Patrick Brennan of Brennan Asset Management presented his investment thesis on Charter Communications (US: CHTR) and provided an update on Megacable (Mexico: MEGACPO) at Best Ideas 2023.
Thesis overview:
Investors’ perception of cable (and multiples they are willing to pay) has fluctuated wildly historically, despite the consistent operating results posted over time and throughout economic cycles. During 2022, sentiment turned dire and cable names sold off around the world. Amid the carnage, there appear to be multiple opportunities, including in Mexican cable name Megacable (MEGA) and US pure-play Charter Communications (CHTR).
Despite posting solid operating results throughout the year, MEGA shares sold off with other cable names during 2022. In December 2022, Grupo Televisa (TV) went public with its proposed offer to merge its cable operations with those of Megacable (MEGA). Under the proposed deal, MEGA would receive a roughly 20 percent premium for its EBITDA contribution and MEGA would receive a 14.8 billion special dividend. While MEGA has publicly noted that it is not for sale, Patrick believes a deal could still be consummated. While TV’s bid is certainly opportunistic, most MEGA minority shareholders support a deal as the combined company would (in addition to offering attractive synergies) likely be more liquid, trade at a higher valuation, and finally fix the inefficient capital structure at MEGA.
TV’s need for a deal is great. TV likely must upgrade at least 50 percent of its plant to fiber and the deal would cleverly allow TV to leverage MEGA’s balance sheet to fund this upgrade. MEGA has already upgraded (outside of the planned fiber rollout) 50 percent of its plant and has already started plans to upgrade half of the remaining 50 percent. Given the cheaper labor costs, there is no real DOCSIS 4.0 vs. Fiber debate – Mexico is heading towards fiber in large portions of the country. TV is particularly vulnerable as MEGA can offer a smaller premium to its base ARPU in TV territories and still come in at a discount to TV. Additionally, TV’s expansion into MEGA’s footprint is generally in places where MEGA has already upgraded and therefore TV is offering a “me too” product at same price as MEGA (and discount to TV base). As if this isn’t bad enough, American Movil (AMX) is talking about upgrading fiber in ~80-85 percent of its footprint over the next several years.
While MEGA is better positioned than TV absent a deal, MEGA could also struggle. US investors could rightfully conclude that the company is “uninvestable” if they had an opportunity to double share price and simply thumb sucked. Additionally, the IRRs on MEGA’s newbuild project could be much tougher to achieve if AMX achieves its targeted fiber upgrades.
A possible path forward is a higher premium for MEGA’s share of the combined company’s EBITDA and a larger special dividend for MEGA. If the combined company took net leverage to 2x from 1.5x (TV needs to contribute some debt to make this deal work), the special dividend to MEGA could be closer to 30 billion pesos and the combined ownership would be ~50/50. Combining the above assumptions with modest cost synergies would equate to ~110+ pesos in total value per share for MEGA assuming the combined company can ultimately trade for 6x post-synergy EBITDA.
MEGA’s company line on the deal (despite the popular press headlines of “not for sale”) is “we are not stupid” and MEGA CEO Enrique Yamuni (who would likely run the combined company) and the other four family owners are not necessarily aligned with the Bours family if Bours (who controls 42% of Megacable) tries a “take under.” MEGA has room to push TV, but it is certainly possible they overplay their hand or that Bours family just hits the self-destruct button and walks away. While a deal is far from guaranteed, there is reason to be cautiously optimistic that a transaction materializes.
After being considered “COVID winners” during 2020 and 2021, US cable names sold off during 2022 with CHTR down nearly 50 percent in 2022. Investor concerns centered around the following: increased broadband competition from fixed wireless and fiber competitors, increased capital expenditures associated with DOCSIS 4.0 upgrades/additional network expansion and higher interest costs associated with more leveraged balance sheets. Valuation multiples contracted throughout 2022 and CHTR shares sold off further in late December following an investment presentation. The selloff occurred despite the company announcing network investment costs below even more bullish analyst predictions.
Outsized broadband gains pulled forward by COVID were not sustainable and a slowdown from these levels was inevitable. Additionally, a substantial slowdown in moving activity has been the primary driver of lower gross additions according to cable companies’ management. That said, the overall cable environment has admittedly become more competitive. On the 5G front, mid band/low band 5G offerings have had better marketplace success than the first higher frequency offerings. That said, the sheer amount of data consumed by internet customers could overwhelm mobile networks which typically transport a fraction of the data consumed on fixed networks. Over 17x more traffic was consumed via fixed versus mobile networks in 2021, and the amount of data should continue rising over time, thus limiting the absolute number of fixed broadband subscribers. While 5G additions dominate recent cable commentary, several of these customers may ultimately switch to fixed broadband offerings over time.
Competing fiber offerings are a legitimate threat to cable. That said, Patrick also believes that the coming cable network upgrades (DOCSIS 4.0) can effectively neutralize the upstream speed differences currently touted by fiber companies. Additionally, fiber overbuilding has been a notoriously difficult business over time. While costs have come down, cable companies have effectively competed with fiber offerings for years. Furthermore, a higher interest rate environment will also be difficult for “micro builders,” as many of these smaller builds employ higher leverage when building new networks. Patrick also suspects that investors are underestimating cable’s potential in wireless, where cable companies offer sizeable discounts to incumbent carriers. Cable companies have posted solid mobile additions the last several quarters, but Charter only has ~8 percent market share relative to the number of homes passed. Reported EBITDA losses by cable companies mask the value of their wireless business and investors are likely incorrectly capitalizing these losses into current valuations. Incremental margins on wireless gains are currently ~36 percent and are poised to increase as more lines per household are added and as data is transferred to CBRS spectrum from Verizon’s network over the coming years.
At an estimated $100 per home passed, CHTR’s estimated network upgrade costs are projected to be lower than most previous forecasts. Additionally, CHTR believes Rural Digital Opportunity Fund (RDOF) buildouts offer mid-teen+ unleveraged IRR returns. While CHTR’s decision to accelerate spending on both buckets increases capital intensity over the medium-term, the spending also increases the long- term growth of the business. Patrick believes current subscriber forecasts do not give full credit for the likely gains from CHTR’s network expansion.
Finally, given CHTR’s ~14-year debt at ~4.9 percent interest rates (85 percent fixed, 95 percent matures beyond 2024), higher interest rates will only have a modest impact on medium term interest costs, even assuming additional debt to keep leverage near targeted levels (4-4.5x). Rumors of cable’s demise have been greatly exaggerated at various points over the past 30+ years and Patrick thinks this latest bout of pessimism provides a unique opportunity for the patient investor.
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About the instructor:
Patrick Brennan is the founder and portfolio manager of Brennan Asset Management, LLC (BAM), a Registered Investment Advisory firm based in Napa, CA, which utilizes a concentrated value investing strategy. Patrick has given presentations at multiple value investing conferences, including presentations to The New York Society of Security Analysts (NYSSA), The Nebraska Society of Securities Analysts and presentations on various names at the VALUEx Vail Conferences. Patrick co-authored an article on tracking stocks with Lawrence Cunningham for The Financial History Magazine and Patrick was featured in a write-up in The Private Investment Brief. Prior to founding Brennan Asset Management, Patrick managed portfolios and led research efforts at two value investing firms in California: Hutchinson Capital Management and RBO & Co.
Previously, Patrick worked at Mark Boyar & Company, where he led the firm’s research team and helped manage $800 million of assets across individual portfolios, institutional accounts and a mutual fund. Patrick also worked for six years in investment banking and equity research with Deutsche Bank, CIBC World Markets and William Blair & Company. Patrick graduated summa cum laude from the University of Notre Dame with a degree in economics and was inducted into Phi Beta Kappa. Patrick received the Chartered Financial Analyst (CFA) designation in 2002 and is a member of the CFA Institute (formerly AIMR). Patrick is originally from Omaha, Nebraska.
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