“I have said in an inflationary world that a toll bridge would be a great thing to own if it was unregulated … you have laid out the capital costs. You build the bridge in old dollars and you don’t have to keep replacing it.” – Buffett
Overview – Merger Arbitrage is Very Profitable Again:
I like Charter here @ $170 per share. I believe heavy selling pressure from arbitrageurs and the complexity of the proposed merger with TWC and Bright House Networks has created a very attractive entry-point. A long-term investment in Charter shares today could potentially generate a very attractive 31% – 39% multi-year annually compounded internal rate of return.
As some of you that regularly read this blog might know by now, I have been a cable bull for quite some time and I still think the industry’s long-term prospects are very attractive both in the US and in most of Europe. I love analyzing and investing in cable equities in general and I love rapidly growing levered equities.
I also like investment theses where the underlying target company is a very good one but is operating within an industry clouded by uncertainty. Despite all the naysayers and the extreme negativity in the mainstream media towards US cable operators – from my perspective it seems like the major papers absolutely love to hate the cable industry – cable is a very attractive business. To gain a better perspective on the negativity, simply take a look at the cover or business section of the Wall Street Journal every other week or so, and you will likely find some article focussed on cord-cutting or cord-shaving (subscribers migrating to less expensive programming packages), the demise of the Pay-TV bundle, some type of major programming dispute a MVPD has with a cable network, or profiles of newly emerging streaming services that will change the face of content consumption. I believe major news reporters have a misinformed view of the economic implications of cord-cutting for cable operators, and that fears are overblown. I think most of the market and the Street still under-appreciate the likely future improving economics of the cable business and are instead overly focussed on the sustainability of their Pay-TV profits streams, programming cost pressures, and regulatory uncertainty. Over the next 7 – 10 years, I expect cable operators in mature markets will continue to transition into very high-margin, less capital-intensive cash cows with a de facto monopoly or duopoly on the high-speed broadband market; moreover, there is ample opportunity to continue to expand into adjacent growing markets such as enterprise/SMB, out-of-home WiFi, and advanced home security/automation services. The industry is also in a rapid final wave of consolidation which should greatly improve economies of scale for aggressive acquirers such as Charter Communications.
The thesis is very simple: Bet on Malone and his legendary capital allocation, bet on Rutledge and his operational prowess, and bet on a growing broadband business.
Charter is acquiring TWC for $195.70 per share in cash and stock and TWC’s shareholders can elect to either receive $100 or $115 per share in cash for the consideration. Based on my numbers, “New Charter” should be able to compound FCF per share at a higher rate if more TWC shareholders elect to receive less cash and more Charter stock – assuming Charter stock stays above current trading levels at the deal closing date.
Nearly every analyst on the Street came up with different purchase multiples based on various adjustments to TWC’s yearend expected balance sheet and free cash flow generation. On my numbers, Charter is paying around 9.3x 2015 EBITDA for TWC. The headline purchase multiple appears optically high relative to prior cable industry deals; however, due to M&A speculation a large chunk of the consideration is comprised of relatively inflated Charter stock, and also with the benefits of massive easily realizable tax, operating cost, capex and financing synergies, I believe the deal is likely free cash flow per share accretive to Charter on a near-term and longer-term basis.
Time Warner Cable: The Sleeping Giant
The deal expands upon the Charter roll-up thesis; TWC’s management will be able to cash out in a huge golden parachute and Rutledge and his highly capable team will better manage TWC’s systems and improve per-subscriber unit economics by investing in long overdue high IRR projects across the entire HFC network. Adhering to the same operating model that has accelerated Charter’s own free cash flow growth, they will: 1) convert legacy analog systems to digital across TWC’s entire footprint (like they have for Charter’s footprint already), which should reduce churn, accelerate ARPU growth, and extend average subscriber lives by offering a higher quality service, 2) greatly improve customer service, 3) up-sell advanced/incremental video services, 4) free up spectrum capacity in the pipe to offer much faster minimum data speeds than most competing broadband services which should allow them to continue growing their broadband share and 5) offer attractive triple-play (and future quad-play) bundles with superior value propositions to existing Telco fiber/copper and direct-to-home Satellite offerings. These initiatives should, along with a management team and board laser focussed on shareholder returns, greatly improve TWC’s fixed asset utilization across their network and accelerate growth in the key EBITDA per homes passed metric.
The bottom line is that Time Warner Cable is a very attractive cable asset with a highly clustered set of systems across America and has reasonable Telco fiber competitive overlap within its existing footprint. The company is managed by a mediocre executive team and had a passive shareholder base focused on near-term shareholder returns over aggressively growing long-term equity value. I believe the market has yet to price in the upside of a growing TWC business.
Altice’s surprise entry into the US cable industry provided TWC with an extra bargaining chip and likely forced Charter to pay ~$15 per share more with less advantageous terms than otherwise. Originally I was expecting a purchase price per share closer to $175 – $185. I feel like the Charter idea was almost a no-brainer prior to Altice’s entry. Mr. Drahi likely ruined the dream bull case scenario for Charter longs now that he will be fiercely competing to buy US cable assets, and consequently inflate industry trading multiples. Aside from the potential minor anti-trust concerns, my previous long-term outlook on Charter was that it would have likely rolled-up the balance of the US cable industry accretively and eventually match or even exceed Comcast’s size. Despite this, I believe Charter remains a very attractive idea and I don’t believe Dr. Malone and Mr. Rutledge would have pursued this deal if they didn’t think it was accretive to Charter. This is also likely Dr. Malone’s final opportunity to come full circle in his career to build a powerhouse cable company in the US where he was a pioneer.
Interestingly enough, the Bright House portion of the deal is the exact same one that that was agreed upon contingent on the consummation of the failed TWC/Comcast/Charter transactions. In my view, the Brighthouse portion of the deal is another example of brilliant financial engineering by Dr. Malone in order to shore up Charter’s balance sheet to make a large cash consideration for TWC. The total consideration is $10.4B comprised of $2B in cash, $5.9B in common stock and $2.5B in preferred stock units that will have a 40% conversion premium to New Charter’s stock price. I think it goes without saying that by preferring to receive such a large portion of the consideration in New Charter equity, the Newhouse family are quite bullish on Charter’s future prospects. And I think they should be. The Newhouse family are long-time successful US cable entrepreneurs and industry veterans and have invested alongside Dr. Malone in the past, partnering in deals such as investing in Discovery Communications when it was nearly bankrupt. I find it interesting that the “smartest money” in the business are all betting big on the US cable industry; three very successful cable entrepreneurs and investors (Malone, Drahi, the Newhouse family) with some of the best value creation track records in the industry are bullish and directly putting their money where their mouth is. Great investors typically see what the market is largely missing several years down the road and bet big when the odds are heavily stacked in their favour.
From Charter’s most recent 14A, Charter’s largest shareholders are some of the greatest value investors and capital allocators of the 20th century.
On the leverage front Charter management stated in the merger deck that they plan to deleverage to the “lower end of their target leverage range” of between 4.0x – 4.5x post transaction. Given that Dr. Malone is the de facto strategic capital allocator/investor behind Charter, I highly doubt that they’re going to deleverage anywhere close to 4.0x, especially if rates stay this low. My bet and part of my thesis is that they’re going to maintain a continuously levered capital structure around 4.5x over my projection period and aggressively shrink the equity. And I don’t see why this leverage ratio is not unreasonable for New Charter. Liberty Global and Altice are similar cable roll-up growth equities with similar risk profiles and are typically levered closer to 5.0 and frequently go above this level. I target a comfortable EBITDA/Interest coverage ratio above 3.5x for New Charter which should provide ample EBITDA cushion.
I think when we have a great proven operator in place that is disciplined in allocating capital and a business which is essentially a non-cyclical, lightly regulated monopoly/duopoly that sells an essential service and generates very predictable utility-like cash flows, a high leverage ratio is appropriate. This is compounded by my view that New Charter’s EBITDA will likely grow in the high single-digit range, supporting an aggressive but appropriately leveraged equity shrink playbook.
Management also confirmed that Charter and TWC should be able to retain their separate lending silos and TWC will likely retain their investment grade rating post-deal closure. I conservatively assume that total transaction debt will be issued at a blended 5.85% rate, and will of course be mostly long-dated, fixed with a staggered maturity profile in separate non-recourse holdcos. Based on precedent high-yield bond and cable debt offerings with similar equity growth profiles (Altice, DirecTV, Charter, Liberty Global etc) along with the current attractive credit market environment, I think the inability to secure adequate financing will be quite low. On future rates, my assumption is that they will likely increase slowly over time and I model the cost of debt creeping up 50 bps higher per annum. If the yield curve flattens on the back of a rising Feds funds rate the long end of the curve should remain attractive for burrowers such as Charter. I also think that there’s a possibility that we may be living in a zero interest rate environment for the next 5-10 years or potentially even longer. There is very little visibility in this future probability distribution curve and the range of possible future outcomes can potentially be very wide.
New Charter Pro-Forma Model:
The numbers above are for my base case and assumes the deal is accretive on a FCF per share basis by nearly 20% in year 1. How I prefer to model is to reverse engineer the projections necessary to arrive at my target return profile, and then assess if these projections are reasonable. Originally I was projecting around $30 per share in fully-taxed free cash flow for Charter by 2019/2020 under the failed Comcast/TWC/Charter proposed transactions. I think that under my base case New Charter should be able to comfortably achieve this same number by 2019 under the new transaction.
Aside from the operating cost synergy upside and aggressive deployment of capital into further M&A and share buybacks, I think a key driver of New Charter’s stock will be whether Rutledge and his team can accelerate TWC’s revenue growth. Most of the Street appears to modelling quite steep video sub declines for both Charter and TWC past 2015. I think continued video sub declines are likely but my decline rates are much softer than most analysts. Given the inherent sizable operating leverage in this business, I believe a return to video revenue growth or at the very least measured, small declines in net video subscribers is likely required for this thesis to play out. The good news is that I believe future cord-cutting is a measurable risk, and in the severe downside scenario of accelerated cord-cutting and shaving, I believe there are 3 major mitigants:
- For consumers that choose to consume their content purely over-the-top instead of part of a traditional cable TV bundle, high-speed broadband has become a ubiquitous service. To the extent that additional OTT competition continues to enter the video streaming market and disrupts the traditional bundle, cable has the ultimate hedge by owning the critical last-mile infrastructure or pipe that efficiently transports high-speed data (HSD) and video services to the customer; cable operators can easily price discriminate with a tiered pricing strategy as higher-speeds and capacity are demanded to stream content online. Cable’s dominant HSD service will only become more valuable over time as data speeds and bandwidth capacity demands continue to grow exponentially. In essence, I view the cable business as a collection of lightly regulated local toll-booths on inevitable, growing data consumption.
- Due to high programming cost pressures over the past decade and promotional pricing strategies in an increasingly competitive video marketplace, Charter’s video business gross margins have been squeezed to around 35% today, and is quickly becoming a loss leader within the cable triple-play bundle. So the net effect of any further declines in video subscriber losses will increasingly become negligible over the next several years. Charter’s Spectrum package currently offers an attractive triple-play bundle at an entry-level promotional price-point of ~$90 that ramps up over 1-2 years. Since pro-forma programming costs per sub per month are projected to be in the mid-$40’s range in 2016 for New Charter, Charter is already selling the video service at near break-even levels. At this point in the video business’ product life cycle, I believe it is more of an “add-on” service for potential cord-cutters, and is used by cable operators to help preserve the customer relationship by enticing consumers to pay around $10-$20 more per month for a competitive triple-play bundle. As long as the entire customer relationship (selling either a data, video, or telephony service) is not lost the hit to an operator’s gross profits and cash flows will not be as severe as standalone broadband services can be priced higher as opposed to within a bundle. For subscribers that purchase pricier pay-TV packages which include more premium content, I believe these customers are typically an older demographic, wealthier, and consequently less likely to “cut the cord”.
- For the growing 12 million or so US homes that will never subscribe to a traditional cable bundle, I see no reason why cable operators or any MVPD for that matter can’t offer their own competitive over-the-top skinny TV bundle to chase this market to help offset the shrinking video business. Despite having roughly 14 million Pay-TV subscribers, DISH has already launched a direct-to-customer online streaming product called Sling which is likely a 10% net margin business at a $20 per month price-point. There is certainly risk of increased cannibalization of their traditional TV revenue streams but I believe these packages are designed, priced and marketed squarely to broadband-only homes. Given the shifting economics of content distribution from the distributor to the cable networks and producers within the traditional Pay-TV ecosystem, I believe ultimately the cable networks that monetize their content through wholesale channels have more to lose than the distributors if more customers elect to replace traditional bundles with skinny ones.
Stepping back from these strong mitigants in a crash case scenario, my view on cord-cutting hasn’t really changed over the years. I think 1) A basic Pay-TV package still provides a great and unparalleled value proposition for consumers looking for basic entertainment, especially considering the fact that Americans on average watch 4-5 hours of television per day 2) US cable networks remain unwilling to aggressively license their “must have” and most valuable content outside the lucrative Pay-TV bundle as they are not willing to cannibalize their existing revenue streams over the short-term, 3) Due to inertia cord-cutting is likely to be a slow, and measured decline as it has been, 4) Operators are now more focussed on improving customer service, 5) Operators are stepping it up on the technology front by offering sleek next generation cloud-based user interfaces that they previously never did, 6) Growth in OTT services such as Netflix have far exceeded the growth in broadband-only homes; Netflix has around 40 million US subscribers which is around 3.5x as many broadband-only homes, indicating that an OTT streaming service is still a complementary service, not a complete substitute, for many consumers. 6) US household formation is ticking up and could potentially provide an additional tailwind for Pay-TV subscription growth, blah, blah, blah… The cord-cutting trend is real but is blown out of proportion by the media.
So the video business is likely a melting ice cube in secular decline, but an upside driver to this thesis is for New Charter to regain lost market share, mainly from the direct-to-home satellite distributors that were able to undercut cable operators in video pricing and were competing against a largely inferior analog cable product throughout the past 2 decades. With the video product becoming increasingly commoditized across all MVPDs with little differentiation now that cable operators are upgrading to an all-digital network, with the right execution, I am confident that cable can regain lost video share. I am particularly confident in Rutledge and his team’s ability to up-sell and cross-sell incremental and advanced video and broadband services at high incremental margins to TWC’s subscriber base, drive up TWC’s existing low ~33% triple-play penetration and ARPU and add more value and better customer service to the customer relationship which should ultimately reduce churn. And Rutledge’s team already have a proven track record of doing just that.
Rutledge left New York-based Cablevision which currently leads the cable industry in EBITDA per homes passing at ~$450 and penetration rates and took the helm at Charter in late 2011. Since then 1) Charter’s video sub base has stabilized as they have nearly stopped bleeding video subs and can potentially start growing positive net subs again over the next several years, 2) Charter’s EBITDA per homes passing has started growing steadily again since the turnaround that began in 2012; it has grown by ~15% since then. Further industry-wide evidence that support the view of an improving cable video business include TWC’s recently reported quarterly numbers showing ~3% yoy net video sub losses; a decent improvement over heavy losses in 2013. Unfortunately, the cable and telco operators don’t disclose their churn and subscriber acquisition costs (SAC) metrics like the DBS operators do – which is really a shame for the purposes of our analysis of a subscription-based revenue model. However, my bet is that New Charter’s greater scale should drive lower churn and SAC as CPE and network-related hardware costs decline over time. Most importantly, Mr. Rutledge has nearly 35 years of industry experience, with a proven track record as COO of Cablevision from 2004 – 2011, and a strong familiarity with TWC’s systems as former president of TWC. So I think if there’s anyone that’s best suited for this job, it’s undoubtedly him.
“During his tenure at Cablevision, Mr. Rutledge met Mr. Malone, a larger-than-life figure who was one of the industry’s pioneers. Mr. Malone tried to recruit Mr. Rutledge to run DirecTV, the satellite operator he controlled at the time.
Mr. Rutledge was not interested, but agreed to meet Mr. Malone for a dinner at the University Club in New York.
“I thought the idea of sitting in a room and telling him why I didn’t want to go to DirecTV would be fascinating,” Mr. Rutledge said. “He is a frictionless thinker. By the end of the conversation, we were talking about how great cable is.”
–The New York Times
At the time, DirecTV was Dr. Malone’s largest personal holding, and he was likely looking for a great operator to replace Chase Carey. One final comment on Rutledge is that I like the fact he’s a very long-term oriented operator who sees the need for cable operators to sacrifice near-term profitability in order to maximize shareholder value longer-term. He has done this by adhering to a proven operating model by investing heavily in the fixed network infrastructure and customer service capabilities necessary to better compete long-term.
The Future: High Speed Data
I am modelling high-single digit residential broadband revenue growth on the back of 1) Increasing broadband penetration from a 40% pro-forma footprint penetration today, to closer to 50%-60% 5 – 7 years from now, and 2) Mid-single digit growth in data ARPU, driven by a mix-shift towards higher speed tiers and modest inflationary pricing increases. Broadband sells for near 100% incremental EBITDA margins excluding subscriber acquisition costs and is a much more attractive business than video as there are no programming expenses. The commercial business also continues to take market share from ILECs and this business is growing top-line at a mid-to-high teens rates, driven by all 3 service lines.
In terms of the outlook for future broadband internet penetration rates, there are a few references. Cablevision is already at an industry-leading 55% penetration in its New York-centred footprint despite competing against Verizon’s superior fiber-to-the-home (FTTH) FioS product which overlaps nearly 70% of its footprint. Yes, New York is a wealthier demographic, but the competition is also fierce. Comcast is currently at around 40% penetration despite having around 55% – 60% telco-based fiber overlap. Another comparable is Telenet which is a Belgium-based cable operator that currently has broadband penetration rates above 55% and has fiber overlap from Belgacom across the majority of its footprint. Other European peers operating in developed countries such as Virgin Media, Ziggo, Numericable Group, Kabel Deutschland and the Scandinavian cable-based operators are still steadily increasing their broadband penetration. Right now I estimate that New Charter has around 38% – 40% fiber-based overlap with U-verse and to a smaller extent FioS which is relatively low compared to its other large, US-based peers.
So I see no reason why over that over the long-term penetration levels will not reach my target.
On pricing, the Federal Communications Commission (FCC) actively monitors broadband and video pricing and it would probably not be wise for cable operators to abuse their market power in “uncompetitive markets”. The big bet here is on data demand growth. Some of us may have read the Cisco reports that forecast rapidly growing data-usage demand (~30%-40% compounded annually) over the next 5 years or so. Personally growing up being enamoured as part the “digital age”, this is one of those few secular trends where I have a very high conviction. It’s not like data services are new – we all remember the crappy dial-up services in the “old days” – the application of the technology just hasn’t accelerated until the recent explosion of bandwidth-intensive applications. With the proliferation of multiple devices outside and within the home, and the increasing amount of time spent on applications on these devices, (an increasing number of two-way interactive, customer-facing applications such as Facebook/Instagram/Snapchat/Tinder/WhatsApp, and streaming HD quality shows/movies) demand for these services will likely grow exponentially from here.
In terms of broadband competition, in a scale business the key question is really who can meet the growing demand for data the most cost effectively. The simple answer is that only cable with its fiber-to-the-node HFC network can. Cable’s current DOCSIS 3.0 technology is capable of providing downstream speeds of up to 1 gbps. The technology roadmap to higher speeds is also clear. DOCSIS 3.1 is already being field tested by Cox Communications and Comcast in select markets and this technology will be able to offer downstream speeds of up to 10 gbps. Most importantly, the incremental cost of capital per home for upgrading to DOCSIS 3.1 is attractive at only $70-$75 or less. Right now only about a third of Comcast’s current HSD customers purchase a broadband service above 25 Mbps – the threshold that was arbitrary defined by the FCC as “high-speed broadband”. But as speed demands increase it will be clearer that cable has a natural monopoly on speeds above this level across parts of their footprint.
The main reason why cable has such a huge competitive advantage today is that operators have already invested the tens of billions of dollars in building out their massive fixed network infrastructure in the 90’s and early 2000’s; these major infrastructure costs have been laid out in old dollars and never have to get replaced. I estimate that both Charter and TWC currently earn a mid-20’s pre-tax return on net tangible capital, and future incremental returns on capital should continue to improve as HSD profits increasingly become a larger piece of company-wide profits. It will likely be another 15 – 20 years before cable operators have to even consider overbuilding a FTTH product to maintain their competitive advantage. Until then cable should continue to take the large majority of incremental new broadband subs – especially from regional incumbent local exchange carriers (ILEC) that offer an inferior DSL service.
Partly due to regulatory uncertainty, the major telcos have basically stopped their fiber roll-outs. AT&T has upgraded parts of its legacy DSL-based twisted pair copper wire network to offer a VDSL product by overbuilding fiber optic cable to the node. Through vectoring and bonding the last-mile copper-to-the-home they can only boost max headline download speeds of up to 100 – 250 mbps depending on the length of the local loop. Verizon’s FTTH FioS service and Google Fiber are the only available products right now that can match and exceed cable’s downstream speeds, but building a FTTH network is extremely capital-intensive and for now the economics only make sense for the highest-density population cities.
Due to the laws of physics, data over wireless spectrum can’t be transported as efficiently over the air than within a pipe, and the price of licensed spectrum is soaring due to shortages across major wireless operators. Right now wireless data demand is far outstripping available spectrum capacity and there is an increasing need to use WiFi offload as a solution. In order to provide seamless mobile-fixed connectivity to customers, convergence has been a hot topic lately in the cable world. The cable WiFi consortium in the US already has over 300K WiFi hotspots deployed across the country using unlicensed spectrum. There is an additional growth avenue by leasing additional wireless network capacity from AT&T and/or Verizon and as a mobile virtual network operator (MVNO) bundle an out-of-home WiFi service. Quad-play bundles typically further reduce churn and improve subscriber economics.
Management have provided a very conservative guidance of $800 million in run-rate cost synergies. I think precedent cable M&A deals where scale efficiencies were sizable and obvious such as Liberty Global/Virgin Media and Liberty Global/Ziggo have demonstrated the massive potential upside in conservative synergy estimates. In both these cases, the actual synergies actually doubled the initial estimates.
New Charter Synergy Assumptions:
- Assuming no revenue synergies.
- Programming synergies
- I estimate ~$775 million in total run-rate programming cost synergies based on a pro-forma affiliate rate card slightly lower than TWC’s 2016 projected monthly rate of $46.60; I conservatively project that these run-rate synergies will be gradually layered into years 1 to 3 by 25%, 50%, and 75%, respectively, as expired affiliate fee agreements are renegotiated over the next several years. It won’t be until 2019 that New Charter will capture the full run-rate programming cost synergies.
Programming cost synergy estimate
- OpEx synergies (excl. programming costs)
- I assume 3.5% of the pro-forma cost base or ~$636 million in full run-rate operating cost synergies by 2018, again gradually layering this into years 1- 3. Most of these cost savings should come from higher efficiencies in local economies of scale in marketing, advertising, and customer service, etc. As you can see on this map below there will definitely be incremental benefits of servicing subscribers in a continuous footprint for New Charter where the 3 companies merging currently overlap (in markets such as Texas, California, etc). The clustering effect of systems will help the new company easily achieve greater economies of scale in local markets.
New Charter’s footprint
- CapEx Synergies and Projected Capital Spending:
- The low hanging fruit here is definitely the increased bargaining power in the procurement of customer premise equipment and other network-related hardware with a larger subscriber base. In Europe, Altice and Liberty Global’s capital spending plans for upgrading their network to DOCSIS 3.1 have cost them ~50-60 Euros per subscriber relationship. If we conservatively assume New Charter spends $75 per sub upgrading the balance of TWC and Bright House’s network to digital (~8-10 million subs I estimate), they will likely spend around $600 – $750 million over 2-3 years for this capex cycle. Remember, this is mostly success-based capex spending where incremental revenues per sub are received for every upgraded home/business, and churn will likely be reduced as well. Upgraded subs are more likely to purchase bundled and advanced/premium services; even if we assume a $5 per month per sub revenue uplift, the payback period for this capex project is less than 1.5 years
- TWC has already begun a 3-year investment cycle upgrading its systems that was initiated in 2014 (the following year after the company suffered a disastrous year with nearly 7% net video subscriber losses), rolling out its Maxx service to select high population density markets. Charter will accelerate this roll-out, along with digitalizing Bright House’s systems and brand the combined company’s service under Charter Spectrum, offering minimum data speeds of 60 mbps, hundreds of HD channels and advanced video services, at-home WiFi, an improved cloud-based user interface, digital DOCSIS 3.0 enabled modems and improved customer service. By year 3 I expect the majority of the network upgrades to be completed, and capital intensity will decline rapidly from there. Charter has already completed upgrading its network to all-digital and on a standalone basis their capital intensity is set to decline. There should also be some capex savings from the increased clustering of systems and less truck rolls from an improved TWC customer service.
- Tax synergies: Very easily realizable. There will be a higher intangible asset base that can be amortized from purchase accounting. On the higher tax basis, I project the company will start paying full cash taxes in 2018 as Charter’s NOL runs out and assume no further M&A.
Integration and execution risk are likely not considerable here due to nature of the assets and the business (human capital is not the most critical resource and company cultural factors are not as important), and given Rutledge’s past track record in integrating cable systems successfully. Overall, I project New Charter can potentially achieve ~$1.4B in full run-rate synergies out of the pro-forma operating cost base by 2019, or 75% higher than management’s initial estimates. TWC should be run much more efficiently under Rutledge and his team.
EBITDA or “Operating Cash Flow” margins and growth, leveraged share buybacks and accelerating free cash flow per share growth
Core Charter is already growing revenue and EBITDA at high-single to low-double digits driven by its operational turnaround. New Charter’s EBITDA and EBITDA per passing should be growing at similar high-single digits. I’m targeting nearly $19B of EBITDA at a 38.5% margin and roughly $375 of EBITDA per passing by 2019. Pro-forma EBITDA per passing is around $270 for 2015, which is still considerably below the industry average. My operating model implies that Charter should be able to partially close the gap with its peers; EBITDA per passing should grow to around $370 by 2019, which would still be a nearly 20% discount to Cablevison today. For reference, Comcast’s cable division generated ~$330 of EBITDA per home passed and ~41% EBITDA margins in FY2014. Despite being larger, Comcast has a much more balkanized footprint largely due to past inorganic growth and a higher % fiber overlap across its footprint than New Charter.
I differ from the Street on the key operating model projections on a longer-term basis (I believe operational gearing, EBITDA and FCF margins will kick in on the backend of my projection period and by 2019/2020 should converge closer to Comcast’s current levels).
Levered Equity Shrink:
I also differ from the Street on New Charter’s capital allocation policy. After reading over at least a dozen of the analyst reports that were released related to the merger, almost none of them (except for one who I won’t mention) modelled future share repurchases. Some of the bulge-bracket investment bank research analysts such as Citi, Goldman and Morgan Stanley have ceased their coverage of Charter and TWC since they are advising on the merger. Still, I find it very typical that after studying the Street’s under-appreciation of potential future buybacks in previous similar situations, most analysts are just assuming that New Charter will use the bulk of its FCF to de-lever the balance sheet. Do we really think that management will just de-lever substantially if tax-sheltered FCFs are growing at mid-20’s percent?
“I used to say in the cable industry that if your interest rate was lower than your growth rate, your present value is infinite. That’s why the cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money. If you do any arithmetic at all, the present value calculation tends toward infinity under that thesis.” – Dr. Malone
It is always difficult trying to predict Malone’s end game strategy, and it’s near impossible trying to stay one step ahead. But one thing I’ve learned from closely studying his opportunistic investment style and past major holdings is that he really likes obscurity and complexity in his deals and investments. This typically leads to mis-pricing, but savvy management eventually unlocks substantial value with hidden catalysts that the market doesn’t anticipate. So my bet is that as long as Charter’s free cash flows are steadily growing, management will aggressively buy back the stock at a 4.5x leverage ratio. Also, if more of TWC’s shareholders decide to receive more Charter stock and less cash, then New Charter should be able to start buying back stock within the first year; I assume that half of them do under my base case and Charter will de-lever by 0.2x in year 1. By 2019 New Charter can potentially retire around 35% of its pro-forma float if management maintains a continuously levered capital structure and uses all available FCF to buy back shares.
Additional M&A Optionality:
Like what Altice’s CEO Dexter Goei has said, everything below Comcast is effectively in consolidation mode right now. I think if the current Charter/TWC/BH deal is approved by regulators as contemplated it will already be a great result for all shareholders, but any additional acquisitions of smaller cable systems is free upside to my thesis. Despite Altice’s intention to grow their US-based revenues, I think it is very likely that New Charter will aggressively compete for smaller cable systems post-merger. In judging the attractiveness of a potential M&A target, I believe the two most important factors to take into account are the competitive fiber overlap and high-speed data penetration. Obviously the smaller both of these are the better. Other considerations include any continuous system overlap in a hypothetical pro-forma company, potential triple-play penetration upside and the percentage of systems that have been upgraded to digital. Suddenlink is an example of a very attractive rural-based operator with a ~12% fiber overlap and a 37% HSD penetration that Altice recently acquired a 70% stake of.
There are a couple of future potential attractive M&A targets:
Mediacom is an incumbent rural cable operator with ~900K basic video subs, an estimated 38% HSD penetration and an attractive ~12% Fiber-to-the-node (FTTN) overbuild within its footprint. Mediacom was taken private by its founder Rocco Commisso a few years ago but he is now 65 and may be looking to cash out soon in the current wave of cable consolidation.
Cable One is an incumbent rural cable system with about 680K total customer relationships and 500K data subs with a total 25% VDSL overlap and 1% FioS overlap in its footprint. This stub will likely get spun out of Graham Holdings Corp. (formerly the Washington Post) over the next 45 – 60 days. On my numbers, I think Cable One is likely worth around $2.8 – $3.0 billion or 9x – 10x 2015 EBITDA / ~$4,000 per customer relationship to a strategic acquirer. Given their lack of scale, Cable One has been shedding basic video subs at 15% – 20% run-rates due to management’s decision to delay upgrading their analog systems. Out of all potential cable M&A targets, I think this asset likely has the highest probability of being rolled-up into a larger player. I place a 95%+ probability that Cable One will get bought out by either Altice or New Charter. Since Charter/TWC will be waiting for the current proposed deal to be approved by regulators, I think it is more likely that Altice will make a bid for Cable One when it gets spun out in the next little while. Altice is basically a well-run, publicly-traded portfolio of globally diversified cable assets run by a management team with private equity-like targeted returns.
Two family controlled and larger operators that are more of a wild card are Cox Communications and Cablevision. Cox is a privately-held operator with a little over 4.1 million basic video subs and a very attractive rural-based footprint. Cox was taken private several years ago and I believe the company is very well run, but it doesn’t appear like the Cox family are in a hurry to cash out. Cablevision is controlled by the Dolan family and its footprint is mainly in the highly competitive New York area market. CEO James Dolan basically put up the company for sale at the Television and Internet Expo 2015. Despite the Dolan’s openness to a sale, I believe they will not be the first in line to get acquired given that the more attractive assets mentioned above will likely get rolled-up first.
Other potential smaller targets include WideOpenWest (WOW) holdings which has ~900K customer relationships and RCN. The common theme among these smaller systems is that they’ve all likely been bleeding basic video subs, typically in the 10%-15% range yoy. As programming costs continue to escalate and these smaller operators delay upgrading their systems, becoming part of a larger company with additional scale benefits remains the end game.
New Charter Base Case: Assuming a $210 YE Charter share price
Malone recently said at the Liberty annual meeting that he is targeting high-teens to low-20’s annually compounded equity returns for Charter. I believe this is a very conservative projection but it is my downside case nonetheless assuming the deal closes.
Unlike the majority of media investors, I do not value cable firms on an EV / EBITDA multiple. I think this metric is relevant for evaluating potential M&A targets but aside from that this metric is misleading because 1) Not all debt is created equal, 2) Future capital intensity should be taken into account, and 3) Cash taxes have to be taken into account to adjust for potential large tax assets such as NOLs.
“It’s not about earnings, it’s about wealth creation and levered cash-flow growth. Tell them you don’t care about earnings.” – Dr. Malone
I think a levered FCF per share multiple is the most relevant metric, and this is another differentiated view I have from the Street that likes to value cable operators on an EV / EBITDA basis. Assuming we back out the present value of Charter’s NOL at $24 per share, currently standalone Charter trades for around 15x 2016 fully-taxed FCF per share. Assuming no further M&A, and all incremental FCF generated will be used to repurchase shares at reasonable multiples, New Charter can potentially earn above $30 per share in fully-taxed FCF ex-growth capex by 2019. I am conservatively assuming a post-merger, pro-forma multiple re-rating to 18x FCF per share or 3 turns higher over a 4-year period, potentially providing compounded annual returns of 35%. On these numbers, Charter shares can potentially be worth $507 – $634 by 2019, providing a huge margin of safety today. I think this is a very reasonable exit multiple given the predictability and non-cyclicality of Charter’s cash flows, future returns on capital, and its growth profile.
Pro-Forma Charter Communications 4-year Target Return Profile:
Unlevered FCF Valuation:
Target multiples on an unlevered basis:
On an unlevered basis we are within the same valuation ballpark assuming we apply similar multiple valuation ranges.
On a side note, I know there are some who consider themselves value investors who would typically avoid investing in any company with a lot of debt. Well, to them I say this: To a man with a hammer, everything looks like a nail, 2) There’s something very powerful called the levered cash-on-cash return on equity model.
In my view, it is quite dangerous to always act within a confined set of hard rules or to be forever chained towards one type of thinking. The best way to negate this inherent bias is to relentlessly seek the truth. Elon Musk who I highly admire often talks about this principal. I think the truth behind appropriately levered equities is that they can potentially yield higher risk-adjusted rates of return than otherwise. Any leveraged equity will always face the probability of an impairment of capital for the equity holders. For a largely subscription-based, recurring revenue business model that sells a basic essential service to an extremely diversified customer base I just think the probability here is very, very low.
Nightmare Case: The Deal Breaks and Charter Standalone Valuation
I place a 10% probability that the deal will get blocked by regulators and no additional M&A event materializes.
Standalone Charter should be earning around $10 of FCF per share by 2016. Assigning a 16x – 20x FCF per share valuation range and adding the present value of its NOL should yield a 1-year target intrinsic value range of $181 – $220 per share. However, there is also the $2 billion break-up fee to consider should the deal break. This would subtract about $20 per share to our valuation so our max downside could be anywhere from $160-$200 per share.
At the core, this is an event-driven / merger-arbitrage type idea, so I think there are a few ways to play the thesis.
- Long TWC @ $176. Capture full deal spread assuming deal closes and roll TWC stock into New Charter to play long-term growth equity thesis. If deal breaks TWC stock will likely fall over the short-term, however, Altice will be waiting just around the corner. I think the probability that TWC remains an independent company regardless of whether the deal breaks or not is very slim. In the absolute worst-case scenario that no other bid materializes, TWC’s core business has shown early signs of improvement and my bet is that this operating momentum will continue.
- Long Charter @ $170. Charter’s FCF growth is already at an inflection point so if the deal gets blocked the max downside should be minimal as I highlighted above.
- Long both TWC and Charter. Both shares will collapse into New Charter at deal close and subsequently long-term growth equity thesis will take hold. I liked TWC @ around the mid $150’s as I placed a very high probability of a Charter bid materializing at around $175 – $185. Like most situations I like, having a longer-term time horizon is a huge edge here.
- Merger Arbitrage Trade: Long TWC @ $176, Short 0.475 Charter shares @ $170 to lock in deal spread, receive $115 of cash per TWC share at deal closing. Trade duration: 6 – 9 months.
Catalysts / Event-Path: Next 12 – 36 months
- Deal expected to close by year end or Q1 of 2016.
- Post-merger re-rating with Street and investors focussed on pro-forma growth numbers and stabilizing TWC video business.
- Post-deal closure synergy estimate revision upside by management and adjusted EBITDA margins and FCF ramp-up; Charter’s standalone free cash flow growth is already at an inflection point.
- De-leveraging post deal close to target leverage ratio and announcement of massive share buybacks by year 2.
- Additional accretive M&A of smaller systems (Cable One, Mediacom, WOW, RCN, etc) and/or system swaps with Comcast, Cox, or Cablevision to drive greater system clustering efficiencies.
- TWC’s video business begins to stabilize and standalone revenue accelerates throughout the rest of 2015 driven by the roll-out of its Maxx service.
- Easing of market concerns over potential increased broadband pricing regulation post-deal.
Risks to Thesis:
Key man risk – Dr. Malone. There is always key man risk when investing behind one of Malone’s holdings, and this is just the reality of betting behind any superstar capital allocator. Based on reading his biography Cable Cowboy, Malone ate “a lot” of steak and drank a lot of whisky with Bob Magness and the TCI team when he was president of TCI. I don’t know what his health habits are now but he looks pretty healthy to me. And for some reason, I have a sense that media moguls live pretty long lives. The legendary cable cowboy is now 74, and certainly appears at the top of his game being actively involved in many large, ongoing complex deals. If he is near the end of his career he will likely be going out in a “bang”, and I don’t mind going along for the ride.
Regulatory risk – As part of their net neutrality/open internet goals, the FCC has recently reclassified broadband from an “Information Service” to a “Telecommunications Service” under Title II regulation of the Telecommunications Act. Title II has raised investors’ concerns about potential increased future regulations on ISPs such as cable/broadband operators like Charter/TWC. If you want more background on the net neutrality debate, I highly recommend the Master Switch by Timothy Wu.
If the FCC just wanted to prevent ISPs from blocking, throttling or allowing paid prioritization of internet traffic, reclassifying broadband to Title II seems quite overkill in my view. Due to forbearance on pricing and forced last-mile unbundling, the medium-term implications on the economics of the cable business are negligible (maybe there will be some increased legal fees), but the real concern is that longer-term, as cable’s market dominance at higher broadband speeds in uncompetitive markets becomes more evident, regulators may impose pricing controls on broadband. I do think that this is the single biggest risk to the thesis. Given the unpredictable actions of regulators at times, it is more difficult to come up with a range of likely possible future outcomes within a defined timeline.
I believe in what appears to be a move framed to protect internet users from the potential abuses of ISPs will ironically cost internet users more over the long-run. Think of an ISP’s broadband pipe as a highway with data from various internet companies such as Netflix, Google and Amazon being transported along the highway to the end user. The open internet/net neutrality principles were designed so that ISPs can’t further monetize parts of their pipe, or sell a “fast lane” to an interested party like Netflix, for example, that wants priority traffic, or alternatively block or throttle a lane when traffic becomes congested during peak hours/usage. What this means is that the FCC has basically decided that internet consumers will basically foot the bill for their higher broadband usage instead of the content/internet companies.
Another irony of Title II is that is has created a more uncertain regulatory environment for ISPs looking to potentially invest in or expand their networks, which is the exact opposite of what the FCC would like to see in the broadband market – increased competition. Title II is most akin to utility-style regulation that has been used for services such as fixed voice networks, electricity and water providers. Due to pricing regulations, companies operating within these industries have barely invested the capital necessary to maintain or upgrade their infrastructure given the regulated returns on capital. That’s why we see deteriorating landlines and poor service quality across these services in America today. But broadband services are much more dynamic. As speed and capacity demands continue to increase, ISPs have to continue upgrading their networks to service the market.
Regarding competition and market power, like most local newspapers in many rural towns and lower tier cities in America today, the business of providing broadband service remains a natural monopoly. The scale requirements to connect every home in a local market provides the incumbent with a substantial entry barrier, and being first to market is a major advantage. It is difficult for any private operator to justify overbuilding a fully upgraded fiber-optic cable network in a poorer, low population density area with an incumbent operator already present. I think as long as incumbent ISPs such as cable operators continue to upgrade their networks to provide faster speeds and more capacity for consumers at “reasonable” prices, they will less likely draw future additional regulatory scrutiny. In addition, as high-speed broadband becomes more ubiquitous over time, and as the economics of providing the service continue to improve, continued overbuilding by the telco competitors can potentially stem regulator’s concerns about competition. Obviously this is a very sensitive topic right now given what appears to be a more hostile regulatory environment. Thinking about this issue reminds me of a great quote from Peter Thiel: “Monopolies like to downplay their dominance to avoid getting regulated, and companies operating in perfect competition pretend to be doing something unique to stand out or raise capital.”
On pricing, the main issue with imposing any future pricing caps on high-speed brand services is that less active users would basically be subsidizing the service for heavy users. Nonetheless, the severity and form of any potential future pricing caps is very uncertain. It could range anywhere from pricing caps for providing speed tiers up to a certain level such 25 mbps in markets that are deemed uncompetitive (which is a type of regulation similar to how prices for basic video services are capped today in “uncompetitive markets”) to regulated returns on capital across the entire industry for all ISPs. I must admit that the probability distribution here is very wide.
One final thought on this is that regulations can change over time, and a new pro-business FCC can easily reverse bad regulation. After reading parts of the ~400 page FCC document / ruling on Title II, I must say that it reads like a crock of shit. A lot of the motivation behind Title II and the blocking of the TWC/Comcast merger seems very politically-driven given the President’s stance on this issue. I can’t help but think that the FCC arbitrary defined high-speed broadband as 25 mbps or above intentionally just to fuck over Comcast. As a reference, I think there are market models in other parts of the world such as the Netherlands that make a lot of sense where there is a single lightly regulated cable company (Ziggo / UPC Netherlands) providing very high-quality, high-speed broadband service across virtually all homes in the country at very reasonable prices.
Increasing broadband competition – Google Fiber expansion, subsidized local municipalities building fiber, and increased Telco fiber overbuilds. Google fiber is only available in a few US cities with plans to expand to a few additional tier 2 cities. This service is currently priced at only ~$70 per month for up to 1 Gigabytes per second. At this price-point it doesn’t appear like the project is earning its cost of capital given the huge initial capital outlay, the existing incumbent competition, and the markets targeted are not particularly attractive. Given that we have a controlled company with a management team that doesn’t prioritize return on capital and has interests not fully aligned with shareholders, it appears that Google Fiber remains just one of many of Google’s pet science projects.
AT&T may look to further expand their U-verse project to more cities after the merger with DirecTV closes. I believe any additional competition from future U-verse expansion plans would emerge slowly. Ironically, Title II and net neutrality goals have created a more uncertain business environment for both AT&T and Verizon in terms of investing in fixed infrastructure, and is one of the reasons why they’ve largely stopped expanding their fiber overbuilds. Aren’t regulators/anti-trust authorities suppose to help maintain/encourage a more competitive market environment instead of hindering one?
Deal risk – I place a 10% probability that the deal will get blocked by regulators. Another potential regulatory concern are concessions that will require asset divestitures. I think this deal has a higher likelihood of passing regulatory approval than the proposed Comcast/TWC merger mainly given that 1) New Charter will have a 30% market share of the FCC defined high-speed broadband market at 25 mbps or higher vs a pro-forma ~57% share for Comcast/TWC and 2) A combined TWC/Charter/Bright House will be a much smaller entity than a combined Comcast/TWC. I also think Charter’s capital plans to upgrade the balance of TWC and BH’s systems to provide higher capacity and 60 mbps minimum downstream speeds to customers and to insource call centre jobs from overseas will be looked upon favourably by regulators. Management and Malone said that they are very confident that the deal will withstand regulatory scrutiny and were willing to provide a $2 billion break-up fee. Most importantly, even in the unlikely event that the deal gets blocked by regulators, the max downside risk I’ve quantified in my standalone Charter valuation is very limited.
There is a cheaper derivative play on Charter, and I think it is quite obvious what it is. Due to an emerging pattern of unusual and/or above average trading volumes on smaller ideas shortly after they have been posted on this blog, I am no longer posting ideas of smaller-cap or illiquid ideas. I’m certainly flattered by Mr. Market now that I’m starting to influence stock prices with an obscure value investing blog but I don’t think it’s worth it to risk looking like a stock pumper or promoter and potentially encourage a portion of my readers to engage in short-term speculation without doing their own proper due diligence. I know that there are many hedge funds and fund managers subscribed to this blog, and I think that it is quite obvious that some of these guys are very short-term oriented traders. As a long-term, concentrated value investor that likes to accumulate shares on weakness, I think it is wise to keep my best ideas a secret from now on, or post them somewhere else anonymously. Given that there are likely close to zero attractive US large caps right now that match my hurdle rate, it may be a very long time before I post anything attractive again.
In general I’m bullish on the entire industry. Other cable names I like include Liberty Global, Altice, Televisa and Comcast.
I like event-driven ideas and I think a potential Global and Vodafone deal looks very interesting. The best outcome for Global shareholders would likely be that Global acquires Vodafone while Vodafone’s non-European/emerging markets segment are spun-out in a separate entity. This way Malone’s team would maintain control over the newly merged entity, maintain an aggressive leverage ratio of 5x and use the bulk of FCF and cheap debt to repurchase shares. Due to the considerable overlap of operations between Vodafone’s European segment and Global’s cable assets, especially in the UK, Holland and Germany, the synergies would be massive. From a high level, I think the FCF per share accretion from such a deal would be very impressive.
Comcast to me just looks undervalued right now and is a more conservative way to bet on the US cable industry.
Of course, I don’t think any of these names are likely cheaper than a potential Charter/TWC. Charter is not one of my top ideas anymore but if I had to compare and reverse engineer a past media investment, I would have to say that I like this idea more than DirecTV when it was @ $50 per share on a 10 p/e.
Does anyone else use Tinder by the way?
Some house cleaning:
Sold out of QVCA, AutoCanada, and AIG warrants. I think these are all still attractive ideas but on a longer-term time horizon not as good as my current holdings. I think Fiat-Chrysler Automotive looks attractive here, and an aggressive actavist investor might be able to force GM to seriously consider a merger with FCA. Idea tracker is now also updated.
“The great personal fortunes in the country weren’t built on a portfolio of fifty companies. They were built by someone who identified one wonderful business. With each investment you make, you should have the courage and conviction to place at least 10 per cent of your net worth in that stock” – Buffett
Media and Telecommunications Information Sources:
- Cable Cowboy: John Malone and the Rise of the Modern Cable Business
- The Master Switch: The Rise and Fall of Information Empires
- Rupert Murdoch: The Untold Story of the World’s Greatest Media Wizard
- A Curious Discovery: An Entrepreneur’s Story
- Call me Ted
- Netflixed: The Epic Battle for America’s Eyeballs
- Comcasted: How Ralph and Brian Roberts Took Over America’s TV, One Deal at a Time
- Blue Skies: A History of Cable Television
- Cutthroat: High Stakes & Killer Moves on the Electronic Frontier
- Captive Audience: The Telecom Industry and Monopoly Power in the New Gilded Age
- The Curse of the Mogul: What’s Wrong with the World’s Leading Media Companies
- The Billionaire Shell Game: How Cable Baron John Malone and Assorted Corporate Titans Created a Future Nobody Wanted
- Light Reading – http://www.lightreading.com/
- CableLabs – http://www.cablelabs.com/
- FCC – https://www.fcc.gov/
- NCTA – https://www.ncta.com/
 Comcast’s X1 platform appears pretty impressive
 Eg. In 2007, DBS video offerings of up to 100 channels were priced at $35 compared to Charter’s most comparable offering priced at $50, or a 30% discount
 Hybrid fiber-coaxial
 Building fiber optic cable to the node
 A FTTH build-out can cost several thousand dollars per home
 This capital spending will mostly consist of replacing some electronic equipment in the cable plants/headends, purchasing DOCSIS 3.0 enabled modems for digital services, and the labor installation/maintenance cost