Description

Underfollowed, misunderstood and catalyst-rich spin-off that I expect to repurchase 25-45% of its shares (30-50% of its float) and generate a 60-100% total return to shareholders in next 2-3 years while assuming only 6% annual EBITDA growth, and assuming repurchases made at increasing share prices over that timeframe.  If they can grow EBITDA a couple points faster, which I believe is quite likely given strong pricing power and customer speed upgrades, total 2-3 year return to shareholders could exceed 100% from here.  Expect ultimate sale of company to Charter/Liberty, Comcast, Altice or other larger cable provider, which, contrary to popular opinion, can almost certainly be done at any time due to preservation of the “super safe harbor” exemption as essentially confirmed by recent CFO comment.  Importantly, I see a low probability of capital loss from this extremely attractive price. 

Based in Phoenix, AZ, Cable One, Inc. (“CABO”) is the 10^th largest cable company in the U.S., and focused on non-urban markets in 19 Midwestern, Southern and Western States.  75% of the company’s customers are in 5 states (Mississippi, Idaho, Oklahoma, Texas, Arizona) where competition is extremely limited (<1% of customers have access to fiber-to-the-home).  The stock’s current dividend yield is 1.5%.

Formerly part of Graham Holdings Company (“GHC”), CABO completed its full separation via a spin-off completed 3 weeks ago, on July 1^st.  Concurrent with the spin, the company raised $550mm of debt to finance a $450mm dividend to GHC and put $100mm of cash on its opening balance sheet.  With 5.8mm shares outstanding (4.8mm floating excluding Graham family), the market cap is $3.2bn and enterprise value is $2.7bn, equal to 9.0x LTM EBITDA.

* Side note:  I have a Stub GHC writeup half-written, but given current cable industry dynamics, and fact that CABO has not been posted on VIC, SZ or otherwise, I figured I’d post this first and Stub GHC next.  I love both parts of pre-spin GHC here, for many similar, and some different, reasons. *

Keys to the Thesis:

* Underfollowed:  Only one analyst covering (JPM initiated with a “Hold” and $476 target and $529 potential takeout price when stock was $425); high absolute share price of $390 and low trading volume makes shares unprofitable for sellside firms; notably the company's data is not even properly reflected in Capital IQ yet

* Misunderstood tax law:  Market likely is mistaken in its belief that there is a 2-year M&A embargo required post-spin for sale event, but I am quite certain CABO has been careful to avoid prior M&A discussion or “plan,” qualifying them for “super safe harbor” exemption (Motorola Mobility/Google 2011, Realogy/Apollo 2006-7, First Data/Western Union/KKR 2007 are examples); GHC/CABO management are extremely tax savvy, as evidenced by their recent stock swap with Berkshire; to that end, CABO CFO recently said “There is a lot of consolidation activity in the industry we have not had any discussions with anybody”

* Spin-off dynamics:  Shares have traded down 12% in 3 weeks from $450 initial price post-spin to $394 currently

* Minimal competition:  Non-urban market focus with minimal high speed internet competition (75% of customers in MS, ID, OK, TX, AZ)

* Expanding margins:  Conscious focus on high speed data (internet) and business customers, running declining video business for cash

* Focus on FCF:  “Offer premium product at premium price” (100 Mbps internet by Jan 2016)

* Recurring revenue:  Subscription business with 92% renewal rate in high speed data

* Price increases:  Large price increase potential (currently charges $1.86/Mbps vs. comps as high as $2.89/Mbps), 21% below Cox, 22% below Comcast, 25% below Mediacom and 35% below Suddenlink

* Underleveraged (but not for long!):  Current gross leverage of 1.8x (1.5x net) at 5.0% weighted cost with 6.6 year average maturity (term A at 2020, senior notes at 2022), targeted to rise to 3.0-4.0x (conservative by Malone standards of 5.0x+) with no material acquisitions expected

* Huge levered buyback likely:  At 3.0x gross leverage and 6% EBITDA growth, could repurchase 27% of total shares and 33% of float as the share price rises to nearly $630 by 2018 (*note that there is circularity here, because if share price does not rise consistently over time, share repurchases will be higher).  It is generally thought that there is a 20% limit on share repos in the first 2 years after a spin, although it may be up to 50% for a “widely-held” stock

* Dividend:  $6/share dividend is 1.5% current yield

* Declining capex:  “Capex cycle materially over by 2015” per management, drives significant additional increases in FCF beyond EBITDA growth

* Small float:  Only 4.8mm shares float, as Graham Family owns 17% of the stock, unlikely to be sellers in open market (Don Graham has committed to personally not selling any stock in open market for at least 2 years); “true float” probably no more than 3.5mm shares due to index funds and long-term holders (e.g. Southeastern Asset Management), but my modeled float simply deducts Graham holdings; simply put, CABO is going to be buying back stock when there simply is not much float available, and that dynamic should begin in the next couple weeks

* High strategic value:  CABO’s strategic value is very high in this rapidly consolidating industry, as synergies are bountiful both in terms of programming cost and SG&A expense rationalization, potentially driving a sale multiple to 11-12x standalone EBITDA for this asset with a long growth runway, strong pricing power and minimal competition; as JPM noted “we believe that Cable One offers more than the typical level of synergies… and believe an acquisition multiple of 11-11.5x could be justified.”

* Clear value creation opportunity:  I believe the management/board plan is to execute an aggressive leveraged share repurchase (of at least 20%, possibly more if permitted) in the first 1-2 years and then sell the company to Malone (or other strategic) in a tax-free stock deal; this was likely a major reason for Graham’s 180 degree pivot and decision to spin CABO (previously he had said no spinoffs)

* Imminent catalysts:  Share repurchase authorization appears set to be announced and implemented in a matter of days (with earnings release?), after which I expect to see very aggressive repurchases and rapid re-rating of shares

John Malone Explains Cable Math

“I used to say in the cable industry that if your interest rate was lower than your growth rate, your present value is infinite.  That’s why the cable industry created so many rich guys.  It was the combination of tax-sheltered cash flow growth that was, in effect, growing faster than the interest rate under which you could borrow money.  If you do any arithmetic at all, the present value calculation tends toward infinity under that thesis.”

“If you think long-term interest rates are going to be high because of inflation, that’s always been kind to our type of industry, because our cost structure is largely fixed.  Inflation lets you raise your rates and devalue your liabilities.  Historically, inflation has been a growth builder for our kinds of industries.”

Illustrative CABO Math

* Growing EBITDA at 6.0% annually and increasing gross leverage to 3.0-4.5x per management guidance will allow the company to repurchase 27-46% of shares outstanding and 33-56% of the float by 2018, even assuming the company is repurchasing shares at increasing prices over that timeframe

* Total returns to shareholders likely 60-100% by 2018 at 10-12x EBITDA exit

* Note that net debt in this model is conservatively well below what many cable executives, including Malone, tend to believe is optimal

Document Links

* Analyst Day presentation:  http://ir.cableone.net/file/4137149/Index?KeyFile=1500073042

* Malone interview (2009):  part 1 (http://www.bizjournals.com/denver/stories/2009/04/20/daily97.html?page=all), part 2 (http://www.bizjournals.com/denver/stories/2009/04/27/daily24.html?page=all), part 3  (http://www.bizjournals.com/denver/stories/2009/04/27/daily45.html?page=all)

Key Risks

* Biggest risk is regulatory, however with Charter/Liberty buying Time Warner and Bright House, and Altice buying Suddenlink, seems the FCC is on board with major provider consolidation; regardless, CABO is tiny compared with these other companies

Disclaimer:  The author of this idea presently has a long position in securities of this issuer and may trade in and out of these positions without notice.  The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein.  Please do your own research.

Catalyst

* Investor awareness and understanding

* Imminent announcement of initial repurchase authorization (with upcoming earnings release?)

* Announcement of additional debt financing, which will surely be used to repurchase stock

* Increasing margins and declining capex, increasing FCF

* Awareness of the “super safe harbor” exemption permitting a sale event

* Sale of the company to one of several likely interested strategic buyers