Some New Ideas

This caught my attention:

http://www.zayo.com/investors/owners-manual-for-zayo-investors

Any publicly-listed CEO that mentions Buffett as a role model typically catches my eye. The stock doesn’t look cheap at the moment but I haven’t dug deep into this one yet.

This is definitely an industry I want to study more in-depth in the near future. Bandwidth demand will only grow exponentially over the next decade – both on the enterprise and consumer side. The continued proliferation of data-intensive devices, both outside and inside the home, is just one driver of this trend.

There are many ways that you can play this big data trend – directly or indirectly. I like the cable firms, and in particular, Charter. Charter may look expensive on an EBITDA basis (currently trades at a 2015E 9.59x EBITDA multiple as per my Capital IQ), but you have to take into account that the majority of their growth CapEx cycle has recently been completed, at least on the residential side. Charter recently finished a multi-year CapEx program of transitioning their footprint from analog to all-digital, so their CapEx was very elevated. That was a major sunk cost. Going forward, I expect their total CapEx will continue to shrink, until their capital intensity is ~13-15% of total revenues, which I still think is conservative on a maintenance CapEx basis; 1) They’re going to continue to grow their higher-value subscriber base which will further spread their fixed costs, 2) the cost of set-top boxes will come down dramatically, 3) upgrading their broadband speeds to maintain their competitive advantage on the high speed residential data side will only require changing a few electronic pieces in the plant. They are, however, pretty aggressive in capitalizing their subscriber acquisition costs; they include the cost of labor in this figure. I don’t think this is too big of a deal, since I think their churn will continue to improve as subscribers now have a much better video product, and are offered a very competitive triple-play bundle. Its been shown in the past that every incremental service added to the bundle improves customer lifetime.

Now if we look at their free cash flow generation, everything else is moving in the right direction. Currently they hold a lot of high-yield debt that was raised coming out of the bankruptcy period, so even if we assume rates will go up, I think their long-term cost of debt will only go up modestly or even remain flat as they grow their subscriber base (taking back share from DBS and increased subscriber penetration). I believe their average pre-tax cost of debt is around 6% right now (could be wrong, too lazy to check), and they’ve been raising long-term at more attractive prices. With the large NOL, they’re probably not going to pay any cash taxes until 2018/19, and there’s real potential to further increase their tax basis via more M&A. CableOne which will be spun-off from Graham Holdings, Brighthouse Networks are potentially targets. Of course there’s also Greatland Connections longer-term which Charter will have a 33% stake post the Comcast/TWC merger. If you want to be fancy you can do a pair trade and short Cablevision – I think Malone is too smart to buy them out at this price, but I could be wrong. The cable networks remain stuck in a tragedy of the commons, and continue to leverage their hoarded content rights to raise programming costs aggressively, so I don’t think these sub-scale cable firms will remain independent for much longer as their video margins continue to get squeezed. Charter is the only viable consolidator, as Comcast/TWC will have close to ~30% of the total US pay-TV market, a cap set by the FCC a long time ago. I’m not even sure they’re going to be able to push their deal through without more concessions. But you never know, I’m sure they have an ARMY of lobbyists in Washington, fighting against title II and for pushing the deal through. If Charter isn’t going to do more M&A, then they’re probably going to buy back a shit ton of stock. Malone and Maffei are directors and hold a large stake via liberty broadband, so it’s almost guaranteed that they’re going to shrink the equity. I rather have a leveraged equity shrink capital return strategy than a dividend. As for Rutledge, he’s by far considered the best operator in the industry, and has track record of improving subscriber level economics.

So it’s not hard to see that their free cash flow per share is going to explode to the upside and I think they’re going to create a ton of value over the long-term, regardless of whether title II caps their broadband pricing. The great thing is that valuing Charter is not simple because of all the moving parts and pending transaction – a typical “Malone thing”. This is why I think the shares remain undervalued today. Institutional managers can keep buying TWC since it pays a dividend, and ignore Charter. I will keep buying Charter and Liberty Broadband shares.

Here’s an excerpt from my letter to investors:

“Prior to Mr. Rutledge coming on board in late 2011, Charter was a mis-managed, over-leveraged and under-invested asset. Due to these factors, Charter was a victim of substantial subscriber share losses mainly to direct broadcast satellite (DBS) players with superior video offerings[1]. We believe that this competitive trend will continue to reverse – as it already has for the past several quarters – with Charter taking back the vast majority of incremental subscribers from DBS and local DSL operators. Our view is that Charter is still in the early to middle-innings of a complete turnaround into a premiere cable asset with a superior upgraded video and broadband product relative to competitors. Despite the market’s concern of credible industry-wide headwinds such as absolute declining video subscriber numbers and programming cost inflation, we believe these negatives will have a light impact on Charter’s ability to generate substantial FCF over the coming years. Contrary to common belief, the US broadband industry remains a secular growth story as ~30% of US households still don’t have a broadband connection. Charter’s current broadband footprint remains under-penetrated at ~40%, and we believe this figure could approach closer to 50% over the next 5 years. As opposed to Charter’s video business which has been experiencing declining gross margins due to programming cost inflation, the broadband business’ economics are much more attractive; gross margins are typically greater than 90% and the cost to transmit bandwidth in cable pipes is literally pennies on a per gigabits basis.

Charter’s competitive position in the US telecommunications industry is a very attractive one as it owns a de facto local monopoly on residential high-speed data services in the majority of its footprint. The major Telco competitors have limited fiber overbuilds in Charter’s rural and Tier II city-focused footprint; AT&T’s U-verse and Verizon’s FiOS are currently present in ~34% and ~3% of Charter’s footprint, respectively. Post TWC-Comcast transactions, these figures will come down to ~30% and ~1%. Aside from Verizon’s superior fiber-to-the-home FiOS product[2], no other service in the market today, including U-Verse, can match Charter’s broadband product. In order to match cable’s hybrid fiber coaxial (HFC) network’s ability to provide broadband speeds of up to 100 mbps or greater, the Telcos will have to overbuild their entire copper-based network, replacing it with fiber optic cable. This is an extremely capital-intensive and time-consuming process, and the returns don’t look enticing to say the least. To illustrate, if we take into account the typical gross margin for an average triple-play[3] AT&T U-verse or Verizon FiOS subscriber, which we believe should be around $60-$100 on a monthly basis[4], the payback period can easily stretch to 6 years.[5] Based on these challenging economics, the Telcos have only focused on overbuilding in the most affluent, densely populated US cities in order to generate a satisfactory rate of return; these urban areas are a very minimal slice of Charter’s total footprint.

In addition, cable’s HFC network provides the most cost-effective infrastructure to provide higher broadband speeds. With DOCSIS 3.1 technology, Charter can easily provide data speeds of up to 1 gbps or more with very little incremental capital.[6] With the continued massive proliferation of data-intensive devices such as smartphones, technology wearables, and tablets, speed requirements will only grow exponentially. Charter and the cable industry are best positioned to cost-effectively fuel the insatiable demand growth for high-speed data services over the next coming decades. The bottom line is that Charter owns a captive growth market, with de minimis future competition.”

[1] Satellite Pay-TV packages typically include over 200 HD channels, exclusive programming, Video on Demand (VOD), “TV Everywhere”

[2] Charter’s Optimum broadband product can match FiOS in terms of download speeds, but not on the upload side

[3] Triple-play is a bundled broadband, video, and telephone package

[4] This is not taking into account the typical 2-year heavily discounted pricing promotional period

[5] We assume the total subscriber acquisition cost (SAC), including line installations and infrastructure investments for a new customer is on average $3,500; this is also taking into account that this is on an undiscounted basis

[6] In the upgrade process, several electronics are replaced in the Cable plants which is relatively light capital spending

Liberty Global: Think the C shares are worth somewhere between $60-70 in a year or so, assuming they trade at a leveraged FCF yield a few hundred basis points premium above their long-term pre-tax cost of debt, which I think is reasonable for the equity of a high-quality, growing cable business. I want to start accumulating this one aggressively if it goes to the low 40’s. They just closed the Ziggo transaction, and I think like the Virgin Media (which I think they stole) deal, the synergies are going to surpass their initial estimates. An interesting thing about Ziggo’s accounting is that they actually expense their set-top boxes so their EBITDA is understated relative to comps. That’s very conservative in cable land since these boxes can make up around 50% of a cable firm’s total CapEx in a modest growth year. I’m sure Malone noticed that and paid the right price for this asset. The Netherlands was one of the markets that was having trouble over the past year or so for Global, because of KPN’s aggressive pricing and FTTH roll-out. Now with Ziggo merged with UPC Netherlands, they’re going to cover most of the country’s footprint, not to mention benefiting from the enormous cost synergies. The Netherlands is one of the densest population zones in Europe I believe, along with Belgium. To be quite frank I can’t believe the local regulators allowed them to even do this transaction. Perhaps they think KPN’s FTTH roll-out will provide adequate competition. What’s most important is that in all of Global’s major European markets, the incumbant Telcos will most likely price rationally longer-term in order to generate a satisfactory rate of return. A duopoly or 3 player market that continues to raise prices on consumers, now that’s an attractive industry I want to be in. The next leg in this story is continued share shrink. Management said that they will return ~$3.5 billion via share repurchases until 2015YE which is around 10% of the market cap today. If you factor in operating cash flow growth of mid to high single digits, they should be able to achieve leveraged free cash flow per share growth close to 20% if not higher for the next several years. They remain way ahead in the technology product curve in Europe relative to the US, and have the luxury of bundling mobile, improving subscriber lifetime values, and a large B2B market opportunity. They also don’t have to deal with programming cost inflation in the high-single digits, as the media ownership remains quite fragmented in Europe and they don’t have to pay enormous re-transmission fees to the local broadcasters. Also Netflix is a catalyst for broadband growth as they continue to expand in this continent.

Again, this is an extremely complicated entity, even more complicated than Charter, so that’s why shares are undervalued. I think I probably spent months studying the industry last year, but it was a very interesting project and well worth it.

Fox, BSkyB, DISH, DTV, Time Warner and Discovery: Looks like Murdoch is showing signs of becoming a more disciplined capital allocator. He didn’t chase Time Warner till the end of the Earth. I suspect that he wanted HBO, which is an extremely unique and valuable asset IMO. Premium channels aren’t supported by advertising fees, so I think their business models will be less affected in an unbundled world. In fact Time Warner has announced that they are offering HBO on a standalone basis without having to subscribe to a cable bundle. Pay-TV subscribers typically have a choice of upgrading to HBO in their packages for $15 at the retail price point, so I think even if HBO retails at $15 over the internet they should do OK and won’t canabalize much of their existing business. I actually don’t think many people are going to cut their cable package just because all they wanted to watch was HBO. What they’re doing is going after the same market Netflix is going after, millennials like me that don’t subscribe to a cable TV package. I’m not a huge sports fan so I don’t need to pay $100 a month for that entertainment.

Charlie Ergen knows this, and wants part of this market as well.

http://www.wsj.com/articles/dish-network-unveils-web-video-service-1420481845

What’s interesting is that ESPN, the largest hoarder of exclusive sports rights, is included in this package, for just $20. Now this is a bit troubling for the Pay-TV ecosystem, in my view. I think sports has traditionally kept the bundle intact. DISH still has a DBS business but it’s becoming an increasingly less valuable component of DISH shares. So on one hand it could cannibalize their DBS business, but on the other hand he wants to start building an online streaming business for a growing OTT market. ESPN gets by far the highest affiliate fees per sub at the wholesale level out of all the networks, above $5 per month. Now if I were the ESPN guys, do I risk part of my ~$435 million or so in annual affiliate fees, and huge advertising fees as well within the bundle or do I think its a bad idea to be part of DISH’s streaming bundle? I think they’re playing a potentially dangerous game here, and if I were a distributor, why would I buy ESPN at the wholesale price and offer it at retail when subscribers can cut the bundle and just get their sports online? Either they’re really confident that the MVOs aren’t going to push back hard or Ergen’s a brilliant negotiator. I think it might be a bit of both.

The spectrum holdings in DISH are becoming increasingly valuable, IMO. Citi’s Jason Bazinet recently published an intriguing report on DISH, suggesting a move to spin off the spectrum assets and “light it up” at wholesale prices to a wireless partner. With 4 wireless players in the US that are starving for spectrum, this would be a viable move to avoid tax leakage. I don’t think there’s a chance in hell that Mr. Ergen is going to sell the spectrum and pay $10+ billion in taxes, which is more than the value of the DBS business if you put a 5-6X EBITDA multiple on it. He holds over half the shares and has a track record of compounding DISH at roughly 20% per annum. So I think he’s either going to do what Mr. Bazinet has suggested or sell the firm to Verizon or whatever option that maximizes shareholder value. The market’s still not comfortable because of the uncertainty with respect to the end game for the spectrum holdings, creating opportunity. At the end of the day there’s huge key man risk here, and you have to put a lot of faith in Mr. Ergen for this thesis to work out. Haven’t initiated a position but I think he’s a genius and I would put his track record on par with Softbank’s Son.

Discovery shares have taken a huge hit lately. I’ve read John Hendrick’s biography which gave me a good background on how Malone accumulated a large position in the company today. I like the business, a lot. They’re the world’s top non-fiction media company, period. The great thing about this type of content is that you don’t have to hire expensive actors like Brad Pitt to produce high-quality shows, and the shows easily transcend across languages, gender, age cohort and cultures globally. What gives me pause is the resetting of growth expectations and their exposure to the bundle. I have to dig deeper into these issues but noticed that they’ve been acquiring production assets in Europe such as All3Media, SBS, and Eurosport. Malone probably wants to increase Discovery’s exposure to production assets as the bundle slowly breaks and content gets re-priced higher. This is smart. I’ll get more interested if shares fall down to the mid 20’s.

http://www.wsj.com/articles/discovery-channel-founder-jumps-into-video-stream-1421268320

Time Warner is also another business I would love to own at the right price. If you look at Jeff Bewke’s track record, it’s been pretty good. Spinning off AOL, TWC, and Time. I noticed in the latest K that they’ve sold their multi-billion dollar Time Warner HQ in NYC. I think these are small details that signal a CEO who is focused on maximizing shareholder value. The next catalyst is probably related to highlighting HBO’s value. I’m not sure what he’s going to do, but I would love to own this franchise eventually – at the right price. Will be interested at $70-75 per share.

DirecTV – Sourced the original idea from Ted Weschler’s pick at Berkshire. Still in love with this business, so I’m going to hold it until the AT&T deal closes or it goes to $100 per share.

I think it’s an interesting merger arb play right now, and I am only playing this since I understand the business pretty well so I won’t cry if the deal breaks.

This opportunity exists because:

1) AT&T pays a fat dividend, so if you want to hedge AT&T you have to pay this and the arb guys don’t like this

2) only $28.5 of the $95 per share consideration is in cash, and the rest is AT&T stock with a collar so you have considerable exposure to T stock

3) Market’s overly concerned with US pay-tv consolidation and the FCC/DoJ’s response, but I don’t think the TWC/Comcast deal should have any impact on the DTV/AT&T deal

4) There’s no reverse breakup fee in the deal. I think AT&T learned their $6 billion dollar lesson when they tried to acquire T-mobile in 2011. Lol.

Overall, I expect the deal to close without too much “hassle”. In pretty much 100% of the areas with competitive overlap between DTV and AT&T there should be at least 2 additional video competitors post this transaction – a local cable firm and DISH.

My edge here is that I’m relatively agnostic to whether the deal breaks or not since I like DTV longer-term, but still think the risk/reward is favorable with a higher expected value of the deal closing. Assuming in my base case scenario that T rallies back up into the collar in the next several months, you could be looking at an unlevered ~25% annualized IRR on DTV assuming the deal closes near the end of q2. Not bad for a low interest rate environment.

As for DTV longer-term, most satellite bears underestimate the resiliency of DTV’s subscriber base. Literally 40-50% of their US subscriber base is probably with DTV just for their exclusive sports programming. In fact this is so important that AT&T did the deal contingent on DTV extending their Sunday Night football contract with the NFL. Like I mentioned previously, Sports has largely been keeping the bundle intact, and if DTV can continue to offer exclusive sports content, they should be able to keep churn low for a very long time. At the same time they’re the largest Pay-TV distributor in the world, with more than 35MM subscribers. These subscriber relationships are very valuable, and I think most bears have ignored the fact that DTV can eventually offer exclusive sports content even on an online streaming platform. In fact this would be an extremely capital light business model – no more satellites, set-top boxes, broadcast centers, trucks, etc. Of course the economics of a streaming business would be different, but its definitely worth something. And management actually tried to buy HULU a year or 2 ago from the consortium of cable networks, so they’re probably thinking the same thing. I think the reason the NFL kept their relationship with DTV is mainly because they have the largest subscriber base out of all the MVOs, and know that they can maximize their revenues by signing a contract with a MVO with access to the largest number of high-value subscribers. At the same time, Latin America continues to grow nicely and has a long runway, and DTV has a massive competitive advantage there over cable. Factor in the accretive leveraged buy backs with management “arbing” the stock at a near 10% FCF yield with a sub 5% pre-tax cost of debt and you have a nice setup for sizable equity returns.

The Tower Operators – Crown Castle, American Tower, SBA

Great Businesses, high barriers to entry, good pricing power, levered to secular growth in wireless data, good returns on capital. Too expensive.

Qualcomm – Potentially a good way to play the big data and mobile growth via their licensing business. I don’t understand the technology risk, so I’ll leave it at that. I know they have a giant cash hoard and it trades at a reasonable multiple if you back that out.

Carrier-neutral Data Centers – Equinix, Telecity, Interxion

Now this is a great way to play the “big enterprise data” trend. I’ve been studying this industry for the past year and am convinced that these guys will do extremely well over the next decade or so. There’s a lot of minor details that you have to dig through in order to get a good understanding of the business model but I’ll say this: The maintenance CapEx is way less than what the market perceives. Enterprise clients actually own the IT hardware themselves, so these guys don’t pay for that equipment. The real upfront CapEx is the building itself (growth CapEx), and minor stuff like cooling equipment and battery related equipment (maintenance). The big selling point for potential customers is the interconnection to other enterprise customers who share the same data center. The incremental margins for this business is close to 100% and there’s a real network effect for sharing a data center with other customers. This is a much better business model than on the wholesale side where pricing is much lower. So you have high barriers to entry, recurring revenues, strong secular growth, pricing power, and I think Equinix, Telecity, and Interxion are quite rational on the supply side, so I don’t see oversupply as a large risk.

US and Canadian Auto Retailers:

This is a main area of DD for me right now. Simple thesis that I’m developing right now is that I think you could see pretty out-sized upside on the parts & service segments of these businesses, along with considerable consolidation in the industry. If you look at where the real money is made in this business its in the auxiliary services like financing, insurance (where gross margins are near 100%) and in parts and servicing. I use to own an interesting subprime auto-lending business called Credit Acceptance so I know a little bit about the financing side. For the dealers, they take 0 financing risk when sourcing an auto loan, and simply clip a fee based on the size of the loan. Combined, these segments typically make up more than 50% of gross profits for an average dealer. Also I think we’re in a sweet spot in the automotive cycle where you’re going to see a larger portion of the fleet aged between 0-5, where the vast majority of vehicles get serviced under warranty. Another interesting fact is that there’s been a sizable decrease in the total number of dealerships in the US over the past decade or so, leading to increased profitability for current dealers in a less crowded market. If you think about it most dealers operate in local monopolies where they have geographic exclusivity to sell a particular OEM brand. I think this attractive industry structure should provide improving returns on capital going forward. Another leg of the bull thesis is consolidation. All together, the publicly-traded US auto retailers barely make up 10% of sales in the US market. There’s going to be a lot of mom and pops ready to retire or semi-retire soon that are looking to sell their family-owned businesses. The OEMs have become less stringent on public ownership of dealerships, and are actually encouraging more consolidation. This is quite a simple process, you buy a private dealer or group of private dealerships at 4-8x EBITDA at private market valuations (higher multiples for Japanese or German Dealerships), professionalize management, improve operations, leverage IT and overhead costs etc. and then you get a “awarded” a publicly traded 10x multiple – simple arbitrage right? Most private owners would prefer a clean transaction with cash, and should be willing to sell at these multiples to well-funded public companies that have the most attractive source of financing. In terms of the auto cycle, I’m not sure if we’re anywhere close to the peak. SAARs are at 17MM per year I think? Most sell side analysts seem to think the peak will be in 18′, I’m not so sure. All i know is that I would rather own a local monopoly where a large portion of the business consists of a recurring, higher-margin revenue stream in P&S, rather than own a super price competitive, economically-sensitive, unionized, capital-intensive OEM business. (Btw, I think Stevens Fiat idea is good but I’m a bit nervous about the CEO’s grandiose spending plans although I think the ferarri piece is very valuable). The great thing about these businesses is that they’re still small-caps, so big institutions can’t touch em. One last thing I should point out is that the floorplan financing that these auto retailers get shouldn’t be considered real debt, since its collatorized by the existing inventory, which I think is de facto OEM inventory – but its just really in the hands of the dealers as distribution points, so I would adjust the enterprise value for this debt. So I think there’s a huge market consolidation opportunity here, and I think these stocks should do well in the US. I’m most excited about the Canadian traded company, its the only publicly traded one in Canada with an even more fragmented industry. They have a fantastic management team so I’ll let you find out yourself which one it is for fun.

Guess who else sees this opportunity?

http://www.wsj.com/articles/berkshire-to-buy-car-dealership-group-1412253366

Altisource: Not very interested in this company, other than the fact that I don’t think Erbey is as ethical as some may think he is. Here’s what I said in an earlier comment:

“Personally after giving it more thought I find it strange that Erbey steps down after a regulator turns his company into a de facto government run enterprise. One would think that he would fight harder against Lawsky given his background. So lets think about this… apparently he worked 24/7, literally moved to Virgin Isles just to save the company taxes, and he had no kids etc. A large part of his life’s work put into Ocwen and its related companies, and amid these allegations, simply steps down? I would guess that there’s probably more behind the scenes here, and more skeletons in the closet. Apparently Lawsky has a reputation and track record for overstepping his authority. Check out the AIG case. But the private sector knows this, so I would think Erbey would at least dispute/countersue Lawsky’s ridiculous demands. But no, he just steps down. Looks like there’s too many “unknown unknowns” here.”

If they become a distressed play I’ll consider taking a closer look. Steven will provide an update post if he wants to. Always do your own DD.

End of rant.

-R

1) All content of this blog, including correspondence between the author and readers, represents only the authors’ personal opinions and is neither investment advice nor a recommendation to buy or sell a security. No information presented on this blog is designed to be timely and accurate and should be used only for informational purposes.

2) The authors are likely to transact on securities mentioned on this blog without notice to the reader. Disclosure of the authors’ holdings of any securities mentioned will be done on a best effort basis.

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2 thoughts on “Some New Ideas

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