Charter Communications
CHTR,
is one of the largest cable companies in the U.S. Our firm views it as an investment in three distinct businesses: cable TV; broadband internet, and wireless.
Cable TV is a high-revenue, low-margin business — most of the revenue (deservedly) goes to content providers. This business is in a mild, long-term, steady decline. Cable companies don’t mind losing this business, for a couple of good reasons: First, after factoring in the costs of customer service, cable TV makes little money. Second, people who quit cable TV consume almost double the amount of broadband (700 gigabytes vs. 400 gigabytes a month).
Broadband internet, conversely, is a growing, high-margin business. It is a utility, just like water and electricity.
Wireless is a high-growing but yet-to-be profitable business. Unlike traditional wireless companies such as AT&T
T,
and Verizon Communications
VZ,
which encounter significant costs in building and maintaining wireless networks and spend tens of billions of dollars on wireless spectrum every few years, Charter is an MVNO — a mobile virtual network operator. It buys a bucket of bandwidth from Verizon at a wholesale price.
Charter sells wireless services only to its cable and broadband customers. Most of Charter’s wireless usage occurs at customers’ homes or offices (80%), on Wi-Fi. The incremental cost of this usage to Charter is negligible. Compared to its wireless counterparts, Charter has a lower cost of providing wireless service and thus can charge less for the service. And it does.
Though the company argues that wireless will be a profitable product in the long run, Charter’s mobile strategy makes sense if the business just breaks even. Offering wireless services widens Charter’s moat as it makes customers stickier (reduces churn). It also makes it difficult for wireless competitors to steal customers, as they cannot underprice Charter’s wireless service. If wireless providers decide to wage a price war with Charter on wireless, they’ll destroy their business, as wireless service is the largest source of their cash flows.
Charter’s stock has sold off significantly from its highs. The market is worried about threats from competing technologies: 5G, fiber to the home (FTTH), fixed wireless, and satellite. After studying these competitive threats, our firm concludes that they are unlikely to have a significant impact on Charter.
All these networks/technologies look like this: a lot of fiber crisscrossing the country, which dead-ends in a neighborhood switch. This part is universal for all players other than satellites. Strategy diverges in how the signal is delivered from the neighborhood switch to the individual house — the so-called last mile.
FTTH is bringing ethernet cable to the home. 5G bridges the last mile from the cell tower through a wireless connection. Fixed wireless does this through airwaves — a direct line-of-sight type of wireless. Once the signal gets to our homes, most of our internet usage happens wirelessly through our Wi-Fi routers.
Each technology has its benefits and disadvantages. Let’s start with 5G. It is exponentially better than 4G. It is faster, has less latency, and drains batteries less. But it is still constrained by the scarcity of wireless spectrum — the “air pipe.” This is why wireless providers usually limit how much you can download on your device. Typical wireless providers put a cap of 50GB a month of downloads per household. The average cable customer consumes 400GB of data if they have TV service and 700GB if they don’t.
(Remember, if you don’t have TV, you stream it over the internet, and so consume more data.) Our internet data consumption is only moving in one direction — up — and at a rapid pace. This will further stress the finite 5G spectrum, whereas broadband’s upward bound is virtually unlimited.
5G wireless customers will pay as much as Charter cable customers but will get 10-15x less data and slower speeds. If each 5G customer used as much internet as broadband customers, wireless providers would either go broke (they’d have to be spending hundreds of billions of dollars on new spectrum) or download speeds would slow to a crawl.
Meanwhile, fixed wireless doesn’t work well in congested areas where there are obstructions — houses, trees, other buildings. Its impact on Charter will be limited.
Fiber to the home is the Cadillac of all available services. Here, the last mile is actually not fiber but ethernet cable. It is twice as fast as cable on download and much faster on upload. The downside of fiber is that rollout is expensive. Telecommunication technology has made exponential leaps over the last decades. However, the technology of digging ditches and getting permits at local county offices is stuck in the mid-20th century.
The history of this industry is full of stories of telecom providers promising to build out their fiber networks, doing it, and then stopping short of rollout, complaining that the rate of return on invested capital is below the cost of that capital. The most infamous example is Alphabet’s Google
GOOG,
thinking it could overcome the miserable economics of fiber and failing to do so, miserably. Things have only gotten worse since — nowadays the telecom industry is experiencing shortages of both labor and fiber.
The wireless industry has a mixed track record of making rational decisions. Verizon spent billions on Yahoo! and AOL and then wrote those billions off as a bad investment a few years later. AT&T has been by far the worst offender in this space. It recently unloaded TimeWarner (a horrible $100 billion acquisition from a few years ago) into a new company and said that it would focus on its core business of wireless and fiber. We expect AT&T to do what it does best: blow a few billions of shareholder capital and then, just like Verizon, Google and others, throw in the towel on fiber to the home.
Low interest rates are more forgiving of capital misallocation than high interest rates. Thus, we don’t expect AT&T’s adventure into the fiber business to last long. Most of AT&T’s effort is likely to focus on its DSL customers, whom it is at risk of losing to cable competitors. DSL has much lower speeds than cable or fiber.
The last competitive threat is low-orbit satellites. They are wonderful for difficult-to-reach places, but quality of service is impacted by weather (heavy clouds or rain). Satellite has slower download speeds than cable and faces similar spectrum limitations as wireless carriers. These providers will unlikely find widespread usage in urban areas and won’t be a significant threat to cable.
Charter’s revenue growth over the few quarters did slow down a few percentage points. But the slowdown was not caused by new competition but rather a lack of activity in the housing market, which resulted in lower industry churn. When people move from one house to another, they switch service providers. They usually drop DSL and choose cable. At some point the churn will pick up, but Charter stock is undervalued even if revenue growth remains where it is today.
Management matters
I’ve written many times on the importance of management — the softer side of investing. Over the last few years we have made a deliberate decision to invest in companies run by great management teams. Great management is not only important because of the value it creates, but because of the value it doesn’t destroy. Great managers make mistakes, but they’ll work day and night to fix them.
Finding undervalued, high-quality assets is difficult in this environment, and not buying them because the management did not pass the smell test requires incredible willpower and discipline.
Management is what attracted our firm to Charter. They have created a lot of value for shareholders, have conservatively managed the balance sheet, repurchased stock at attractive prices, and did not blow money on stupid acquisitions. Moreover, Charter management plays a long-term game. Charter’s broadband service is priced at $60, which is $15-20 cheaper than fiber- and cable competitors in other markets. They want to make it painfully uneconomical for new competitors (mainly fiber) to enter into their market. But as Charter’s CEO, Tom Rutledge, said, it’s the right thing to do for the customer.
Charter is a carnivore of its own shares. Over the past five years it bought back almost half of its shares outstanding, and will continue the practice. Charter is not shy about using debt, and it shouldn’t be — after all, it has stable recurring revenue and cash flow. It uses debt intelligently: debt maturities are spread out in small chunks into the future. If the debt market freezes and has a 2008 déjà vu moment, Charter will be able to pay off all of its debt maturities with cash on hand and annual free cash flow.
Charter is a perfect business for an inflationary environment: internet is a necessity, and Charter has pricing power. If it raises prices, it will not lose customers (its competitors are getting away with 20%-30% higher prices). A large chunk of its costs are fixed and thus will not rise with inflation. In fact, inflation improves Charter’s cost advantage against new entrants. The bulk of its fixed costs were spent in pre-inflationary dollars and won’t rise with inflation, while a new entrant has to spend newly inflated dollars to build out its network and is thus forced to charge much higher prices to recoup those inflated costs.
Charter should have about $45-$50 of immediate free cash flows per share. The stock currently trades at around $450 a share. The combination of slight revenue growth and share repurchases should lead to $70-$80 of free-cash-flows per share in three to four years. At a 13-17 price-to-free cash flow multiple we get a $900-$1,300 stock. At the current price we see essentially no downside, only upside, in Charter’s value. Let’s say the business only achieves $60 of free-cash-flows and the market decides to give it just a 10x multiple. It will then trade at $600. Heads we win ($900-1,300); tails we don’t lose ($600).
Ironically, the worst thing that could happen would be for the stock to go up quickly, which would reduce the amount of its own shares it would be able to buy and thus its future free-cash-flow per share and upside.
Vitaliy Katsenelson is CEO and chief investment officer at Investment Management Associates, which owns shares of Charter Communications for client portfolios. He is the author of “Active Value Investing: Making Money in Range-Bound Markets,” and “The Little Book of Sideways Markets.”
Here are links to more of Katsenelson’s views of the inflation landscape (read, listen) and how to invest in inflationary times (read, listen). For more of Katsenelson’s insights about investing, head to ContrarianEdge.com or listen to his podcast at Investor.FM.
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