Description

1. Cable is an extremely attractive industry, particularly for operators such as Charter.
2. Assuming only an increase in internet penetration from 32% to 39%, Charter’s EBITDA improves by 30%, and share price increases by 100%, without any M&A.
3. However, TWC deal offers substantial upside for CHTR shareholders at either CHTR’s bid or TWC’s ask.
4. Investors and media are currently pessimistic about cable’s growth prospects owing to three major misconceptions about the industry.
5. Charter is poised for a turnaround under its new management team.
6. Charter’s new Chairman is one of the greatest capital allocators of the 20^th century.

Background on the cable industry

Cable operators sell three major products: video subscriptions, internet subscriptions, and telephone subscriptions. The nature of the cable industry is such that cable operators have de facto monopolies. For an average home, a cable operator owns the only data connection into the home with enough capacity to provide that home with high definition video, high speed internet and voice services simultaneously.

Moreover, cable operators seldom overbuild one another. Operators have learned over the past decades that it is nearly impossible to both engage in a price war and earn an adequate return. Other industry advantages include two-year contracts with annual price increases, no inventory, no labor problems, and no long-term benefit liabilities. Furthermore, cable has a major competitive advantage in broadband internet.

The term “broadband” is used to refer to any kind of Internet service that provides high-speed, continuous Internet access. The term was originally used to distinguish high speed internet from traditional dial-up internet services at 56kbps speeds. While the term “broadband” is used to describe cable and DSL, cable has a fundamental technological advantage over DSL, which allows cable to provide faster speeds at lower cost than competing technologies.

A fully upgraded cable network can carry over 1 gigabytes per second of data to the home using a cable system’s existing coaxial network. In contrast, DSL’s copper twisted pair systems were designed for non-data intensive applications such as telephone services and have maximum capacity of around 100 megabytes per second of data. Aside from fiber optic cable used by Verizon FiOS and upgraded DSL used by ATT U-Verse, there is no technology that can match cable’s internet capacity.

Certain telecommunications operators (i.e. ATT U-Verse or Verizon FiOS) have spent capital upgrading portions of their networks to fiber optic cable or upgraded DSL to overbuild and compete with cable. It costs about $3,400 to make a new or upgraded connection to a single average suburban customer, including infrastructure, line extensions and home installation. Since the average margin per household is $50 to $100 per month, the payback can easily take more than six-years.

As a result, over-builders such as Verizon and ATT generally focus on Tier I Cities, wealthy suburbs, and geographic areas with enough density to earn an adequate return. Charter’s plant footprint is comprised almost entirely of Tier II cities and rural areas, so Charter’s plant footprint has negligible overlap with the two main cable over-builders. Verizon FiOS has about 4% overlap, and ATT U-Verse has about 30% overlap. This lack of footprint overlap is what makes Charter one of the nation’s best-positioned cable companies. In its rural areas, Charter competes almost exclusively against regional telecom companies (Centurylink, Frontier), which cannot afford to make expensive capital investments over their entire networks.

Therefore, there’s no reason over the long term why Charter will not eventually achieve the same broadband penetration rate as the overall U.S. With Charter's technological advantages, Charter could capture more than 70% of the households its footprint, achieving the same penetration rate as the overall U.S. today. 

Price target of $260 per share by 2015 

Already expensive? At a present price of about ten times 2012 EBITDA, Charter may be considered more than fairly priced. Free cash flow in 2012 amounted to $1.19 per share, or approximately 110 times market value. However, Rutledge and his team only began their turnaround strategy in Q2 2012.

Assumptions? Increasing internet penetration of its existing footprint from 32% to 39%, capital expenditures as a percentage of revenues should decline from 23% in 2012 to 19% in 2015, as a result of completion of deferred maintenance by 2015, Charter has targeted maintaining its net debt to EBITDA ratio at about 4.5 times.

Outputs? Charter can drive EBITDA per serviceable passing from $220 in 2012 to industry-average levels of $300 in 2015, and EBITDA will expand by about 34%. Charter will therefore generate approximately $5,300 million of free cash flow and incremental borrowing through 2015, which represents about 34% of its current market capitalization. Charter can use this capital to repurchase shares or buy other cable businesses.

Free Cash Flow Yield? If Charter repurchases shares, the company can reduce its share count by over 30% by 2015. Free cash flow per share would increase from $1.19 per share in 2012 to about $12.53 per share in 2015, which represents a 10% free cash flow yield relative to its current share price of $131.

Price Target? Holding Charter’s Enterprise Value to EBITDA multiple constant at about 10 times EBITDA, Charter’s stock price will increase to $262 per share.

M&A? CEO and Chairman have indicated that Charter will look for opportunities to consolidate the cable industry. Other cable companies trade at cheaper multiples. Already, Charter made an acquisition, acquiring Bresnan from Cablevision in July 2013 at a multiple of 9.6 times 2012 EBITDA. Bresnan is included in the projections and price target. However, further acquisitions of cable companies, which would also be accretive to value, are excluded from the price target.

TWC Upside (and Update)

On January 13, 2014, CEO Rutledge took his proposal to acquire TWC directly to TWC shareholders at multiple of about 8 times 2013 EBITDA (7.6 times 2014 EBITDA) comprised of cash (from newly issued debt) and shares (giving TWC about 50% ownership of the business).

TWC immediately rejected the offer and stating that it effectively wants 9 times 2013 EBITDA, to which CHTR responded with its same price and penciled out the NPV of tax assets and CHTR-led growth. This back and forth will probably continue for a few more months, as CHTR assesses the willingness of TWC owners to back a deal, and TWC pushes CHTR for a higher number.

With several of the great deal makers of the 20^th century involved, something will get done. The difference between TWC’s ask of $160 and CHTR’s bid of $132 is about $7bn or only about 1 turn of TWC EBITDA. This would drive the net debt to EBITDA ratio from about 5.5 times to 6.5 times, so Newco would have to spin some stuff off to Comcast and other cable companies, but this wouldn’t kill the deal in today’s environment.

In any case, Charter stockholders benefit from TWC’s lower multiple. If CHTR manages to convince TWC shareholders to do the deal, then assuming CHTR’s multiple, the new business will be worth about $190 per (CHTR) share. If TWC manages to hold out for $160 per TWC share, the new business will be worth $152 per (CHTR) share.

Factoring in synergies, in so far as cable is an extremely scalable business with massive overlapping costs of overhead and potential for negotiating leverage on content, then CTHR could be worth over $200 per share after the deal is done.

My own $0.02 view is that TWC was the cheapest cable company, by far, prior to CHTR’s offer. It was so cheap that CHTR will benefit regardless of whether the deal gets done at 8 times or 9 times EBITDA. However, even without an acquisition of TWC, CHTR is a fundamentally undervalued company, for several reasons.

Investors and media are overly pessimistic about cable’s growth prospects owing to three major misconceptions about the industry

Despite an immense opportunity for growth in revenue and earnings, most investors and media are overly pessimistic about the cable industry due to three major misconceptions.

First, many investors and media focus excessively on declining margins in cable’s video business. This is because of highly publicized battles between content providers and cable operators. Cable companies claim that rising content costs are squeezing their margins. The reality is that the majority of cable industry gross profits are generated from internet subscriptions. For Charter, internet subscriptions generate 43% of gross profits, and video subscriptions generate 38% of gross profits. While cable video is an important product, internet subscriptions are already the dominant driver of cash flow.

Second, many investors believe that all households in the U.S. have high-speed internet. In fact, 50% of U.S. households use cable or fiber internet, 20% of U.S. households use DSL internet, and 30% of U.S. households do not have broadband internet. As recently as 2012, U.S. cable companies such as Comcast, Time Warner Cable, and Charter all had more video subscribers than internet subscribers. Over the next three years, many more consumers will demand higher internet speeds as a result of greater usage of tablets and smartphones. The percent of households in the U.S. with high-speed internet will surpass 70%, with cable taking nearly all of the incremental subscribers based on current run rates.

Third, many investors believe that consumers are “cutting the cord” and subscribing to Netflix or other “over the top” (“OTT”) content providers rather than paid television. In fact, the number of video subscriptions in the U.S. has grown slightly from 92 million in 2007 to 97 million in 2012. Americans today are purchasing both paid television and OTT television. Rather than customers cutting the cord all together, the cable industry has lost customers to satellite operators and over-builders (ATT, Verizon). However, cable companies are making substantial recent investments in video quality and features to compete with satellite. Additionally, the cable industry is bundling its video and data products together and enhancing its sales and branding strategies. Rather than suffer cord-cutting, the cable industry has the potential to take market share from satellite and grow its video subscriber base over the next three years.

Charter is poised for a turnaround under its new management team.

Charter is the fourth-largest cable operator in the U.S. It suffered from overleverage and financial distress nearly from the time of its IPO in 1999 until it filed for bankruptcy in 2009. Charter emerged from bankruptcy in 2010 with reduced debt, as well as $7 billion of NOLs, which will shield Charter’s income until around 2017.

Prior to bankruptcy, Charter was chronically undermanaged and over-levered. It focused on generating cash to pay down debt, outsourced its customer services, and offered inferior video products. Charter had among the lowest customer satisfaction ratings in the industry. As a result, satellite and DSL competitors captured most of the subscribers in Charter’s footprint. In 2012, Charter provided internet service to only 32% of the households in its footprint, as compared with peers such as Comcast at 36%, Time Warner Cable at 41%, and Cablevision at 54%.

This large underpenetrated market opportunity motivated Tom Rutledge to become Charter’s new CEO in December 2011. Rutledge was formerly COO of Cablevision. Under his leadership, Cablevision has consistently achieved the best operating metrics in the cable industry. Senior industry operators and experts have described Rutledge as “brilliant”, “steady”, “no mistakes”, and “extremely intuitive”. He got his start in the cable industry installing customer homes, rose through the ranks to become COO based on competence, and is considered by many operators as the best operator CEO in the industry.

To help turnaround Charter, Rutledge recruited nearly his entire team from Cablevision, including Cablevision’s COO, EVP Field Operations, EVP Customer Operations, EVP Engineering, EVP Marketing, EVP Network Operations, and EVP Customer Care. Industry operators jokingly refer to Charter as “Chartervision”. Rutledge’s new employment agreement includes about 1.3 million share awards vesting over four years. Each of his new managers also received share awards.

Rutledge oversaw a successful turnaround comparable to Charter during his time at Cablevision. Under his leadership, Cablevision acquired Bresnan Communications in December 2010. Bresnan operates in similar Tier II and rural markets that are similar in density to Charter’s markets, although Charter is nearly 18 times larger than Bresnan. After acquiring Bresnan, Rutledge outlined a turnaround strategy to improve Bresnan’s EBITDA per serviceable passing starting in June 2011. EBITDA per serviceable passing is the standard industry metric for measuring financial performance of a cable company.

Under Rutledge’s new strategy, Bresnan enhanced sales and customer service, boosted internet speeds, and upgraded its video products. The result of Rutledge’s strategy at Bresnan was that in only six quarters from June 2011 to December 2012, Bresnan increased its video, data and voice penetration by 0.2%, 5.6%, and 1.3%, respectively, and improved EBITDA per Serviceable Passing from $207 to $270.

Compellingly, Rutledge’s strategy for Charter is nearly identical to his strategy for Bresnan. Using a proven management team and strategy, Charter will grow internet subscriptions both taking market share from DSL operators and capturing incremental broadband customers. A conservative projection is that Charter achieves 39% internet penetration within its footprint by 2015. Driven by this turnaround, Charter’s EBITDA per Serviceable Passing will improve from $220 in 2012 to $300 by 2015. For comparison, Time Warner Cable showed $265, Comcast showed $300, and Cablevision showed $370 in 2012.

Charter’s new Chairman is one of the greatest capital allocators of the 20^th century.

John Malone, profiled recently in The Outsiders, is one of the greatest CEO and capital allocators of the 20^th century. Mr. Malone’s company Liberty Media Corporation acquired a 27% stake in Charter in March 2013 at a price of $95.50 per share. Liberty has the right to increase its stake in Charter to 35% ownership between now and June 2016 and 40% ownership after June 2016. At that time, Mr. Malone also became the new Chairman of the Board of Charter, and Liberty appointed three more board members. This strong team of capital allocators will be an asset for shareholders given Charter’s growth trajectory.

Most investors on VIC know of (or maybe know personally) John Malone and his penchant for stock repurchases, however, a quick quote from WEB from 1984 may be helpful in terms of how to think about a business governed by a capital allocator such as Mr. Malone:

“By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders.  Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business.  This upward revision, in turn, produces market prices more in line with intrinsic business value.  These prices are entirely rational.  Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer.”

Risks

Valuation. Charter is valued more highly than other cable companies. In fact, many cable operators are surprised by Charter’s current high EBITDA multiple, which is in excess of private transactions. For instance, Charter acquired Bresnan for a multiple of 9.6 times 2012 EBITDA and 9.3 times LTM March 2013 EBITDA. The truth is that Charter is both expensive and cheap. It’s expensive relative to its peers. However, Charter’s rapid improvement in free cash flow generation makes it cheap based on future growth. As a side benefit, Charter’s valuation provides an acquisition currency for consolidation.

Video Profitability. Another risk is that the cable industry faces shrinking video profitability as a result of aggressive price increases by content providers. The content industry is stuck in a “tragedy of the commons”; it doesn’t hurt any one content provider to raise prices, but it hurts the overall industry to continually raise prices each year. The likeliest scenario is that content prices continue to rise, creating a margin headwind for distributors such as cable.

Cord Cutting. A further risk is that OTT products will provide a viable substitute that causes true “cord-cutting”. The cable industry is only in the beginning stages of OTT, similar to the position of radio at the advent of television, or network television at the advent of cable television. It’s possible that the reason “cord-cutting” hasn’t occurred is that there hasn’t been a sensation (e.g. “I Love Lucy” in the days of radio) that has caused people to view OTT as a complete substitute rather than a complement. While this is a risk, OTT is provided using broadband internet, and the cable industry could evolve new forms of revenue capture such as usage-based pricing.

Regulation. There is also a risk that government and consumers could force regulators to act to limit prices or data caps if high speed internet really does become a “basic need”. While this is a risk, historically the fact that customers have had the option to purchase both DSL and satellite services has prevented the cable industry from being considered a monopoly. Moreover, the cable industry is extremely cautious today given its experience under the 1992 Cable Consumer Protections Act, which enforced rate freezes and price rollbacks after some industry excesses. This risk is further reduced by Congress’s inability to pass new legislation.

Wireless. Lastly, advancements in wireless broadband could substantially reduce the value of cable’s proprietary pipe into the home. Although the cable industry has the most cost effective ability to provide high speed internet and HD video to the home today, it’s wise to assume that Verizon and ATT have already been planning and building fixed wireless LTE infrastructure capable of video and high speed data. Already, Verizon has introduced a 4G/LTE fixed wireless product. This product today costs $135 for only 30gb of data per month, but prices will come down and data caps will increase in the future. In addition, ATT requested the FCC in November 2012 to allow them to run two market tests, where they plan to take down historic fixed wire networks and deploy video and high-speed internet over fixed wireless LTE technology. These substitutes pose the greatest risk to cable operators in rural markets with less network congestion, untapped wireless spectrum and cellular existing infrastructure. While investors should closely watch ATT and Verizon’s next moves, the truth is that fixed wireless broadband is still in its infancy. In addition, ATT and Verizon are highly successful without a fixed wireless product. Lastly, these activities could represent posturing to regulators in hopes of alleviating fixed line telephone regulations and associated liabilities on their extensive telephone networks rather than a major strategic push to expand fixed wireless LTE into rural areas.

Summary

• It’s not true that the entire U.S. has high-speed internet. 70% of U.S. households have broadband (>1.5 mbps) internet. This penetration level will increase, with cable benefiting more than DSL operators.
• Cable has a major competitive advantage in broadband internet. Charter can supply unlimited 100 mbps today, with a pathway to speeds well in excess of 100mbps, while DSL is limited to about 20 mbps in most cases.
• Charter has an extremely underpenetrated footprint and competes almost exclusively against regional telecom companies using DSL internet. Charter has about 32% internet penetration within its footprint, as compared to Comcast at 36%, TWC at 37%, CVC at 54%. Charter will reach 39% penetration by 2015.
• While cable video is an important product for cable, internet subscriptions are already the dominant driver of cash flow for cable. Public and media are overly pessimistic about video product. Video subs in the U.S. have actually increased over the past five years, if satellite, fiber, and cable are counted.
• Board of Directors with proven record of intelligent capital allocation. Brilliant management team (“Chartervision”) and board of directors with track record of shareholder-friendly actions (buy-backs, prudent acquisitions).
• TWC was the cheapest cable company, by far, prior to CHTR’s offer. It was so cheap that CHTR will benefit regardless of whether the deal gets done at 8 times or 9 times EBITDA. However, even without an acquisition of TWC, CHTR is a fundamentally undervalued company.

Catalyst