INVESTMENT THESIS
Charter Communications Inc. (NGS: CHTR). It has also upgraded its network to offer super-fast internet and is working to lower costs.
Charter’s broadband internet service has never been more vital than in the new stay-at-home/work-at-home environment. Having moved past 2Q20 and the June 30 end date of its Keep America Connected obligations, Charter can return to more normal operations, though COVID-19 uncertainties remain. COVID-19’s impact on Charter may be mixed as customers value the company’s broadband services, even as some may find it hard to pay for these services in the near term. Charter is managed by cable industry veteran Thomas Rutledge. Mr. Rutledge previously served as COO of Cablevision, and we believe that his presence is a key factor in the company’s growth.
Charter shares have advanced in the market rally over the last year, though valuation remains within bounds.
RECENT DEVELOPMENTS
Charter reported 3Q20 results on October 30. Revenue rose 5.1% year-over-year to $12 billion, driven primarily by 12.5% growth in residential internet revenue, another near doubling of revenue in the mobile wireless business, and a solid contribution from advertising. Commercial revenue was flat due to a tough comparison with 3Q19, when the company sold its Navisite business. Excluding the Navisite revenue from 3Q19, Commercial revenue would have increased 6% from the prior year.
Programming expense, the company’s largest cost center, fell 2.3% or $63 million, benefiting from $163 million in sports network rebates for games not played during COVID-19, a higher mix of lower-cost video packages, and fewer video customers. Adjusted EBITDA rose 13.6% to $4.6 billion, and the adjusted EBITDA margin expanded by 280 basis points to 38.5%. Net income attributable to Charter rose 110% from the prior year to $814 million. The increase was driven by the higher adjusted EBITDA and lower depreciation expense. Diluted EPS also more than doubled to $3.90 from $1.74 in 2Q19, as stock buybacks added another 14% to EPS growth. Average common shares outstanding fell 7% from the prior year.
Residential service provides about 80% of Charter’s revenue. In 3Q20, Charter gained a net 416,000 residential customers as the residential customer base increased 6.9% year-over-year. Driven by $218 million in sports channel rebates to customers for games not played. Excluding this one-time effect, the decline would have been 0.4%. Residential internet customer growth of 494,000 was, as usual, robust in 3Q20. However, Charter has 60,200 customers on its books that would have been disconnected under pre-COVID collection practices, but that continue to receive service due to state mandates.
EARNINGS & GROWTH ANALYSIS
Management has not provided forward guidance. However, Charter operational momentum combined with aggressive share repurchases and continued upside surprises have made us more optimistic about future quarters. Our current estimates imply average growth of 67% over the next two years, well above our long-term earnings growth rate forecast of 5%.
Charter’s strategy focuses on subscriber acquisition and retention through the delivery of higher levels of service, including adding new services without large rate increases. The company has invested in network upgrades and improved customer service, while also holding the line on cable package rate increases – a combination that initially hurt profitability and cash flow. Charter and its cable industry peers have often seen stagnant or declining subscriber numbers due to competition from lower-cost, over-the-top digital distributors like Netflix and Hulu. Charter’s goal is to increase the value of its cable system footprint by increasing both the number of subscribers and subscriber usage of its system. However, the company’s ramp-up in Spectrum Mobile will still require ongoing investments. Mobile operating expenses ballooned to $1.25 billion in 2019 from $346 million in 2018, leading to a 2019 segment operating loss of $510 million. The trend continued in 1H20, with mobile expenses of $1.24 billion, leading to a mobile EBITDA loss of $307 million. Management expects operating losses to continue as the service continues to scale. However, it expects Spectrum Mobile to become a ‘meaningful driver’ of subscriber acquisition and retention.
By the end of 2018, the company completed its all-digital transition. The company also completed its network upgrade and launched a gigabit-speed internet tier across its service footprint. Going all-digital freed up more cable spectrum to devote to higher internet speeds, and has enabled the use of a digital-cloud channel guide/user interface and a two-way interactive connection that allows the company to offer new services. It should also provide a better customer experience, and, perhaps, increase customer retention. Charter has also been upgrading its systems to offer superfast broadband internet service. Over 85% of its residential customers take internet plans offering speeds of 100 Mbps, with one-half receiving 200 Mbps. The company also offers 400 Mbps and 1 gig speeds across its entire service footprint. Superfast internet speeds are a key service differentiator for Charter and a factor in subscriber growth/retention. Management also touts a low-cost upgrade path to 3 gigahertz speeds, enabling advanced applications like gaming, 8K video, and virtual reality, as well as medical and educational use cases.
The TWC/Bright House transactions added scale to Charter, expanding its potential footprint from less than 13 million households to 51 million. The added scale should also drive down programming costs by enabling the company to obtain greater volume discounts and exercise greater leverage in negotiations with program suppliers.
Charter launched its new mobile wireless service, Spectrum Mobile, on June 30, 2018. Spectrum Mobile charges $45 per month for unlimited service and offers a ‘by-the-gigabyte’ service for $14 per gigabyte. The unlimited service cost is comparable to Comcast’s offering, though the gigabyte service costs $2 more per gigabyte. Both Charter and Comcast use the Verizon wireless network under a mobile virtual network operator (MVNO) agreement and pay Verizon wholesale rates for network use. In April 2018, Comcast and Charter also formed a 50/50 partnership aimed at developing and designing backend systems to support their wireless services. We expect Spectrum Mobile to be more of an add-on, intended to cement customer loyalty to the cable bundle, rather than a truly competitive wireless offering. We think the company is determined not to be left behind by the development of new 5G fixed wireless technology by Verizon, AT&T, and T-Mobile, which could potentially invade its markets over time. Spectrum Mobile has been growing well as Charter reported that its mobile service added 363,000 lines in 3Q20, 325,000 lines in 2Q20, 290,000 lines in 1Q20, 284,000 lines in 4Q19, 276,000 lines in 3Q19, 208,000 lines in 2Q19, 176,000 lines in 1Q19, 110,000 lines in 4Q18.
FINANCIAL STRENGTH & DIVIDEND
The company had $79.7 billion in debt at the end of 3Q20, with $69 million maturing in 2020 and $2 billion maturing in 2021. Charter issued $3 billion in debt in October after the end of 3Q, after issuing $3 billion in new debt in July. Charter has been using the new debt to both refinance old debt and for aggressive share repurchases. The company had $1.3 billion in cash and an additional $4.7 billion in borrowing capacity under its credit facility at the end of 3Q. Trailing 12-month free cash flow was $6.57 billion, up 68% year-over-year. Cash flow from operations has increased as capex has moderated in 2020. Charter’s credit ratings are in the mid-B’s, just one notch below investment grade, and outlooks are stable.
Charter does not pay a dividend. The share count has declined about 6% over the past year.
MANAGEMENT & RISKS
The millennial generation (those born between 1980 and 2000), is a key demographic whose purchasing power is growing. ‘Cord cutting’ is simply a reflection of what we see as the secular trend of video consumption in the U.S. moving first to the internet then to the mobile internet as broadband bandwidth has grown and mobile devices have proliferated. COVID-19 effects, particularly increased unemployment and business closures could accelerate this trend by some accounts into the mid-to-high single digits from the low single digit rates of the last few years. Charter’s video subscriber losses accelerated in 2019 to almost 500,000 from about 300,000 in each of 2018 and 2017, probably due to cord cutting and other competitive issues. The practice of cord cutting will likely continue to accelerate as more consumers begin to see OTT as a viable alternative to cable video rather than as a complement. We think that this would compound the negative impact of subscriber losses on Charter even as it sells more broadband subscriptions. Subscriber losses in the cable industry as a whole have been accelerating.
The threat from streaming internet video depends on over-the-top video services from content aggregators like Netflix, Hulu and Amazon Prime Video as well as new entrants including Disney+ and Apple TV+ with new entrants HBO MAX and Comcast’s Peacock joining in. The burgeoning Netflix has become a deadly threat through its aggregation of content and viewers and rapid global growth ramp. It is joined by a host of service other than those already named, including Dish’s Sling TV, CBS All Access, YouTube, and Facebook Video. As internet download speeds continue to increase, disintermediation is a risk that bears watching.
Charter faces increasingly intense competition in the cable industry, including satellite broadcasters DirecTV and Dish. Resurgent telecoms AT&T, Verizon and T-Mobile are also ramping up comparable service offerings, including video, high-speed internet and digital phone, and are combining them with wireless services that further intensify competition in the cable market. The telecoms are competing vigorously by offering low-priced promotions of their comparable broadband and video services. Charter and Comcast have added their own wireless service component through a mobile virtual network operator (MVNO) agreement with Verizon. The specter of in-home 5G wireless service as a replacement for cable connectivity, while not yet a reality, looms over the next few years as the telecom carriers build out their next-generation wireless networks.
Programming is Charter’s largest expense, and competition to license ‘must-have’ content may require the company to pay ever-higher prices for that content; particularly critical is sports programming, which tends to be watched live and is therefore more valuable. However, post-merger Charter may have the heft to bargain down program suppliers. Programming expense inflation currently runs in the mid- to high single digits. Increasing payments to local broadcast television owners for retransmission rights will also raise the company’s costs.
Charter also has large debt obligations following the TWC/BH mergers, which could limit investment in other business opportunities and potential acquisitions. For example, Charter peer Comcast made a blockbuster acquisition of Sky plc in October 2018.
Charter has an exceedingly complex capital structure, with multiple separate operating and debt-issuing subsidiaries. Charter’s controlling shareholder, John Malone’s Liberty Broadband, continues to own a controlling 20% of the company following the TWC/BH mergers. Advance/Newhouse, the controlling shareholder of Bright House, owns 13% of New Charter and has granted Liberty Broadband a multiyear voting proxy. The interests of the controlling shareholder may not necessarily conform to the interests of minority holders.
The cable industry is highly regulated at the federal level, with the FCC ruling on critical issues like net neutrality, set-top box policy, and internet privacy, among others. Local municipalities also regulate cable franchises.
Thomas Rutledge, a 40-year cable industry veteran, is the CEO of Charter. Mr. Rutledge was the COO of Cablevision from 2004 to 2011, and previously served as president of Time Warner Cable. Greg Maffei, the CEO of Liberty Broadband – famed cable investor John Malone’s investment vehicle and Charter’s minority controlling shareholder – is a member of the Charter board.
COMPANY DESCRIPTION
Charter provides cable television, high-speed internet, and digital telephone services to communities across the United States. Charter is the third-largest multichannel video program distributor in the U.S. John Malone’s Liberty Broadband and Advance/Newhouse, the former owner of Bright House, together own a controlling minority interest in Charter.
VALUATION
Charter’s trailing enterprise value/EBITDA multiple of 12.2. The forward enterprise value/EBITDA multiple of 11.2 is 45%.
On November 4, BUY-rated CHTR closed at $634.47, up $42.48.
Source: Argus
