Charter Communications Could Pop By 100%

May 29, 2023

This article first appeared on SumZero, the world's largest research community of buyside investment professionals. In some cases Barron's edits the research for brevity; professional investors can access the full version of this thesis and tens of thousands of others at SumZero.com.

Disclaimer: The author's fund had a position in this security at the time of posting and may trade in and out of this position without informing the SumZero community.

Target price: $575

Recent price: $304.32

Timeframe: 2-5 years

Charter has capex behind them, increased penetration ahead and rapidly growing FCF per share driven by share buybacks yielding +100% in 3 years

Overview:

Charter is the second largest cable company in the United States, offering television, Internet and telephone services to 27m customers through a large cable infrastructure. Charter benefits from first-mover technological advantage and limited competition, creating pricing power and a long trajectory of growth in an Internet-hungry world. The company has an economic moat that, to compete with, requires enormous up-front investment with limited levers to persuade customers to switch other than price.

Charter is a toll-road on the internet with high-margins and free cash flow generation. The company has major capital expenditure behind them, penetration growth ahead of them and trades at an attractive valuation of 12% free cash flow yield on 2021 estimates. We believe Charter will continue their transition into the more profitable broadband segment, grow penetration and yield +100% upside in 3 years.

Segment Overview:

Charter covers 50 million households or 35% of the US population. Approximately 80% of revenue is derived from residential customers with the remainder coming from small business accounts as well as providing data solutions to large enterprise customers. While video revenue as a percentage of total revenue has been coming down over the past 3 years (pro-forma for the two large acquisitions completed in 2016), broadband has continued growing in the residential segment. Although Charter does not disclose profit on a segment basis, we believe that margins for broadband are much higher than that of video due to high programming expenses and carriage fees to content producers. The evolution of revenue is shown below:

Broadband:

Charter offers internet packages to residential and business customers through their extensive fibre-powered cable network. Broadband internet offered via cable offers superior speed and reliability than other technologies. The broadband segment of Charter makes up approximately 34% of revenues and we estimate Charter generates +50% EBITDA margins from broadband compared to the 30% for the whole business. Charter does not break down earnings by segment, however, programming expenses for video account for 40% of total operating costs. As broadband grows with increased data usage across households, we expect this high margin business to be a driver of earnings overall.

Charter now offers internet (including Wi-Fi) with speeds of 100 megabits in 99% of their footprint (up from 50% in June 2017) and gigabit services across 50% of the footprint, superior to DSL and satellite speeds. Charter plans to roll out the gigabit service to the remaining footprint over the next year. Cable as a connector to internet is dominant in the U.S. broadband market, representing 59% of all internet connections in the U.S. versus competing services (i.e. DSL, fibre, satellite & fixed wireless).

Cable connection speed continues to improve at a more rapid rate than inferior connectors. Cable's average download speeds improved 47% from 2011 to 2015. This compares to DSL that improved only 21% and fibre growing speed by only 14% over those 4 years. This superior speed is set to continue with the roll-out of DOCSIS.

Video:

Charter offers subscription-based video services, including high definition television, video recorder services and video on demand. Video on demand is a new offering that can be streamed through a computer, phone or smart TV where users can view 35,000 titles, including movies and shows, or live TV, which includes local television and sports. Services for video packages range from a basic package starting at approximately $30 per month to a premium package of $70 per month, which includes HBO, specialty sporting events, newly released movies etc. All programming is available on any device and anywhere in the home on the ‘Spectrum’ app. The company is deploying ‘cloud’ based set-top boxes that enable third-party apps - e.g. Netflix – this product is like Apple TV and will be deployed across the Charter footprint in 2018 onwards.

Video makes up 40% of total revenue for Charter as of 2018 – down 300 basis points from 2015. The decline in video can be partially attributed towards the trend of ‘cord-cutting,’ meaning that users are ending their cable video agreement and signing up solely for broadband to stream movies and shows. Customers are also changing their television packages to ‘skinny bundles,’ whereby users are trimming their channel subscriptions to only include the basics. The percentage of residential non-video customers (meaning they only subscribe to internet) has grown from 28% in 2015 to 36% at the end of 2017.

This is a good thing for Charter, users that end their video cable agreement typically use 2x more internet data due to streaming, gaming etc. A ‘cord cutter’ also means that the content cost goes to zero making the ‘cord cutter’ even more profitable than before.

Bundle:

Charter offers bundled services of video, broadband and voice (the "triple play"), which are available to substantially all of Charter's ‘passings.’ Approximately 59% of customers subscribe to a bundle of services – 25% of which subscribe to a ‘double play’ and 34% that subscribe to a ‘triple play’ package. The benefit to the customer is they are paying less per service. For example, in a triple play – the customer is paying approximately 40% ‘less’ for internet and television, however, overall the bundle is 60% more than a single play. A bundled service is also typically contracted for at least 2 years. Currently, the monthly residential revenue per customer is $110.

Other: (Voice, Advertising, Small Businesses);

The remainder of Charter is made up of telephone landlines, services sold to small businesses, which includes broadband and voice, the sale of local advertising on the cable platform and management of 16 local news channels. These segments make up 20% of revenue and are steadily growing at approximately 4% per annum.

Local Monopolies:

Cable companies negotiate directly with local municipal governments to use public rights-of-way to lay core cable infrastructure. Cable companies are then granted ‘franchise’ rights by local governments, and in return local governments receive a franchise fee. This franchise fee is capped by Federal Law at 5% of local revenue which cable companies are legally allowed to pass on to the customer. Currently, Charter ‘passes’ 50m homes and is connected to 27 million of these homes or apartments. Charter's customer relationships are not concentrated in one geography, covering 35% of the US population in 41 states across local fragmented monopolies.

Penetration:

Currently only 27 million of the 50 million homes that are ‘passed’ subscribe to either broadband, voice or video. We expect an important driver of growth to be the increased penetration of these homes as more of the homes ‘passed’ sign up for one or more services. Charter is pursuing this volume strategy, which will increase profitability per passing. Charter focuses on penetration rather than price increases by keeping product prices low and therefore incentivizing more customers to sign up. The overall number of ‘passed’ homes continues to grow 1-2% per annum organically and through acquisitions.

Theoretically, if Charter expanded penetration across their ‘potential’ footprint passings, incremental revenue could increase by 20-70%, however we do not apply value to this optionality.

Why is Charter Cheap?

There is negative sentiment across the cable industry around ‘cord cutting,’ and an underestimation of the cable business's profit drivers going forward. Charter's historical money maker was the video business, which is made up of content such as regional sports networks, local sports and licensed content. The cost to license this content has grown exponentially over the years due to growing demands from content providers to receive a bigger piece of the pie. Twenty years ago, the cost to license programming was approximately 30% of cable revenues and today these costs are 64% of cable revenues for Charter, making the video segment of Charter less and less profitable.

The growth and profitability in broadband is eclipsing the video segment. Broadband customers are more profitable, utilize more data and do not come with the cost impost of having to pay the ever-growing programming fees for content. The same drivers that are pressuring cable TV such as Netflix, Hulu, etc., are creating more demand for high-speed internet. Subscriber growth since 2005 through 2017 (excluding the major acquisitions of TWC and BH in 2016) has seen video subscribers decline by 26% and broadband subscribers increase by 186%.

Demand for high speed internet will only increase over time with expansion of the ‘internet-of-things’ i.e. wearables, Wi-Fi enabled appliances, security systems, vehicles, etc.

Cord Cutting Fears:

Cord cutting is a blessing in disguise for Charter. Charter will be able to slowly move away from the low margin business of video distribution and focus on the high margin business of broadband. Cord cutting and the unbundling of services increases the stand-alone value of the internet-only package, which is $15-20 per month more than its value within a TV bundle – and doesn't come with the content licensing cost.

When a customer cuts the ‘television’ cord, they typically use 2x more internet data due to streaming etc., making the ‘cord cutter’ even more profitable than before.

The average monthly broadband usage in households is approximately 190 gigabytes per month, according to a report from iGR Research in 2016, and 95% of this traffic is streaming video. Enhanced video quality across more screens within a household will only increase the amount of broadband that households require. Using Netflix as an example, watching an ultra-high definition (UHD) show will use 22 times more data per hour per screen to stream versus the standard definition quality.

Another positive side effect of cord cutting is as customers become more engaged by streaming services, then stickiness to their former content provider (i.e. satellite, DirecTV) dwindles. The customer will shop around for the fastest internet speed available without worrying about the content provided on that platform, making Charter's superior network the winner in this cord-cutting world.

Capital Expenditure:

Capital expenditure over the past several years has been driven by an all-digital initiative, DOCSIS 3.1 and ‘new build’ expenditure, which was a part of the SEC agreement (related to gaining approval to acquire Time Warner & Bright House) to build more broadband in rural areas. Capital expenditures for cable will begin to taper in 2019, with both capital intensity and dollars declining. Charter indicated in 2015, in an internal proxy statement which later became publicly disclosed, that capital expenditure as a percentage of revenue is targeted to be around 12% by 2019, compared to the 20% expected in 2018. Management have not confirmed the percentage, yet have guided for capex to be materially lower going forward.

The all-digital capital expenditure program for the legacy Charter initially began in 2012 and took approximately 2 years. This initiative was rebooted in 2016 after the TWC and BH acquisition to convert these networks to all-digital. To summarize, the all-digital transformation created a new product suite of video with 200 HD channels and enhanced broadband speeds to minimum offered internet speeds of 100 megabits across a majority of the footprint. At the end of 2017, 74% of Charter's total footprint is all-digital, the remainder to be ‘digitized’ are the remaining 20% of the legacy TWC and 60% of the legacy BH networks which continue to carry full analog video and will be converted through 2019. This will also allow for a larger suite of products to these customers, making them more profitable. As this capital expenditure program tapers, we expect capex as a percentage of revenue to come back to around 15%, versus the average 23% during the all-digital transformation.

Mergers & Ownership:

Time Warner & Bright House:

In May 2016 Charter completed the merger with Time Warner Cable and Bright House Communications for $80bn and $10.4b, respectively. The merger combined TWC (the second largest), Charter (the fourth largest), and Bright House (the tenth largest) cable companies in the U.S., with a combined 27m customers and 50m homes passed through in the United States.

The offer for TWC implied a trailing valuation of 9.1x EV/EBITDA, or 8.3x adj. for synergies and tax benefits and the offer for BH implied a trailing 7.6x or 6.5x including synergies and tax. As a part of the deal, Liberty Broadband, run by John Malone, invested $5.0 billion and received 20% of the New Charter.

As a part of the deal, Charter expects annual run rate cost synergies of $1 billion by 2019 for the three businesses, coming from streamlined operating practices, pricing and bundling. The combination also resulted in opex and capex synergies across purchasing, product development, engineering and IT.

As mentioned, as a part of these acquisitions Charter plans to roll out all-digital services across TWC and BH. Currently 20% of legacy TWC and 60% of legacy BH continue to operate full analog video lineups. Charter plans to fully digitize these services and deploy fully functioning 2-way digital set top boxes within the remaining footprint that have not been converted. This will increase internet speeds, opening the door for better packages and pricing across this footprint. Charter is also working to move the legacy users to the pricing and packaging of the new Spectrum, currently only 50% of the legacy footprint have converted. [See full report for chart]

Active Ownership:

Avenir is in good company in owning the stock alongside long-term oriented, activist investors. As a part of the Time Warner Cable & Bright House deal in 2016, Liberty Broadband invested $5.0bn in exchange for 20% ownership and 25% voting power in Charter. Liberty Broadband is headed by John Malone who serves as a director on the board of Charter. Malone is a heavyweight in the media space, with ownership interest and board seats at Liberty Media, Discovery Communications and Lionsgate Entertainment.

As a part of the Bright House acquisition the former owners, the Newhouse family, as of December 2017 have an 11.7% stake in Charter through partnership units and convertible shares. The Newhouse's family media empire spans the magazines of Condé Nast (owner of Vogue, Vanity Fair, Wired, House & Garden etc.) and a controlling stake in Discovery Communications. Michael Newhouse serves as a director on the Charter board.

TCI is another reputable activist investor, owning approximately 4% of shares outstanding since June 2016. And lastly, Berkshire Hathaway owns approximately 3.5% of shares outstanding since June 2014.

Competitors:

Residential video service faces competition from direct broadcast satellite (DBS) service providers, which have a national footprint and compete in all of Charter's operating areas.

Residential video service also faces competition with fibre-based networks, primarily AT&T U-Verse (27% overlap), Frontier Communications FiOS (8% overlap) and Verizon FiOS (4% overlap). AT&T also owns DIRECTV, and as a combined company provides video service (via IP or satellite) and voice service across Charter's entire footprint. AT&T delivers all three; video, voice and mobile services across 45% of Charter's passings. In 2016, AT&T offered to purchase Time Warner and this deal has just been approved.

Subscription video on demand (SVOD) such as Netflix, Hulu, Amazon Prime and virtual multichannel video programming (V-MVPD) such as YouTube TV, Sling TV, Direct TV Now are all competitors to the video offering of Charter. Charter has launched Spectrum App, which aggregates these offerings to stream through for a varying fee. As of the end of the 1st quarter in 2018 approximately 20% of Charter customers had their Netflix account integrated in their Spectrum offering.

Charter has minimal geographic footprint overlap with competing cable operators that offer video, voice and broadband at competitive speeds. Charter and Comcast represent 80% of the high-speed broadband market and the geographic overlap for Charter and Comcast is minimal.

Satellite, Telecoms & DSL, Oh My!

Charter is currently not threatened by telecommunication companies that have been investing in laying cable for broadband purposes. Currently, 80% of the bits of the major American telecommunication companies (Verizon, T-Mobile, Sprint, AT&T) wireless devices flow through Charter's Wi-Fi network. AT&T has taken initiative to build out their broadband business, yet has only grown their footprint to 3 million homes. AT&T offers approximately 5 megabits, compared to Charter providing 100 megabits to 99% of their footprint. The largest threat from the telecommunication companies will come via 5G implementation.

Satellite broadband is an internet service that is technically available anywhere in the U.S. However, it is slower, more expensive and its connection is more vulnerable to interruptions from bad weather.

Google Fiber:

Google Fiber was the largest threat to cable when Google's ambition to become a provider of high-speed internet was announced in 2010. Google, being one of the world's wealthiest companies, launched the fibre-to-the-premises service in 10 metro areas over 5 years. The company revealed that Fiber made up the "majority" of capital expenditures for ‘other bets’ segment and initially targeted 5 million subscribers within 5 years. Google struggled to meet that goal and reported in mid-2016 an estimated 453,000 broadband customers. In October 2016, all expansion plans were put on hold and over 1,500 jobs were cut in the Fiber segment. Google's failure and large cash burn validates the moat that Charter has with its existing infrastructure.

Optionality to Valuation:

We did not apply value to the below initiatives that Charter is taking within the business, however, we believe that the company could realize significant upside in these ventures and an investor is receiving this optionality for free (excluding, of course, required capex):

Wireless Network Rollout:

Charter plans to launch a wireless and mobile service in the second half of 2018. The company currently has 250m devices (i.e. iPads, iPhones, etc.) that are connected to a Charter network via Wi-Fi, and Charter wants to expand this into 4G connectivity. To build out this network, Charter has signed into an MVNO agreement with Verizon. Charter also plans to take advantage of their 700 retail stores across the US to sell the cellular phone hardware.

In April 2018, Charter and Comcast announced a 50/50 partnership to work together on building this wireless mobile network. Charter will initially fund the venture to reflect the investments that Comcast has already made into development of systems and processes – however Comcast and Charter will share costs thereafter. Under this deal, Comcast and Charter have agreed to share Wi-Fi hotspots and the agreement also prevents either company merging with an existing cellphone carrier.

Charter will structure the service like Comcast's mobile network, Xfinity Mobile. Comcast only offers mobile access to current internet subscribers and runs over Verizon's wireless network. This service includes an ‘auto-connect’ feature across Comcast's 16 million Wi-Fi hotspots and large data packages. Since launching the mobile service in mid-2017, Comcast has 557k mobile subscribers as of 31 March 2018, up 50% from December 2017.

5G Rollout:

Charter is on the front foot with formation of a fifth generation (5G) wireless network. As the 5G network will require ‘small cell’ implementation, the dense cable network is able to assist in the short-wave technology that requires closer vicinity to connect, Charter has been doing trials to test this technology.

5G may also pose a threat to cable and will be important to monitor across the telecommunication and cable companies. 5G will eventually have the capability to compete directly with wireline technologies such as DSL, cable and fibre (in some cases) which could result in more broadband options for consumers taking away Charter's ‘monopoly’ benefit in urban areas.

Risks:

We view the below points as the key threats to Charter's business:

•Acceleration of decline in video/phone

•Large capital expenditure increases due to rapid technological change

•High leverage

•5G and technology risk

Conclusion:

Charter has capital expenditure behind them, increased penetration across their ‘passed’ footprint ahead of them, and trades at an attractive valuation of 12% free cash flow yield based on our 2021 estimates. In three years’ time, assuming the company continues to trade on the current 5% free cash flow yield and management continue their buyback program, Charter would be worth $575 per share and could yield investors a +100% return.

For valuation discussion and charts, see the full report at SumZero.