Description

I believe Charter Communications (CHTR), through its purchase of Time Warner Cable (TWC) and Bright House Networks (BHN), is one of the most compelling investment opportunities in public markets today, and I believe the most interesting (interesting = complex), lowest risk, and cheapest way to invest in Charter is by buying shares of Liberty Ventures (LVNTA).

Liberty Ventures was written up in 2012 by mjw248, and there is a lively discussion in that write-up around the complexities of the assets and structure which you can reference for background.  There have been some major structural changes since the prior write-up so I’ve updated the NAV analysis in this write-up.  If you’re already familiar with the Charter and Ventures stories, feel free to skip to the punch line at the end.

The basics:

• Charter Communications is a predictable, cash flow generative, compounding machine undergoing significant structural changes which are accretive

• Charter is trading for ~12x FCF, and FCF / share should compound >20%

• Liberty Ventures is the cheapest way to create Charter (high 30s% discount to market)

• Liberty Ventures has NO DEAL RISK

• Liberty Ventures has attractive other assets and several free options

For those new to the story, I’ll try to lay out it in its most basic form below.  Please reach out with any questions and or requests for more detailed information.  I’ll be happy to provide anything and everything I have.

Charter

I like to invest in companies that are easy to understand, have recurring / predictable business models, and management teams that both efficiently operate the business AND responsibly invest excess capital.  I like investing alongside smart people.  I’d prefer to buy these businesses at low double digit multiples of FCF, and if possible buy them with some sort of significant catalyst in the not too distant future.

Charter has ALL of those characteristics.

Charter, pro forma for the purchase of TWC and BHN, will be the second largest cable operator in the US with nearly 24m customer relationships and 48m homes passed.  

Cable business models are pretty simple; you have a two-way pipe going into a home which can deliver video and internet content. For this service, Charter charges customers a monthly fee.  They are considered “subscription” businesses because in many cases customers sign an annual agreement for service, and even in cases where there is no agreement, customers tend to be sticky.  Because Charter is half penetrated today, there is opportunity for further expansion within its existing footprint.

Charter is run by Tom Rutledge who is well known and respected in the industry.  He has done a tremendous job improving the assets and financial trajectory of Charter since taking the CEO role in early 2012.  For more on that story, which is a good one, refer to the CHTR write-up on VIC by JRSteelers from Jan 2014.

John Malone, who many consider to be the best cable investor of all time, is on the Board of Charter, and owns a significant stake in the company through Liberty Broadband (26% of the current equity, dropping to 19% pro forma for the mergers).

After a lot of drama with Comcast and the FCC, Charter / TWC / BHN agreed to combine in a two-step transaction where Charter would essentially merge with Bright House, then the new entity will acquire TWC for a roughly 50/50 mix of cash and stock.

You can learn more about the deal by downloading the presentation and listening to the webcast from the deal announcement here: http://ir.charter.com/phoenix.zhtml?c=112298&p=irol-calendarPast

The combination is transformational to say the least.  Charter is essentially David buying Goliath, transforming from a ~6m customer relationship business to a ~24m relationship business overnight.  Besides transforming Charter, this deal transforms the US Cable industry from a “snow white and the seven dwarves” setup, to use Malone’s words, into two large players (Comcast and Charter).  There are benefits to scale, and free optionality in the new industry structure which I’ll go into more later.

As mentioned above, my primary reason for writing up Ventures is because I believe it is the cheapest way to invest in Charter (with zero deal risk), and here’s why I think Charter is so compelling:

1. John Malone, a billionaire and cable pioneer, is investing $3.1bn of cash into the Charter / TWC / BHN merger at $173 to $177 / share through two of his companies, Liberty Broadband and Liberty Ventures

2. The Newhouse Family, also billionaires and early cable investors, are investing over $8bn in Charter at $173 and $242 / share through common and convertible preferred stock by taking equity for their privately owned BHN assets

3. Four well known and respected hedge funds are investing $2bn into Liberty Broadband at $56.23 / share, implying $177 / share for Charter, to help fund this transaction

4. Based on management’s public projections from the deal proxy (filed 6/26/15), I believe Charter will generate $15 / share in FCF next year, growing to ~$40 / share over the next 4 years

At $186 / share, Charter is trading for just over 12x FCF per share, assuming that multiple stays flat, Charter shares should look like something like this:

A more detailed look at my numbers is at the end of the report, but my basic assumptions are:

• the combination closes year end 2015 / early 2016

• management’s projected EBITDA and Capex for the combined company are correct (proxy dated 6/26/15, page 211)

• $62.2bn of total debt post close at ~5.25% (4.5x levered pro forma)

• Maintained 4.25x leverage going forward (Charter fixed income presentation dated 7/6/15, slide 21)

• $9.8bn of annual depreciation from the asset step up (proxy dated 6/26/15)

• Company begins paying cash taxes in 2019, full cash tax payer in 2020 (Charter fixed income presentation dated 7/6/15, slide 27)

• Assumes all excess free cash flow used to repurchase CHTR stock, price of stock repurchased assumed to compound at 20%+ annually

There are several risks to the Charter thesis:

1. The deal doesn’t get regulatory approval; in which case CHTR must pay TWC shareholders $2bn pretax in a break fee (that is about $18 / share)

2. Charter needs $23.6bn of new financing to close the merger and to date has only raised $15.5bn; if spreads widen materially or capital markets close altogether, the interest rates on new financing could be higher, or the debt may not be available at all

3. Management’s estimates in the proxy assume they are able to operate the TWC assets as efficiently as they have CHTR assets; if they are wrong, there is downside risks to the estimates

4. Competition in cable / cable over builders; AT&T is promising to improve internet speeds to 11m homes in the US as part of their DTV purchase, this will increase competition for the cable incumbents; and Google has been overbuilding with its Google Fiber product, if that increases, it could pressure cable economics

5. So called “Over The Top” or “Breaking the Bundle” is a risk to the video business cable has today, any acceleration would be detrimental to the above estimates

Some of these risks can be quantified.  The easiest is the deal break fee, which is an $18 / share haircut (though we would get 39% of that back over time through tax savings).  Higher interest rates are relatively easy as well - $62.2bn of debt with 10bps of incremental interest is $62.2m / year pretax, or about 19c / share on the pro forma share count.

I believe the impact from OTT / skinny bundles can be ring-fenced as well.  Charter earns ~32c on every video dollar of revenue (TWC earns 40c), but ~100c on an incremental dollar of high-speed internet.  We know that when a customer goes internet-only, the price of internet increases materially, which I’m assuming is 100% margin:

If 10% of Charter’s video customers went OTT tomorrow, the impact would be material, but it wouldn’t completely crush the thesis.

Some have expressed regulatory concerns and questioned whether the deal will be approved.  I believe (obviously) that it will, and have several good data points if anyone is interested, just let me know in the Q&A and we can talk it through.  However, if you’re looking to get up to speed quickly, I wouldn’t focus too much on it given LVNTA is not taking any risk if the deal breaks.  

There are some free options to the Charter thesis:

1. Scale should allow CHTR / CMCSA to develop better “random access” video options, which could accelerate video share gains from satellite operators and improve the overall growth profile

2. Liberty Global is offering “quad play” in the UK, whereby they offer mobile service through an MVNO (mobile virtual network operator) agreement, meaning they lease tower space from a current mobile incumbent; which not only provides more EBITDA per sub, but also reduces churn by 50% according to management; this could be done in the US, which would benefit all remaining cable operators here

3. Scale could allow for improved Commercial subscriber growth, given many of the Commercial customers are looking for providers with national scale

4. Management figures out more accretive ways to invest free cash flow other than repurchasing shares

To learn more about those free options, the regulatory outlook for the deal, and the state of the cable industry generally, I would HIGHLY encourage you to check out the webcast of Liberty Broadband’s annual meeting from early June, which you can find here: http://ir.libertyinteractive.com/events.cfm

Liberty Ventures

Liberty Ventures is an amalgamation of “dogs and cats” that Liberty Media and Interactive have collected over the years – in a very real sense, Ventures has been the catch-all as Liberty has looked to clean up its corporate structure.

LVNTA is a tracking stock, created originally to separate non-controlled investments and deferred tax assets from owned / controlled primarily retail businesses (the biggest of which was QVC).  There have been several significant events since the 2012 spin of LVNTA, the three largest were the spin of Trip Advisor into LTRPA, the so-called re-attribution where Ventures took cash and investments from QVC in exchange for stock, and now the investment in LBRDK.

In May, Liberty Ventures agreed to invest $2.4bn of cash into Liberty Broadband (LBRDK) at NAV ($56.23 / share), which Liberty Broadband will use to purchase shares in Charter at $177 / share to help fund the CHTR / TWC / BHN transaction.

A few important things to know about the transaction before going into Ventures:

1. The investment is contingent on the  CHTR / TWC / BHN deal closing, so there is NO DEAL RISK

2. The investment will be made at NAV ($56.23 / share) assuming a CHTR price of $177

1. Today LBRDK is trading for $54.15, so the deal is dilutive to LVNTA (by ~60c) initially

2. CHTR is now $186 / share, so the NAV of LBRDK is over $59 today

3. John Malone expects the transaction to generate returns for LVNTA “in the high teens, low 20’s”

1. Quoted from the 2014 Liberty Interactive Annual Meeting, broadcast replay available here: http://ir.libertyinteractive.com/events.cfm

4. Greg Maffei says there is “a path to monetize” the investment for Ventures holders

1. Again, quoted from the 2014 Liberty Interactive Annual Meeting

The pieces of Liberty Ventures:

• Cash

• Basket of Public Securities (EXPE and LBRDK are the biggest)

• Some Exchangeable Debt

• Three Internet Based operating companies

• A cash tax liability of $250m due ratably through 2018

• Some high IRR “green” investments

• A large and complicated deferred tax assets

Liberty Ventures NAV:

Owned Shares in the Basket (in millions):

Full disclosure – I’ve shorted out 100% of EXPE in Ventures to isolate the LBRDK, Cash, DTA and operating assets.  This isn’t a call on EXPE either way, but it’s a high multiple stock with its own deal risk (OWW), so to me it’s easier to just cancel it out.

Ventures shares are currently trading for $40, or a ~20% discount to fair value.  Applying the full $10 / share discount to LBRDK implies you’re creating the stock for ~$20 / share, versus the current price of LBRDK at $54, and the price where Malone and four hedge funds purchased it at $56.23.

Said another way, through Ventures, you are able to create CHTR for $64 / share, or just 4.5x 2016 FCF per share.

Of course the downside to this is that it is a diluted way to invest in Charter, and you have to short EXPE to really isolate Liberty Broadband.  The upside, however, is that you are able to invest in the deal ‘risk-free’, and in fact could actually make money if the deal breaks.  Notice the difference in NAV between Today and Pro Forma – the investment in LBRDK is 60c dilutive to NAV, if the deal breaks, NAV goes higher and theoretically, so does the stock.  It’s also worth noting that Liberty Ventures shares are down ~$4.50 / share since the announcement of the transaction despite this only being 60c dilutive.

Operating Companies

There are three operating companies within Ventures – below is the consolidated EBITDA and EBITDA growth for all three:

While not broken out, I believe BackCountry EBITDA is about $25m, BodyBuilding.com is about $35m and CommerceHub is about $40m (all trailing).  BackCountry was sold a few weeks ago – and while the price isn’t disclosed, I believe the amount was around $250m (10-12x EBITDA).  Of the two that are left, Bodybuilding and Commerce Hub, I value BB.com at 14x (it is growing 20-30% annually) and CH at 20x (this is a phenomenal business, with its nearest competitor, SPSC trading for 40x forward EBITDA).

As a measuring stick, management ‘re-attributed’ these assets at ~$1.0bn last fall.  Since then, EBITDA has grown 27% (from 2Q’14 to 1Q’15, trailing).  I value all three at $1.56bn, or 16x trailing EBITDA (~13x forward).

Valuation

Assuming the deal goes through, I believe Ventures shares are worth $55 / share, or +38% over the next year.  

From there, I believe the shares of CHTR compound 20%+ annually, which adds $4 / share to Ventures each year (+10%), and the digital businesses (ex BackCountry, which was just sold) compound 20%+ as well adding another $2 / share to Ventures (+5%).  The way the DTA works, roughly $1 / share in value is realized annually in cash to the NAV (+2.5%).  In total, I’d expect Ventures to compound 15-20% annually through growth in Charter, the digital businesses, and the DTA.

That of course assumes EXPE shares stay flat.  If you short out EXPE, the returns on your stub investment should be more like 30% annually.

I assume no discount to NAV and assume no taxes for any of the owned securities.  The reason for the lack of a discount is simple; Malone will ultimately put the underlying securities (CHTR, EXPE, and Op Cos) in the hands of Ventures holders.  This has been done numerous times before (TRIP, DTV, DISCA), all in a tax efficient way (which is why I assume no taxes).

Catalyst

The first catalyst is the closing of the CHTR / TWC / BHN transaction, which is expected by the end of the year, though Malone has said publicly he thinks the transaction will close sooner than most people think.

The second catalyst is the monetization of Ventures investment in LBRDK, which I believe will take at least 12 months, and come in the form of a spin or split transaction that will put the physical LBRDK securities in LVNTA holders.

The third catalyst is LBRDK merging into CHTR, which will likely be done at NAV and a year or so from the closing of the CHTR / TWC / BHN.  This will put CHTR shares directly in the hands of the LBRDK holders.

I expect to get structure and timing clarity on the second and third steps mentioned above at the Liberty Analyst meeting in November.

Eventually, as discussed in the prior LVNTA write-up, EXPE will be monetized.  There are several ways that could happen – and while timing is uncertain, it could happen at any time (just need Diller and Malone to agree on structure and valuation, which is made more difficult by Diller’s proxy of the shares and the fact that LVNTA owns “B” shares of EXPE, which presumably have more value given the super vote).

Also expect more monetizations like the BackCountry announcement made last week.  Eventually, I would expect Commerce Hub to be the only business left in the complex and be spun into a separate public company.  

Summary

Charter is a great investment opportunity today, offering 20%+ compound returns over the next four to five years.

Liberty Ventures is a “no deal risk” and cheap way to create Charter, and has other valuable assets and optionality.

If the deal closes, Liberty Ventures shares are ultimately worth $55, or +30%, compounding mid to high teens thereafter.

If the deal does not close, I believe Liberty Ventures shares actually trade up and ultimately are worth $50, or +25% from current levels.

Charter Estimates

Again, please hit me up with any questions / clarifications – will try to get back to you as soon as I can.

Clark

Catalyst

The first catalyst is the closing of the CHTR / TWC / BHN transaction, which is expected by the end of the year, though Malone has said publicly he thinks the transaction will close sooner than most people think.

The second catalyst is the monetization of Ventures investment in LBRDK, which I believe will take at least 12 months, and come in the form of a spin or split transaction that will put the physical LBRDK securities in LVNTA holders.

The third catalyst is LBRDK merging into CHTR, which will likely be done at NAV and a year or so from the closing of the CHTR / TWC / BHN.  This will put CHTR shares directly in the hands of the LBRDK holders.

I expect to get structure and timing clarity on the second and third steps mentioned above at the Liberty Analyst meeting in November.

Eventually, as discussed in the prior LVNTA write-up, EXPE will be monetized.  There are several ways that could happen – and while timing is uncertain, it could happen at any time (just need Diller and Malone to agree on structure and valuation, which is made more difficult by Diller’s proxy of the shares and the fact that LVNTA owns “B” shares of EXPE, which presumably have more value given the super vote).

Also expect more monetizations like the BackCountry announcement made last week.  Eventually, I would expect Commerce Hub to be the only business left in the complex and be spun into a separate public company.