The Case for Charter (2019)

What follows is a writeup I sent to clients in April 2019 that details the investment case for Charter Communications. I thought it would be a good exercise to revisit the thesis 3 years later and see what’s changed for better or worse – that post will be forthcoming in the next few weeks. Commentary on specific prices and valuation targets is password-protected and for clients only. For access email rahul@micawber.us.

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Cowboy Up!

In 2010, after hearing a compelling investment pitch, I purchased shares in Liberty Interactive, a John Malone-controlled entity. I had heard Malone’s name before and had invested in some of his companies in the past, most notably DirecTV and Starz. When it was pointed out to me that his shareholder return record rivals Warren Buffett’s, I decided to learn more about him. I purchased Cable Cowboy which chronicled Malone’s genius in essentially pioneering the cable industry in the 1970s and then consolidating it before a sale at the top of the market to AT&T for $50B in 1999. In the years since, he had been making very successful investments in media and internet companies. While I was 40 years late to the party, it was clear to me that the party was still going. So, every time Malone did an interview or Liberty did a deal, I paid close attention and found some great investments to invest in alongside them.

Fast forward three years later, Liberty Media announces that 14 years after their sale of TCI they are re-entering the U.S. cable industry by purchasing a 27% equity stake in Charter Communications from private equity owners that had owned Charter’s debt during bankruptcy. Why? Malone gave a few interviews after the deal was announced where he discussed not only what he viewed as strong internal growth opportunities but also the potential for horizontal acquisitions. Charter was going to be his vehicle to consolidate the US cable industry.

Hierarchy of Needs

When the average person thinks of their cable company, they are thinking of the company that gives them their video package of sports, news, and the Kardashians. However, it should be noted that the gross margins of the pay TV business are fairly low because most of the dollars you pay to your provider are actually being forwarded on to the content producers like ESPN, AMC, Discovery etc. (As an aside: most of the hatred for cable companies is misplaced and should be directed towards the content guys. Your bill goes up every year because ESPN wants an extra $1.50/month for their shows not because you are getting price gouged.) Pay TV also requires a lot of high-touch interactions with expensive service people and truck rolls (try taking an afternoon off to get your set-top box installed!). On the other hand, the internet you pay for is almost pure profit. It runs over the same cables, has much lower setup cost, has fewer requests for service, and has no third party that needs to be paid.

So, to me, Charter being called a cable company is a misnomer. It is an internet access company that offers additional services like television, telephone, and cell phone as a convenience if customers want them. And, internet will be one of the very last expenditures that a household will cut back on in times of stress. Much like your local electricity, sewer, and water company, internet access has become a basic utility. Similarly, because it doesn’t make economic sense for multiple companies to create the infrastructure (two sets of sewer/power lines in every city?), each town serviced by a cable company generally gives out exclusive rights to provide their services, also known as a franchise. Yet, despite being selected to offer this fundamental service to ~50 million homes, Charter is not currently regulated in the same manner as a traditional public utility. It is a lightly regulated monopoly business.

Furthermore, cable internet is competitively advantaged versus their traditional competition of DSL, wireless, and even fiber. It is the lowest cost to deploy while also being capable of higher speeds with lower interference and latency. At 3Mbps it was a tossup between DSL and cable; at 300Mbps it’s a no- brainer. And while fiber is unequivocally the fastest internet available, the cost of building out the infrastructure makes it uneconomic to compete with cable lines that were laid decades ago. These same lines can also be upgraded to speeds of up to 10Gbps for minimal incremental dollar amounts. So, Charter is the lowest cost seller of the best product.

Next, there are significant benefits to scale in the cable industry – a playbook that John Malone knows very well. Charter purchased Time Warner Cable and Bright House Networks in 2016 and thus become the 2nd largest internet company after Comcast. At the time of the merger, they noted large synergies in sales, marketing, service, call centers, procurement, and more. This makes intuitive sense – same product sold over a larger connected footprint. They also were able to drive a harder bargain with content companies during renewal negotiations.

This leads to the concept of utilization. If you own a hotel, you want to maximize utilization because the majority of your costs are fixed. You already paid for the building, the furniture, the utilities, housekeeping, concierge, etc. You want as many rooms as possible filled at the maximum price possible on as many days as possible. Charter’s network is effectively our hotel and each home on the network is a room with each occupied room (a subscriber) paying a rate based on the number of services they use. As of year end, Charter had 50.6 million homes on their network and 49.9% of them subscribed to internet services. Last year’s penetration rate was 48.2%. This is a hotel that is half empty but filling rooms quickly thus spreading fixed costs over a larger base i.e. high incremental margins.

Finally, the subscription-like nature of the revenues that Charter earns allow it to use a large amount of leverage against those cash flows. A helpful way to think about this is to note that lower volatility assets can stand high amounts of leverage e.g. most people are willing to borrow 80% or more when they buy a home but not when they buy stocks. These highly stable cash flows increase the returns to equity holders like us. Overall, this is a good industry with a lot of tailwinds.

The Best Boss

When Charter emerged from bankruptcy in 2012, the company tapped Tom Rutledge to be the CEO. Tom has over 40 years of experience and was formerly the COO of Cablevision from 2004-2011. He’s generally regarded as the best operator in the cable business. He has spent the last three years upgrading his network and streamlining the business at the expense of short-term free cash flow. He has been very vocal that 2019 onwards will be the time to reap what they’ve sown. Moreover, when the board constructed a pay package for him and his team in 2016, it was set up so that it didn’t fully pay out until the price of Charter stock reached $564.04 (the current price is ~$360). If this all goes according to plan, Rutledge will walk away with well over half a billion dollars! I like those incentives. Meanwhile, John Malone and his right-hand man Greg Maffei are both on the board overseeing capital allocation decisions. That gives me a lot of comfort. The company has had a voracious appetite for its own shares and if you recall our last discussion about AutoNation, we know what kind of positive effect that can have on stock price over time.

Our Hypothesis

An investment in Charter is a fairly simple idea; a lightly-regulated monopoly business will grow free cash flow at high teens rates through operational improvements and capital allocation. Specifically, here are the main performance indicators we are looking at:

1. Penetration rate of internet subscribers continues to go up. Below is data taken from Charter’s filings. It speaks to the success that cable has had against its competitors. We also believe that the penetration rate can continue to rise for the foreseeable future. Altice, formerly known as Cablevision/Suddenlink, has over 60% penetration in some of its tri-state regions.
   

	2010	2011	2012	2013	2014	2015	2016	2017	2018
Homes Passed	11,800,000	12,000,000	12,100,000	12,800,000	12,900,000	12,800,000	48,955,000	49,820,000	50,652,000
Internet Subscribers	3,384,600	3,654,600	3,978,000	4,640,000	5,072,000	5,572,000	22,593,000	23,903,000	25,259,000
Internet Penetration Rate	28.7%	30.5%	32.9%	36.3%	39.3%	43.5%	46.2%	48.0%	49.9%

2. Average revenue per user (ARPU) goes up. Not only do I think that they will continue to add subscribers, I think they will be able to raise prices on them at rates greater than the market. For instance, Comcast had ARPU of $153.95/month and Altice had ARPU of $142.44/month in 2018. Meanwhile, Charter’s ARPU is sitting at $111.56/month. The comparisons aren’t exact but they are directionally valid. Rutledge is suppressing prices in order to gain customers now and has the lever to pull later.
3. Operational costs go down. Charter has spent the last 3 years squeezing costs out of the business during their integration with Time Warner and Bright House. This process is nearing an end and they are set to reap the benefits.
4. Margins go up to levels at least as high as peers. This is just math. Revenues up and costs down equals higher margins. I’d note that Comcast has EBITDA margins that are 3-400bps higher than Charter; Altice is over 700bps higher. There’s no reason this gap can’t be closed. Additionally, margins for the industry as a whole can continue higher – the incremental margins are very high.
5. Capital expenditures goes down. After spending a high teens percentage of revenue on capital expenditure for the last few years upgrading their network infrastructure, Charter gave a forecast for capital expenditures around $7 billion this year (15% of revenues) – down significantly. The expectation is that 2020 will be an even lower percentage of revenue.
6. Share count goes down. Charter has spent $17.2 billion dollars buying back shares in the last two years (almost 20% of the shares outstanding). I expect the pace to pick up!
7. Free cash flow per share goes up a lot. Based on points 1-6 above, you don’t need to make very heroic assumptions to get to north of $40 per share of free cash flow and continuing to grow over time.

Very Fine People on Both Sides

People that are bearish on Charter and cable in general usually point to the same few risks. Let’s discuss them one by one.

1. Alternatives to fixed internet like 5G wireless or satellite constellations. This debate comes down to two things: physics and economics. A physical cable from point A to B will deliver better speeds, lower latency, lower interference, and greater coverage than a network of 5G towers or satellites. And, besides all that, there’s the issue of cost to deploy AND time to deploy. These services are at least 3 to 5 years away if at all. Verizon has already dialed back their claims about the availability and cost of their 5G fixed wireless service. SpaceX’s Starlink constellation of satellites that is supposed to bring broadband internet to the world is having its economic viability questioned There will be a constant drumbeat of 5G promotion but it can be safely ignored.
2. Cord-cutting, cord-shaving, and cord-nevers. A common refrain of bears is that the decline in video subscribers will put tremendous pressure on the business. While it is true that video product sales still account for the largest segment of revenue, it is a low margin business as mentioned above. Moreover, the primary losers thus far have been satellite (DirecTV/Dish) because of their inability to provide a bundled product like triple play. Likewise, customers who switched from paying Charter to paying YouTubeTV, DirecTV Now, and Sling for skinnier bundles are finding that they’ve been bait and switched. Cable once again looks like the best option if you want pay TV. Of course, there will be some homes that just want Netflix… and maybe HBO… and ESPN… and to watch the Superbowl… and This is Us… wait, why do I have all these subscriptions? And why am I once again paying over $100? Maybe I should just get a cable bundle. Anyway, I think pay TV is stickier than the market does.
3. Regulation. A-ha! Here, we have a true risk. In 2015, Tom Wheeler and the FCC attempted to regulate internet providers until Title II of the Communications Act of 1934. You may recognize this as part of the very public net-neutrality debate. The internet companies argued that they never broke any of the rules that were being put in place and, in effect, were being pre-emptively regulated by a power hungry government agency. When the presidential administration changed, Ajit Pai, the new head of the FCC, effectively repealed and killed net neutrality in 2017. We will be keeping an eye on 2020 to see if industry regulation will once again become a risk.