Description

Charter Communications

Charter Communications has been written up three times in the past on VIC so I don’t want to reiterate details from previous posters. In this writeup, I intend to describe why I think Charter is a compelling investment at today’s prices and why I think it has the ability to compound for years to come.

Business Characteristics / Competition

Cable is the most efficient / fastest way to get a 2-way data connection to a house to consume video and internet. Specifically, with the internet, as the slide from the FCC below shows, for high speed internet (defined as above 25 Mbps by the FCC), roughly 55% of the country only has one option for a provider. As Charter tends to be in Tier 2 cities, it has an advantaged position in that, pro forma for it acquiring divested Time Warner Cable subs, it will have roughly 1% Fios overlap and no Google Fiber overlap based on Google’s currently announced plans. Fiber to the home is a competitive and superior product to cable but given the capital intensity of deploying it, it is tough to justify overbuilding especially given the population density characteristics of Charter’s footprint. When thinking about DSL competition, a U-Verse type high speed fiber to the curb deployment can get you to a 40 Mbps type connection in real world speeds assuming a VDSL deployment which in itself is expensive and tougher to justify for less densely populated areas. Charter already substantially exceeds that speed today with a minimum of 60Mbps in all of its areas by the end of 2014 and with the rollout of DOCSIS 3.1 in the next couple of years, substantially higher speeds can be achieved (1Gbps+). Just to put this in perspective, a single 1080p HD stream requires 5Mbps. According to the Netflix CEO, a 50Mbps connection is required for a 4K video to stream smoothly. As speeds get faster and faster, capacity will turn out to be the key bottleneck and cable has the fattest pipe to most of the homes in the USA.

On the video side, competition comes primarily in the form of satellite and over the top. It bears pointing out that over the top is a competitor to the video product, but increases demand for the broadband product. It also bears pointing out that the broadband product is nearly 100% incremental margin whereas the video product has inferior incremental margins given the cost of programming. On the video side, there are a couple of factors at play. Given the increased demand for random access video (watch a video anytime, anywhere, on any device), a 2 way connection is vastly superior to a 1 way connection that does not permit random access. This is the essential advantage that cable and OTT have over satellite. However, given that OTT effectively unbundles some part of the cable video package, it is a superior value proposition to the customer from a pricing perspective. Given the rising cost of sports rights and the bundled nature of video programming rights given the consolidation of media ownership, there has increasingly been cord shaving and cord cutting from US consumers as programmers continue to increase prices. It is very difficult to predict the cable video position 10 years out and it is not necessarily certain that there will be meaningful revenue streams from a cable video product. However, cable, unlike satellite, has a huge hedge with their broadband product given that increasing OTT consumption has to necessarily come through broadband for most households in the US.

Management

Tom Rutledge, one of the best operators in the cable industry, is effectively deploying a digital upgrade initiative to all assets as well as potentially all acquired assets. This consists of spending meaningful amounts of capital to get rid of all the analog channels in the pipe to free up more room for more digital channels as well as more broadband speeds. This allows cable to have a competitive set of HD channels with satellite with 200 HD channels as well as having today with DOCSIS 3.0 a minimum of 60 Mbps on the internet side. John Malone, an excellent capital allocator, plans to roll up the cable industry through Charter. CHTR is getting divested subs from the TWC / CMCSA transaction, however, in the unlikely event that the transaction doesn’t go through, CHTR plans to bid for all of TWC. Given their relative size and positioning in the cable industry, there is unlikely to be any other credible bidder for these assets giving CHTR the potential opportunity to acquire all of TWC at a good price. Beyond this transaction, assuming the TWC / CMCSA transaction goes through as currently contemplated, CHTR has the opportunity to acquire Greatland Connections, the spun off subsidiary, as well as smaller assets in the cable space. Given the size and leverage that CHTR has with its programming contracts, as well as potential synergies from geographical continuity, and the fact that if TWC / CMCSA goes through, CMCSA will be effectively barred from doing incremental acquisitions for antitrust reasons, CHTR has the ability to execute highly financially accretive acquisitions in which there will be a very limited competitive set of other bidders. John Malone completely understands this dynamic and plans to execute on this vision. In addition, this is a highly levered equity in a very attractive interest rate environment. Given the duration of debt, the fixed interest nature of most of the debt, and the utility like nature of the cable industry, this is a very low risk way to dramatically increase equity returns especially given Malone’s history and expertise with levered equities.

Price

Assuming the TWC / CMCSA transaction goes through as currently contemplated, and assuming mid to high single digit EBITDA growth driven by increased penetration and pricing on the broadband side, and a continuously levered capital structure, CHTR can potentially do $30 in FCF / share out 5 years on a fully taxed basis resulting in a 2-3x return over a 5 year period. Upside to this target would be from incremental acquisitions that tend to be highly accretive.

Risks

The biggest risk is regulatory risk. The main regulatory risk is regulation by the government on broadband pricing. I believe the risk of government intervention on pricing is low. As enumerated by Tom Wheeler, the current chairman of the FCC, the government potentially wants to retain pricing discrimination among consumers to allow low income consumers greater access to potential services. The argument is along the following lines: why should Grandma, who checks her e-mail once a week and consumes very little data, effectively subsidize the wealthy family across town that stream four 4K videos simultaneously every night from Netflix. To have equal pricing across all consumers independent of usage would seem to be a very low likelihood event from the government and unfairly discriminate against low usage / low income consumers. The recent volatility around regulation has focused on the net neutrality debate. I think the outcome of net neutrality is immaterial to the long term future prospects of the cable industry. Whether Netflix has to pay to reach consumers or can get there for free doesn’t materially make any meaningful difference to the economics of cable companies given that if there are any payments, these payments are unlikely to ever represent substantial economics to cable co’s. If it does end up representing substantial economics, that’s a source of upside that is currently not baked into cable prices. In terms of regulation under Title II, it’s unclear how this will effectively shake out at least for the next couple of years, but what is clear is that all calls for Title II regulation has explicitly called out the government not intervening in pricing (both in remarks enumerated by FCC Chairman Tom Wheeler as well as President Obama) which seems consistent with the argument that the government does not want to unfairly discriminate against low income consumers.

Catalyst

Higher FCF / share.

Acquisitions.