Not So Deep Dive: Charter Communications
(Ryan) What they do: Charter Communications is the 2nd largest cable operator in the United States. They serve more than 32 million customers in 41 different states through its Spectrum brand. While the cable space nationally is competitive and somewhat fragmented, Charter has strong market dominance at the local level. According to one report I read, Charter has an average market share greater than 60% in the markets where it’s the incumbent. And in looking through it’s map detailing its service areas, they tend to operate in a lot of rural spots.
Through Spectrum, Charter provides essentially 4 services which are offered to both residential and commercial customers (most of which is almost all residential except voice has a little more SMB customers) on a subscription basis:
Internet - (What they’re most known for). With Spectrum consumers can get different packages of fixed internet (wireline internet) or WiFi. Charter’s entry level fixed internet download speed is 200 Megabits per second across 85% of their footprint. For reference the recommended internet speed for 4 or more devices is 25 mbps. Charter services 28.3M residences across the country. This segment has grown steadily for Charter over the years.
Video - This is their 2nd largest segment by subscribers and they provide customers with a variety of choices on video programming packages. They can get these services either through a digital set-top box or they have a CTV device as well. And they have a SpectrumTV application for Smart TV’s where subscribers are increasingly going to. This segment has been declining slightly as the run-off from linear tv hurts them but they seem to making a decent transition towards ctv.
Voice - These are wireline voice communication services (think landlines). They offer unlimited local and long distance calling, but as you can imagine this is a shrinking business for them at least on the residential side. They also offer voice services for SMB’s and that part is growing, albeit quite slowly.
Mobile - Spectrum Mobile is offered to customers that subscribe to Charter’s fixed internet service and it runs on Verizon’s mobile network combined with Spectrum WiFi. They have what they call the best deal in mobile at 2 phones, unlimited talk, text, and data for 29.99/month. They are the fastest growing mobile provider in the country (i imagine that’s on a % basis). But this is Charter’s fastest growing segment by percentage.
On the cost side, obviously Charter has high fixed costs required to build out their network infrastructure which today passes by more than 54 million households in the US.
(Ryan) History: Sort of a convoluted history here because there have been so much mergers throughout the years, but Charter was founded in 1993 in St. Louis, MO by 3 former executives from Cencom Cable Television (Barry Babcock, Jerald Kent, and Howard Wood). They started by acquiring various cable systems throughout the 1990’s and by 1998 Charter had 1 million customers across the US and in 1999 they decided to IPO. Interesting note: Paul Allen acquired a controlling stake in the company in 1998.
The 2000’s marked even more acquisitions and they even began swapping customers with other cable providers to improve its geographic clustering. However, in 2008, Charter’s stock failed to meet NASDAQ standards and in 2009 the company announced that it planned to file chapter 11. This “restructuring reduced Charter’s debt by 40% or $8 billion and cancelled the outstanding common stock.” ie. left shareholders with an empty bag.
Charter did emerge from it with a much cleaner financial position and they changed management teams and were able to relist on the NASDAQ. In 2016, Charter acquired Time Warner Cable and Bright House Networks for just under $80 billion, making them the second largest cable operator in the US.
Charter also provides cable video, but since that is in run-off we are going to focus on broadband + wireless mobile industry
The industry TAM is internet users in the United States, so the majority of the population
Broadband providers like Charter have an estimated 83% - 85% market share of internet users in the United States. This has steadily risen over the past two decades. They are taking share from slower providers of DSL, others.
Competition is interesting because in a lot of places broadband has a virtual monopoly for the majority of customers who would never use DSL or slow services.
However, competition from new sources is heating up. These can be put into 3 categories:
Fiber to the home, and fiber overbuilders (AT&T, Verizon Fios, Ziply, Century Link, tons of small ones). They are increasingly adding new lines or replacing DSL, which is adding more competition for internet customers. Fiber is slightly better than broadband but basically equivalent for today’s internet needs.
Fixed wireless to the home (T-Mobile, Verizon, AT&T). T-Mobile is the biggest threat here and you should think of this as an offering similar to a mobile phone plan but for your home.
Moonshots like Starlink and Starry. These are a lot smaller threats right now
In Mobile, Charter has licensed spectrum from Verizon and is able to compete with the big 3 mobile wireless providers to offer phone plans to customers. Charter currently has 3.9 million mobile lines
What competitor do you think is the biggest risk for them?
(Brett) Management and Ownership:
CEO: Tom Rutledge. Also chairman of the board. Been CEO at the company since 2012, stock has more than doubled the S&P 500 total return during that timespan from my quick math. 43 years of experience in the cable industry. A member of the Cable Hall of Fame, inducted in 2011. Base salary of $2.5 million a year, $8.9 million cash bonus last year (metrics/hurdles looked decent, not great). $30 million in annual option grants.
CFO: Jessica Fischer. Been at Charter since 2017, worked in traditional finance/consulting roles before that. She manages treasury, accounting, etc. and is in charge of the buyback program.
Executives get paid heavy stock options grants based on long-term share price performance. This will be a slight headwind on share count reduction
Liberty Broadband owns 27.6% of stock, Advance Newhouse owns 12.55% of stock, TCI Fund Management owns 5.12% of the stock, Rutledge owns 1.08% of the stock. There is a heavy influence here from the Liberty Complex
Both Liberty and A/N have seats on the board
Liberty people a positive or negative here for you?
Given the debt load, liabilities, etc. valuing Charter is a bit more complicated as there is some debate on what should get included in the enterprise value
Market cap of $87.5 billion using fully diluted shares outstanding plus exchanged shares (they have some weird structures that we don’t need to get into on this episode)
Enterprise value is $180 billion due to heavy amounts of debt. They target a 4x - 4.5x debt to EBTIDA target (explain)
EV/FCF of 21. This is the key metric to track
Heavy repurchaser. According to Q1 presentation, they have bought back 42% of shares outstanding since September 2016
Also, note they have almost $20 billion in deferred income taxes. This could become a headwind on free cash flow growth this decade
Total revenue during the quarter was $13.2B, up 5.4% YoY
Internet contributed the most to that growth
Video stayed relatively flat YoY
Voice declined by about 2%
And Mobile, which is still only about 5% of revenue, grew at 40% YoY
On that $13.2B in revenue, about 39% of it they generated in EBITDA.
So $5.2B in EBITDA in Q1, up 5.4% YoY
And about $1.8B in FCF (this was actually down year over year but if you exclude a one-time litigation related payment, it grew by about 9% YoY).
To bridge the gap between EBITDA and free cash flow, the big expenses are typically interest and capital expenditures. This quarter, they had:
$1.1B in interest expense during the quarter
$1.9B in capital expenditures (most of which is their cable buildout)
In summary, this is a business that steadily grows through both subscribers and price increases and steadily increases its margins, since the bulk of its cost structure is fixed.
(Ryan) Balance sheet and liquidity:
Charter’s a company that uses a ton of debt to grow.
They have ~$95B in total debt. $4.5B is current and about $90B of it is long-term.
The weighted average cost of that debt is 4.6%
And the weighted average life of the debt is just over 14 years. (92% of the debt matures after 2024).
This is important because they pay a ton in interest expenses each year, so EBITDA is not a truly relevant proxy for earnings.
Cash and cash equivalents of $2.4B
Their current leverage ratio (Total Net Debt/LTM EBITDA) of 4.43x. (they generated just under $21B in EBITDA during the last 12 months). In other words, how many years of their current EBITDA would it take to pay off all their debt? About 4 and a half years.
I’m gonna steal a paragraph from Andrew Walker’s work on Charter “Most Liberty stans know this, but Charter is a classic John Malone company in that it pursues a levered buyback model. This means that, as the company grows earnings, they take out more debt, which they then use to buyback shares. An example might show this best: say EBITDA this year is $10, and the company commits to 5x leverage. That means they need $50 in debt. If EBITDA grows to $12 next year, the company needs $60 of debt. That means they’ll go borrow an additional $10 of debt to bring their debt from $50 to $60, and they’ll give that $10/share to shareholders in the form of a share buyback. On top of that, they’ll generally give whatever free cash flow they generate to shareholders as well.”
(Ryan) We lived in a small college town and Spectrum was the only internet provider (i believe), so I used them.
(Brett) They are not in our area so hard to get a good grasp. The mobile strategy seems solid I think I would use it if they gave a bundled discount.
Future growth opportunities:
(Ryan) Comcast partnership. Last quarter, Charter and Comcast announced a joint venture. This is apparently a 50/50 venture to push Comcast’s Flex streaming platform into more homes. So Comcast will be licensing Flex to Charter, so Charer’s Spectrum subscribers can get access to the interface. Flex boxes, I believe are being given away for free to new broadband subscribers. I’m not sure exactly how this benefits Charter aside from completely losing customers to Roku and other providers, but if it helps Charter retain its video subscribers then great.
(Brett) Mobile. They are getting great traction with mobile at 3.9 million subs, and apparently account for 30% of wireless net adds over the past year. If this segment can continue growing and get to profitability, this can be a great and profitable bundle for Charter. It should also lower broadband churn, helping fight off the new competitors for internet subscriptions.
Highlights and lowlights:
(Ryan) Highlights: Durable business and it’s a needed service. They also have a lot of tax shields – get to depreciate their infrastructure assets and deduct interest expenses. They only paid $27M in cash taxes on $5.2B in EBITDA. Lowlights: Some of their business segments are in steady decline. Also, carrying the debt load that they are, means that they’re flying fairly close to the sun. That’s fine given the stability of their business, but any long-tail risks (I’m thinking either Starlink or Project Kuiper) that permanently impairs Charter’s earnings means common stockholders are in for a world of hurt.
(Brett) Highlights: Clear moat, great capital allocators at the helm with experienced leadership, love how they are trying to better position themselves with mobile offerings, repurchase strategy seems sound. Lowlights: Competition from fiber, heavy debt load adds interest rate risk when the refinance over this decade. Will capex stay elevated due to competition? Is saturation for broadband closer than we think? Is Mobile never going to make money? What if the video business suddenly goes away?
(Ryan) I’ll let you lay the numbers out. But I think if they are able to stabilize their video business and see continued progress with their internet business shareholders will probably be alright. I think the path to 2-3% annual growth in both subscribers and prices seems achievable.
(Brett) I modeled out 4% annual revenue growth (remember, video business is steadily in decline), 100bps expansion in adj. EBITDA, consistently better conversion to FCF, and share count going down by 5% a year. This gets to a FCF/s CAGR of 19% through 2025. At price, you’d likely do well in this scenario.
(Ryan) New CTV players eat away at Charter’s video business. Competition in the internet space slows sub growth and limits pricing power. If those two things happen, there’s a world where Charter could see flat to declining revenue.
(Brett) Flat revenue, stable adj. EBITDA margin and weak FCF conversion (due to high capex, high interest expense), and I estimated FCF/s would only grow by 8%. I think the floor is high here but in this scenario there’s a risk the stock price is still in between $400 and $500 in 2025.
Disclosure: The author and podcast guests are not your financial advisors. Ryan Henderson and Brett Schafer are general partners and portfolio managers at Arch Capital. Clients of Arch Capital may hold securities discussed on this show.