll start with corporate infrastructure and SG&A. When the company IPOed in 2017 its SG&A was $140M; this year SG&A will be close to $180M (a CAGR of nearly 9% during a time when revenue fell slightly). This growth is attributable to significant and necessary investments in technology (e.g. WOW did not have the ability to take online orders in 2017; these now represent 30% of new orders), as well as a replenishing of the VP-level management ranks at the company, and an ongoing restructuring of the workforce below that.

However, SG&A growth should decrease if not disappear over the next few years. The company insists that restructuring costs (which are included in the SG&A line and which will likely peak at ~$30M this year) will finally start to decline going forward, while underlying overhead costs should grow at a pace closer to inflation. If this happens (we assume restructuring costs decline to $15M within three years), reported SG&A should remain flat-ish at $180M for the next three or so years.

Regarding the issue of video profit losses, as WOW’s video subscriber count has fallen its video business has deteriorated from both a volume perspective (video subs will end this year around 300K, vs. 547K in 2015) and a unit economics perspective (we estimate monthly “gross profit”— i.e. revenue minus programming costs — in video is currently $15 per subscriber, versus $25 in 2015). As a result, total video “gross profit” has fallen dramatically, from $173M in 2015 to approximately $70M this year.

The primary driver of the declining per-sub economics in video has been the fact that TV content prices have risen more quickly than WOW’s video prices to consumers (a 9% CAGR for programming costs vs. 5% for video ARPU). Why? Because WOW operates in markets where customers have demanded TV, and up until recently the management feared that raising video prices too much would risk driving customers into the arms of competitors.

However, COVID-19 has hastened the trend of cord-cutting nationwide, and in recent months there has been a clear shift in customer behavior, with data-only customers rapidly growing as a percentage of new sign-ups. In the first quarter of 2019, 45% of WOW’s new customers purchased a video product as part of their bundle. In the most recent quarter, that figure was just 13%. Data-only customers may soon exceed 90% of new sign-ups.

This change in customer behavior has emboldened the company to move aggressively toward a data-first (and eventually, data-only) approach. In July of this year the company implemented what amounted to a 10% price increase in video, and management has said that from now on, it will raise video prices by however much is required to offset the increase in programming costs, regardless of video sub losses.

The company’s willingness to take this step — essentially sunsetting its original cable TV product over time — is a very strong tell regarding management’s commitment to transforming WideOpenWest. And this shift away from television has the potential to dramatically improve the economics of the overall business. Per-sub gross profits in video will stop falling. But programming costs aren’t the only expensive part of offering video services to customers: video customers are also the primary driver of the next two largest operating expenses, customer call centers and field techs. They are also the biggest driver of CapEx, with more than half of capital spending historically being customer premise equipment, which is primarily set-top boxes. These indirect video costs have already been declining, but now that the company has made a clear strategic decision to abandon video over time, it can speed up its dis-investment in these areas. 

This shift away from video, where the incremental contribution margin from a new customer has been declining for years, and towards data, where the incremental contribution margin is closer to 80%, will have profound implications for WOW’s bottom line.

The high-speed data trend is powerful: in 2015 WOW had 712K broadband subscribers paying $41 per month for data. The company will end 2020 at approximately 810k broadband subscribers paying $59 per month. This year, HSD net adds are up 92%, the highest number of net adds in the company’s history. WOW’s “gross profit” from broadband was roughly $340M in 2015 but will be closer to $550M this year. That’s good for a 10% CAGR over five years.

While 10% profit growth might not amaze in this age of ultra-growth SaaS companies, net debt/EBITDA is 5.5x and EBITDA/interest is 3x, turning this 10% growth rate into something more like 40% from the equity holder’s perspective, with the bottom line impact amplified by declining interest costs thanks to de-leveraging. As a cherry on top, over $850M of NOLs could make most of WOW’s incremental free cash flows effectively tax-free.

WideOpenWest is led by CEO Teresa Elder and new CFO (hired June 2020) John Rego. Since WOW became public, Elder has been a consistent buyer of its shares in the open market, purchasing over $800K worth across 10 separate transactions, with a blended cost basis of $6.94. These purchases represent a significant percentage of her after-tax cash compensation.

Since John Rego joined the company (and brought his head of IR Andrew Posen with him), there has been a marked shift toward a more open and transparent dialogue with investors, as well as an increased urgency regarding the company’s strategy to transform itself into an HSD-first company, and thereby grow free cash flow and multiply the share price. The company is in the process of dramatically increasing its attendance of conferences and roadshows, and is finally enthusiastic about telling its story to investors. If you are interested in WOW, we recommend that you reach out to John and/or Andrew directly.

Below, we’ve included some of management’s recent public comments about WOW’s transformation.

CEO Teresa Elder, at the Credit Suisse Technology Conference on December 1st:

"In the last year, we've done some really transformational things for the company. Specifically, it was a year ago at this time that we launched a trial in Charleston, South Carolina, for really emphasizing streaming services first rather than our video packages with our customers. That was so positive, we decided to launch that across the whole company.... We also, early this year, launched in our first market, WOW! tv+, which is our IPTV-based service, which allows us to offer those video packages in a way that is much more visually appealing and easier navigation for our customers, but operationally, much more efficient for us and allows us to reclaim bandwidth. So we've launched in the last year, WOW! tv+ as a service to over 80% of our footprint.

The other big change, of course, we have to acknowledge is with COVID. We have dramatically accelerated our self-install capability. Since, of course, like all of us, customers don't want people in their homes. So that has been a win-win for customers. But also, it has been financially good for us as well [because of fewer field visits from techs], and it keeps our technicians safe."

And from CFO John Rego, at the same conference:

I was fascinated that the company was at that pivot point into the broadband first strategy, and that this was going to become predominantly a high-speed data provider. When I started drilling into the numbers, what remained looked a little bit like a software business, it's high 90% gross profit margins with less OpEx below the line and less CapEx [than video] in running that business. And I just think can you — in a period, a very short period of time, you could do something absolutely transformational. I also saw a company that had a stock price that struck me as somewhat depressed versus where peers were trading.

When I was doing my diligence on the company before joining, I took a look at the roadshow deck from the IPO, which was only 3 years ago. And there was a slide that stuck out because it showed high-speed data at 97% gross margin; TV, 40% gross margin. Well, the funny thing is, high-speed data is still around a 97% gross margin and TV is sub-20% in 3 years. Our programming costs are so high.

In the last earnings call, we published incremental contribution, which is the gross profit for subscription-based services. And you can see that's up 300 basis points in a very short period of time. That's going to continue to climb, and the gross profits of the company will continue to climb as TV starts to go away. So we're going to see this shift, and we all know it's going on, we're selling more and more HSD, we're selling more and more higher tiers of HSD. So I believe we can reach a point a couple of years out, where we can actually get our revenues back up to, say, the 2019 level, but at a significantly higher gross profit margin, and as I'll tell you in a second, at a significantly higher EBITDA margin below that. Because even at the gross profit level, TV really hurts you in the operating cost to run the business. TV is really expensive. TV drives a disproportionate amount of calls into customer care. They are long calls, they're not the calls that are resolved in 30 seconds. They take time, oftentimes they might not resolve without having a truck roll go out. So it puts a lot of burden on the business to support TV….

So as the shift happens, we can expect increasing EBITDA and increasing EBITDA margins. But more importantly, or as important, is also increasing cash flow generation. TV drives the largest amount of CapEx for the business, and the company's business has been fairly CapEx intense, as you know. So when you look at TV, the biggest drivers of CapEx there are the CPE because the set-top box is pretty pricey. The truck rolls themselves, much of the cost of a truck roll is capitalizable under current accounting standards. And so as we start to see less and less TV, there'll be a natural decreasing of CapEx. We saw a bit of that this year with COVID and the drop-off of video subs. So we saw our CapEx for the nine months this year versus a year ago is down around $33 million, sort of substantial….

We're at that stage now that the company has done all its operational things, has gotten the pivot going, the whole dynamic of what this company is, is changing. So we should hopefully see ever-increasing EBITDA and ever-increasing cash flows. That's the plan.

Finally, Mr. Rego at the UBS TMT Conference on December 8th:

Q: “If you were a 100% broadband-centric company, what could EBITDA margins be?”

A: “Close to 50%."

The net of all this is that, going forward, we expect operating expenses to decline, CapEx to decline, and SG&A growth to slow. Meanwhile, we expect broadband profits to keep chugging upwards at a high-single digit pace. We think FCF of $200M three years from now is reasonable. The current market cap is less than $775M.

What is WideOpenWest worth? It is an overbuilder, meaning that it built its networks in markets with pre-existing incumbents. Overbuilders typically compete with these incumbents by offering a combination of lower prices and better service, thus compromising their own economics a bit. They also tend to have lower penetration of homes passed than incumbents, and higher CapEx per home passed as a result. For this reason, overbuilders have historically traded at a discount to cable incumbents. 

How much of a discount though? Not a huge one. Prior to a few weeks ago, the last major overbuilder transaction in the US occurred in 2016, when TPG bought RCN/Grande for about 8.4x EV/EBITDA. TPG then added additional assets to RCN/Grande, renamed it Astound Broadband, and sold it to Stonepeak, an infrastructure PE firm, for 12.5x EBITDA in November of this year. While some of the Astound assets are incumbent networks, at least half the business is comprised of overbuilt networks.

Despite this upward slant to the precedent multiples, we value WOW more conservatively. We use a 9x EBITDA multiple, and have the company generating $500M+ of EBITDA in 2023, as well as $200M+ of FCF. Assuming a few hundred millions dollars of debt reduction between now and 2023, the shares would be worth approximately $30. It’s worth noting this might only equate to 12x or 13x FCF. At 10x EBITDA (and ~15x FCF) the shares would be worth $40.

Our revenue model is in-line with the Wall Street consensus, but our EBITDA is significantly higher. The reason for the difference is that we don’t think the analysts appreciate how dramatically OpEx and CapEx can shrink as a result of the dis-investment in video. The company itself has not emphasized these facts until very recently. We think analysts will update their forecasts once they gain familiarity with the new CFO.

We also think there is a fair chance the company will divest one or more of its non-core regional cable networks in the near future. Presumably these transactions will happen at multiples that are far above where the consolidated WideOpenWest business currently trades, highlighting the dramatic undervaluation of WOW stock. The proceeds of the sale(s) would also speed up the de-leveraging process while demonstrating management’s commitment to increasing shareholder value.

The main risk to our thesis is obvious: debt. While there is no escaping the fact that the debt load is high, it offers the equity holder magnified exposure to the multi-decade freight train that is demand for broadband internet access. The debt does not mature until August 2023, giving the company ample time to refinance as its financial profile improves. Moreover the current leverage ratio is below the 7x+ ratio that PE firms typically use for cable companies, and will decline rapidly over the next few years if our forecasts for the business prove correct.

Our thesis could also be impacted by a slowing of price growth in broadband, though we already model this to some extent; we have data ARPU growing 5% annually going forward, vs. 7% historically (and 10% compounded in the three years leading up to COVID). We take comfort in the fact that high speed data represents one of the greatest bargains in the history of consumerism, leaving room for substantial future price increases. Nor do we think it is unreasonable to ask a customer who was accustomed to paying $175+/month for triple play, now to pay $70+/month for a high speed data service that can reasonably replace both TV and phone.

Disclaimer

This document is for informational purposes only. All content in this report represents the author's opinion. The author obtained all information herein from sources believed to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind — whether express or implied. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any information contained herein. As of the publication date of this report, the author and/or their affiliates have a long position in the stock of WideOpenWest. Following publication of the report, we may transact in the securities of WideOpenWest without notice. This report is not a recommendation to purchase the shares of any company, including WideOpenWest. The information included in this document reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity. Any or all forward-looking statements, assumptions, expectations, projections, intentions or beliefs about future events included in this document may turn out to be wrong. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment prior to making any investment decision.

Catalyst

1. Continued growth in HSD ARPU and subs

2. Stabilization of per-subscriber margins in video, and accelerating reduction in video subscribers and associated OpEx and CapEx

3. Reduction of SG&A growth and declines in capital expenditures

4. Divestment of non-core assets at an attractive price, and concommitant debt reduction