Description

Charter Communications

CHTR $389.50

December 26, 2023

A Shrinking Moat and Questionable Capital Allocation Weaken the Investment Thesis for Charter

Summary

Charter Communications (CHTR) is the #2 broadband connectivity company and cable operator in America, serving more than 32 million customers in 41 states through their Spectrum brand. Their network passes over an estimated 55 million households.

The cable industry is mature and generates significant cash flow. However, the competitive moat around the business has shrunk as the industry faces true competition. Fiber overbuilders have established a position in almost half of Charter’s household passings. Fixed wireless providers are displacing DSL broadband in the rural markets that Charter is entering. This competitive dynamic has suppressed pricing power and has resulted in the need for continual capital investment to simply maintain its competitive position. These new investments are not likely to generate sufficient absolute returns, but they may be justified if their absence would cause further deterioration in the business.

Charter operates with an aggressive capital allocation strategy that is driven in part by management incentives that reward growth while ignoring the related costs. This is evidenced by Charter’s investment in low return capital projects, aggressive buybacks without regard to valuation, zero dividend policy, and a highly levered balance sheet.

The primary risks to the bullish Charter investment thesis include:

• Rural Expansion: probable cost overruns and lower sales penetration due to fixed wireless taking DSL customers prior to Charter finishing their network buildout.

• Low cash flow growth: increased competition impacting sales and pricing power, limited opportunities for further cost reduction, continued funding of low (and negative) return capital spending, and the difficulty of moving the needle of a large scale business constrain growth.

• Capital markets: Charter needs favorable credit and equity market conditions to persist for highly-levered firms.

To invest in Charter today, an investor must believe that:

• Growth will be above expectations, resulting from some combination of network expansion, pricing power, and cost savings.

• Returns on capital spending including share repurchases will achieve acceptable levels of return.

• Capital markets will remain favorably disposed to Charter’s leverage and management.

While it’s certainly possible that investors will continue to reward the company by focusing on artificial non-GAAP earnings, the risk profile of the business, combined with factoring in the cost of growth and buybacks as well as the agency issues, makes Charter an unattractive investment for a long-term investor at the current price.

Company Overview

Charter Communications (CHTR) is the #2 broadband connectivity company and cable operator serving more than 32 million customers in 41 states through their Spectrum brand. Their network passes over an estimated 55 million households.

Company History

Charter started as a Michigan cable company in 1980. In 1998, Microsoft co-founder Paul Allen purchased a controlling interest. Mr. Allen purchased cable assets in the late 1990s at what were then full valuations of $3000+ per subscriber. The acquired assets necessitated significant capital investment to expand the cable plant to offer broadband access to fulfill Mr. Allen’s “wired world” vision.

Mr. Allen combined his other cable properties with Charter and took the company public via an IPO in 1999. Charter completed 10 acquisitions in 1999 alone.

Capital expenses to build telecommunications networks are incurred well before revenue is received. The combination of high initial prices paid to acquire the cable assets, the significant capital expenditures necessary to upgrade the plant, combined with a slow build in consumer appetite for broadband pushed Charter into financial distress.

At the end of 2008, Charter’s debt stood at $21.7 billion while EBITDA for 2008 was only $200 million – a Debt/EBITDA of 109x – on revenues of $6.5 billion. Cash flow from operations was $400 million for the year and capital expenditures were $1.2 billion, yielding free cash flow of ($800 million).

Charter Communications declared bankruptcy in early 2009 and entered a “prearranged bankruptcy,” The company emerged from Chapter 11 bankruptcy in November 2009 after erasing $8 billion of debt and the new company was left with borrowings of $13 billion. Bondholders who exchanged $8 billion of debt ended up owning substantially all of the newly reorganized company. The public equity was wiped out although Mr. Allen remained Chairman.

In 2010, Charter stock was relisted on NASDAQ. In 2011, Mr. Allen stepped down and in 2012, Tom Rutledge, who was COO at Cablevision and previously at Time Warner Cable, became CEO.

In 2013, Liberty Media, led by John Malone – founder of TCI – purchased a 27.3% ownership in Charter largely by acquiring shares from investment funds that had participated in the restructuring. Liberty spun off the Charter holdings into Liberty Broadband (LBRDA) in 2014.

In 2014-2015, Charter prevailed in a bidding war for Time Warner Cable against Comcast. The deal closed in May 2016. This purchase made Charter the third largest pay-tv company in the US behind AT&T (DirecTV) and Comcast. Liberty Broadband invested an additional $5 billion in Charter to have a roughly 20% ownership stake in the combined company.

In 2012, Time Warner Cable and Comcast sold wireless spectrum to Verizon for $3.6 billion. The agreement had a clause that gave TWC and Comcast perpetual access to Verizon’s cellular network as a Mobile Virtual Network Operator (MVNO), essentially reselling access to Verizon’s network under their own brand. In 2017, Charter, who acquired the TWC agreement, started offering wireless services under the MVNO agreement as Spectrum Mobile, following Comcast who launched mobile service in 2016.

Verizon reportedly made a $100 billion offer to acquire Charter in 2017 that was spurned as inadequate.

Charter has aggressively bid for licenses to expand under the Rural Digital Opportunity Fund (RDOF) auctions. The RDOF, combined with state programs and the forthcoming Broadband Equity Access and Deployment (BEAD) program, is designed to expand broadband access into underserved and rural communities by offering licenses and subsidies to incent development. Charter intends to spend $6 billion from 2022-2025 for the RDOF, and likely will spend more through BEAD in 2025/6 – 2028/9.

In 2022, Tom Rutledge was succeeded as CEO by Christopher Whitney who had been COO since 2021 and CFO for a decade prior.

Business Segments

Charter reclassified its operating segments in 2023. It now reports Residential revenue, which covers Internet, Video, Voice, and Mobile; Commercial revenue which covers small and medium business (Internet, Video, and Mobile – although not broken out) and Enterprise; Advertising sales; and Other.

Video and wired Voice are in decline. Advertising sales are tied to Video and benefitted from political spending in 2022. Charter and Comcast established a joint venture, Xumo, to provide a streaming platform. Although Charter doesn’t break out profit by segment or product, Video margins are significantly lower than Internet margins due to programing and regulatory/access costs. The goal with Xumo is to provide a Video product to both create further customer stickiness as well as have a platform to capture advertising revenues as well as product sales revenues like it receives from QVC.

Leadership

Tom Rutledge was CEO from 2012 – 2022. Prior to Charter, he was at Cablevision and Time Warner Cable and joined Charter following its emergence from bankruptcy in 2009 and return to public equity markets in 2010.

Rutledge is considered a very effective operator and gets credit for the integration of the Time Warner Cable and Bright House acquisitions in 2016 which took Charter from $2b to $12b in operating cash flow.

Rutledge received some criticism in recent years for focusing more on financial engineering (Charter’s levered equity strategy) than on innovation.

In 2022, Tom Rutledge was succeeded as CEO by Christopher Whitney who had been COO since 2021 and CFO for a decade prior. 

Rutledge’s exit was unexpected. Rutledge retained a position as Executive Chairman. 

Rutledge attracted criticism for recent capital allocation decisions that are questionable, including repurchasing a massive number of shares at elevated prices in 2020-2021 in front of a significant increase in capital expenses. In addition, Rutledge aggressively pursued the RDOF auction, even though the reverse auction was compromised by unqualified parties bidding down required subsidies to a point that they are arguably uneconomic. 

Whitney was a convenient, but not necessarily obvious choice to succeed Rutledge, if Rutledge was pushed out for his capital allocation decisions, Whitney played a supporting role. These capital allocation decisions would have been presented to the board, and Whitney seems committed to the same path, so it might be more likely that there was a personality dispute with the board rather than a strategic difference. 

In December 2022, Charter – which typically doesn’t give many details to the investment community – held an investor day where they laid out in detail the projected increase in their capital expenses for the next three years while being light on the details of what the expected returns on capital might be. The stock fell -22% to $304 following the investor day. 

What might have prompted Charter management to hold the investor day in December, when they could have simply disclosed their capex plans on the Q422 earnings call in late January 2023? It may not be coincidental that Charter prices its annual option grants in mid-January. In 2023, the grant date was January 17th, and the options are priced with a strike price at that day’s closing value of $388. These options have a 10-year life. The benefit to executives of a lower share price on the grant date is twofold: they get a larger number of options at a lower strike price. 

In the January 2023 grant, Whitney received a $17 million options grant and Rutledge received a $15 million options grant, which seems rather generous considering he is no longer actively involved in the business. It’s hard to see this as anything other than a buy off, and likely relates to the fact that at the end of 2022, many of the executive’s options grants – including $90 million granted to Rutledge in 2020 – 2022 – were underwater.

In February 2023, Charter issued an additional and unique grant to the executive team, excluding Rutledge. Executives were granted a package of 90% options and 10% RSUs for 4x their January grants. Whitney received an additional $68 million grant at a strike price of $381. This grant is unique in that while there is a 5-year vesting period, accelerated vesting occurs at share prices between $500 - $1,000 by 2029.

A significant agency conflict exists between Charter management and shareholders. While both are rewarded for a higher stock price, Charter management is not being constrained by controlling risk. There is no return on invested capital criteria in Charter’s compensation structure. The rewards are solely tied to growth in revenues, EBITDA, expansion, and stock price. The executive incentives tied to the RDOF buildout are limited to achieving execution targets on the buildout, without regard to the capital cost or the returns achieved on said capital.

Charter management truly has been given a free call option on Charter’s stock price with virtually no restrictions on how it achieves that goal. This implicitly encourages risky capital allocation strategies that may well be contrary to the interests of shareholders who have invested capital and bear a risk of capital impairment if Charter fails to meet their stated goals.

Industry Analysis

The history of cable television dates to the 1950s. Many small operators obtained a license to deploy cable TV to a given geography. At the time, TV was primarily accessible through over-the-air antennas (satellite TV arrived in the late 1970s). While the cable provider had to spend capital upfront to build out the network, they had a captive audience as they provided a superior product to over the air (more stations, better quality) and they had an exclusive license from the municipality. As a result, penetration and growth was significant and provided the operator with a very steady income stream and high customer stickiness. As a monopolist, the operator had significant pricing power.

Three primary factors changed the competitive dynamics of the industry. 

First, the networks shifted from analog to digital in the late 1990s, driving a significant increase in capital expenditures to essentially rewire the network. Cable still had a significant advantage as its broadband product was demonstrably superior to DSL over copper offered by the telcos. John Malone, an astute investor, sold the company he founded – TCI – to AT&T in 1998 for $4,100/subscriber. AT&T sold the assets to Comcast in 2001 – after investing significant capital to upgrade the cable plant – for $4,500/subscriber.

Second, inexpensive capital in the last 15 years resulted in selective overbuilding of fiber networks in the cable operators’ territories, bringing real competition for the first time as fiber is a superior product to cable in terms of both network speeds and maintenance cost. It’s estimated that Charter faces fiber competition in almost half of their 55 million passings.

Wireless providers started offering fixed wireless internet, providing additional competition at the low end and in rural markets. Fixed wireless has been successful in displacing DSL lines in rural areas (T-Mobile), muting its impact on cable net adds to date. However, this has significant adverse implications for the penetration rates and returns on Charter’s rural broadband expansion as the low-hanging-fruit of DSL customers may largely convert to fixed wireless customers before Charter can deploy broadband in those communities,

Increased competition has forced the cable operators to invest significant capital in further upgrades to remain competitive. Google’s launch of Google Fiber in 2010 was done explicitly to create the incentive for cable operators to invest in their plant to increase broadband speeds.

Charter has historically spent around $25/passing per year on network evolution to keep pace with the competition. 

In December 2022, Charter announced that it would be spending an additional $100/passing ($5.5b) over 2023 – 2025 to further upgrade the cable plant to support multi-gig bidirectional speeds. No benefits were discussed relating to this capital deployment. I view this as an entirely defensive act to remain competitive with fiber that offers both higher absolute speeds, but also higher upload speeds than cable. There isn’t much current demand for multi-gig residential broadband, as most homes connect devices using wifi and neither the devices nor the wifi routers can rise above 1g speeds, and are typically able to sustain mid hundred megabyte speeds. Charter is investing today with the expectation that the demand will come, but that thesis appears risky and questionable.

Third, as television migrated towards streaming over the last decade, the cable operators lost video customers and were left offering a broadband product that, while essential to most households, is also viewed as a commodity product – and one that they increasingly have competitive offerings to choose from. 

This combination of increased capital requirements, real competition, and less customer stickiness has eroded the quality of the cable business from exceptional to above average. Simply put, Charter’s competitive moat has contracted.

Industry Structure

There were 131 million households in the US in 2022. 65 million were traditional pay TV subscribers, versus 101 million in 2013. These subscribers have been declining by roughly 10% per annum and are forecast to fall to 48 million in 2027.

117 million households had broadband internet service in 2022. 

A survey conducted by Leichtman Research Group in late 2022 of 1,910 adults in the US revealed the following observations:

• 90% of U.S. households get an internet service at home, compared to 84% in 2017, and 74% in 2007.

• Broadband accounts for 99% of households with an internet service at home, and 89% of all households get a broadband internet service, compared to 82% in 2017, and 53% in 2007.

• Individuals ages 65+ represent 34% of those that do not get internet service at home.

• 61% of those reporting speeds >100Mbps are very satisfied with their service.

• 40% of broadband households get a bundle of services from a single provider – compared to 64% in 2017, and 78% in 2012.

• Among those that do not get an internet service at home, 58% also do not use a computer at home.

The implication of this data is straightforward: the broadband market is mature and well saturated. Most households that currently do not get internet service in areas where it is currently available are unlikely to until there is turnover at those residences.

In addition, as customers shift towards getting broadband only versus a bundle of services, their switching costs – which are limited to inconvenience rather than financial – decrease, making them more susceptible to switching providers. The counterpoint to this is that with the majority of those with high-speed broadband being very satisfied with their service, the inducement necessary for them to switch providers is increasing – and probably at least as driven by a negative experience with the incumbent as a competitor’s promotional activity.

Over the last 20 years, broadband has shifted from local monopolies to local oligopolies. In any given market, there are a few competitors selling an undifferentiated service. Each seller has a high percentage of market share and cannot afford to ignore the actions of the others. There are relatively high barriers to entry. This creates an environment where broadband providers have limited control over setting prices independently, but the high capital costs and limited number of competitors should lead to a stable, rational pricing model. Occasionally, new entrants will emerge – often at the lower end of service quality (fixed wireless) – and try and pick off the low end of the market with aggressive pricing, but these entrants often run out of capacity and capital to be more than a periodic nuisance.

Broadband has become a critical utility for most, equivalent to electricity. Yet broadband remains largely unregulated in comparison to electric utilities.

Competitive Dynamics

Charter had 32 million customers in 2022, representing 58% of the 55 million homes passed by its network. Comparing company data to country data is not apples to apples, if we use the national data as a proxy, most of the remaining homes passed in Charter’s network (and this is true for all providers) are current broadband customers of a competitor.

In the 2022 and 2023 earnings calls, Charter and Comcast have called out the current suppression in customer mobility (people moving residences) as weighing on net adds. This reveals both the stickiness of the product (people usually select an internet provider upon move in and rarely change providers) and competition (Charter needs people to move in the hope of retaining the business of homes that were previously Charter customers as well as winning business away from homes that were previously customers of a competitor.

Aside from the subsidized rural expansion, there are limited greenfield opportunities. New housing starts have been roughly 1.3 – 1.4 million per year. The vast majority of these are in new housing developments, which often have multiple broadband providers wiring the neighborhood at inception, providing competition from day 1.

The existence of competition has both raised capital intensity by the frequent need to upgrade the plant to remain competitive as well as limiting pricing power.

What are emerging trends? Threats?

Emerging trends include the convergence of wireless and broadband which presents both an opportunity and a threat.

The wireless operators own radios on leased towers connected by either leased or, increasingly, owned fiber. They have a wired broadband network, with a wireless connection to their customers. They are not well positioned to deploy fiber from the towers into homes, but they do offer a competing broadband product – particularly appealing at present to the low-tier consumer and to small businesses with modest broadband needs.

The broadband providers have a hybrid-fiber-coaxial (HFC) network with fiber to the neighborhood and coaxial cable to the home. In homes served, the cable modem/Wi-Fi router also serves as an external hotspot offering Wi-Fi to customers passing by. This has allowed for the Charter and Comcast to enter the wireless market utilizing a combination of leased wireless capacity from Verizon and offloading as much traffic as possible onto their owned Wi-Fi network where there is minimal marginal cost.

Charter and Comcast have a unique agreement with Verizon giving them access to Verizon’s mobile network. In the last few years, both have rolled out their branded mobile service as an MVNO utilizing Verizon’s network. These efforts are best viewed as a low capital cost trial. The MVNO agreement is said to be priced on a $-per-gig basis, creating a strong incentive for the cable providers to offload wireless traffic onto their networks at low marginal cost. Both operators have been successful at this and are offloading 75% - 85% of traffic onto their networks.

The near-term goal of offering mobile wireless service is to create additional customer stickiness by making it more inconvenient to change providers when multiple services are involved.

The long-term goal of offering mobile wireless is a belief that ultimately there will be a convergence of wireless and wireline broadband. Rolling out wireless under the MVNO agreement allows the cable providers to build a customer base while expanding their knowledge and capabilities. At some point, they may achieve enough customer scale to start installing their own wireless radios to move away from reselling Verizon’s network. Alternatively, in a more relaxed regulatory environment, there is the potential for a merger between a wireless operator and a cable operator.

Mobile is currently a loss leader. Customer acquisition costs including zero-interest financing on phones and 1st year teaser prices creates an upfront cost that expands as Charter accelerates growth. In 2022, mobile operating losses were $1.1b on top of $0.5b in capital expenses. Charter claims that after excluding customer acquisition costs, it is achieving Adjusted EBITDA margins of 18%, which remains well below the 40% margins for the broadband business. Mobile can drive growth in revenues and profits, while achieving a lower ROIC than the legacy business. Management states that a big reason for offering wireless is to increase customer stickiness, which has been reduced by the secular shift away from cable tv towards streaming. Offering a bundled package increases customer switching costs.

Rural expansion is the largest greenfield opportunity for broadband and supported by subsidies at the federal and state level. At the federal level, there are two main programs: The Rural Digital Opportunity Fund (RDOF) and the Broadband Equity Access and Deployment (BEAD) program. The RDOF will offer up to $20.4 billion over ten years to subsidize the construction of broadband assets into rural communities. Only $9.2 billion was allocated in phase 1 and it is unclear what will happen with the remainder. Charter is the largest winner of RDOF subsidies. The BEAD program is part of the 2021 JOBS Act and will offer up to $42.5 billion for the construction of high-speed internet in rural areas. The funds are allocated to the states to distribute to operators. Building under the BEAD program should commence in the 2025-2026 timeframe.

The attractiveness of these initiatives to the cable operators is greenfield expansion with subsidized construction costs. There also is a prevailing sense by Charter that it’s a defensive move – if they didn’t build it, a competitor would. This should result in high penetration rates. In addition, subsidies are available to low-income households that should further boost adoption. The disadvantage is that because of the lack of household density in rural markets the cost per passing is forecast at $5,000 - $6000/passing – which is why these communities have historically been underserved.

As with mobile, the challenge with rural lies both in the magnitude of the opportunity and achievable returns on capital. Charter passes 55 million households with its broadband network. Adding an additional 1.3 million passings represents only 2.4% growth and a capital investment of $6.7 billion. While the investment occurs over 3 years, the subsidies are paid out over 10 years, lowering the return on capital. Construction costs are far more likely to exceed their estimates than not. With T-Mobile aggressively offering fixed wireless to convert rural DSL customers to an acceptable broadband product for most households before Charter can build out its network, the likelihood that Charter’s penetration rates may fall below the levels necessary to earn an attractive investment are high.

Financial Summary

How does the company make money?

Charter provides telecommunications services including broadband internet, video, voice, and mobile to homes and small businesses for a monthly fee.

What are the drivers of growth? And how have they evolved over time?

The primary drivers of growth are users and pricing. User growth has slowed as broadband has become a mature market. The rapid adoption of broadband over the last twenty years has hit a 90% threshold. The remaining 10% (13 million households), is split between the unserved (which is addressed by the rural broadband initiatives) and those who choose not to purchase broadband. The latter households are likely to convert to broadband users over time with generational change.

Pricing is relatively stable due to competition in most markets. Typically, discounted prices are offered to new customers for a year. Charter does not disclose ARPU by product. Residential ARPU increased 1.9% in 2022 and SMB ARPU was flat. 

In mobile, Charter is expanding rapidly by offering plans that dramatically undercut most wireless providers. Since the beginning of 2021, Charter has added 4.3 million mobile lines and had 6.4 million mobile lines as of 6/30/23. They are offering one line for free and two lines at $29 for the first year. T-Mobile has questioned Charter’s growth, suggesting that their net adds are not coming at the expense of other wireless providers. Given that the mobile market is mature with very high penetration, there is some question as to the sustainability of this growth, particularly as customers roll off their free year.

What is the runway for growth?

Broadband is a mature market, with high penetration in urban and suburban areas in the US that are often served by multiple providers due to the fiber overbuilding by telcos and independent operators like Google Fiber. Pricing power is limited, and discounts are regularly offered to new customers and to retain existing customers who call to cancel or downgrade their service.

There is a revenue headwind on video and voice services due to the secular shift towards video streaming and wireless telephony, but this has a modest impact on profitability and cash flow due to the programming and regulatory costs associated with video services.

Growth might pace GDP at 2-3% per year due to customer growth and price increases.

There are two primary growth avenues for the cable providers: mobile and rural.

The largest growth opportunity is rural expansion. Rural markets have historically been underserved with broadband access due to the low density of households making the potential return on massive capital costs unattractive. In recent years, the federal and state governments have taken action to provide incentives for rural broadband deployment.

The first large program is the RDOF which is being built out from 2022 – 2025. The BEAD program has the potential to be 2-3x larger than the RDOF with construction commencing in 2025-2026.