This article is excerpted from a letter authored by Samer Hakoura, principal at Alphyn Capital Management, based in New York.
In April 2017, Liberty Media acquired General Communication, the largest cable provider in Alaska, for $2.8 billion and, in a complicated set of transactions, merged it with certain assets of its Liberty Interactive subsidiary. The combined GCI Liberty, owns approximately 8% of Charter Communications, the #2 cable company in the US with a $90 billion market capitalization, as well as its Alaskan cable business and stakes in a few smaller businesses such as Evite (the online card company, private) and Lending Tree (a 27% stake worth approximately $1 billion). The majority of the Charter holding is through yet another Liberty Media subsidiary, Liberty Broadband. Liberty Broadband is a tracking stock that owns 54 million shares of Charter plus some debt, and trades at a 12% discount to the value of its holding in Charter. GCI Liberty in turn trades at a “double discount” of approximately 19% to its assets (GCI Liberty has a market capitalization of approximately $6.4 billion and owns net assets worth almost $8 billion). GCI conducts opportunistic share buybacks, with a current repurchase authorization of approximately $494 million. Given the discount, these repurchases are highly accretive.
Conceptually, this investment fits into my recurring theme of buying advantaged businesses, under the control of a skilled capital allocator, bought with a margin of safety — due to a “double discount” to Charter in this case.
The thesis on Charter is well understood by investors, and has been repeated publicly by management for years. It is based on three components: attractive and highly defensible cable assets, management’s strategy to leverage these assets to drive both revenue and margin growth with a longer term mindset, and superior capital allocation that takes advantage of the predictable, recurring nature of subscription revenues to effect “leveraged buybacks.”
Cable companies at scale have highly defensible positions as their substantial wire line networks deliver not only traditional video, but also high capacity two-way data connectivity for fast broadband internet, and would be prohibitively expensive for competitors to replicate. This has typically resulted in local monopoly and duopoly situations over each network’s footprint (excluding Telco and satellite competitors with their relatively inferior offerings).
I view cable as a digital infrastructure play that is best positioned to deliver video and internet data to people’s homes. An analogy is how the railroads are irreplaceable assets that transformed the delivery of goods across the US and are currently, by far, the most cost effective way to transport goods over long distances. Whether the consumer wants traditional video, or is a cord cutter looking for over-the-top, or “skinny bundle” programming, content providers still need distribution to reach customers. On the subject of cord-cutting, evidence is that the mix of services needed to replace traditional pay-tv cost just as much in total, and that is before accounting for planned price increases by the streaming services. Moreover, with the ever-increasing cost of programming, selling broadband services are much higher margin than video packages to the cable companies.
Cable is well positioned to satisfy the ever-increasing demand for data to enable for immersive, low latency, high compute applications directly to people’s homes (think 8K video, gaming, virtual reality and Internet of Things). Cisco in its bi-annual forecast on global internet usage, predicted that Global IP traffic will increase nearly threefold from 2016 to 2021. Charter spent approximately $9 per home passed to upgrade to an all-digital 1Gbps speed network, and according to management the company has a relatively low-cost upgrade path to 10Gps symmetrical speeds. For comparison, Deloitte estimate it will cost mobile telephone companies $130 billion to $150 billion to roll out 5G.
Recognizing that cable is a scale game, CEO Tom Rutledge has adopted the “Charter playbook.” His goal has been to increase the overall number of customers by providing compelling, high-quality products combined in packages at prices that can’t easily be replicated by competitors. “As you penetrate a fixed infrastructure, your average cost against that fixed infrastructure on a per-customer basis goes down, so your margins go up by higher penetrations in the fixed asset.”
The company is coming off a heavy investment cycle. In 2016, Charter acquired Bright House Network and Time Warner Cable; it launched into a massive multi-year integration effort, bringing the three companies into a singular network, pricing strategy, and product strategy. This included labor and capital intensive projects such as combining 11 billing systems and service environments into one, and in-shoring customer service calls from 30% to 92% (with associated costs to build call centers and hire people). Concurrently, the company upgraded the network to all-digital, which meant shipping digital set-top boxes out to millions of customers, and took data speeds to 1Gbps over 750,000 miles of infrastructure (their DOCSIS 3.1 project). Lastly they rolled out a mobile offering supported by a Verizon MVNO throughout the footprint.
The faster digital network and improved customer service reduce churn, resulting in fewer activity-intensive functions such as customer service calls and technician visits, which in turn reduce operating costs. 40% of new customers can now self-install digital set-top boxes that are shipped to them, again eliminating technician visits, and increasing numbers of customers consume media over their own devices (whether Roku or Apple TV), eliminating set-top box costs altogether. All told, capital expenditure will drop from $9 billion to $7 billion in 2019.
The results of all the above are beginning to be reflected in the numbers: in Q2 2019, Charter increased year-over-year total customers by 1 million (4%), revenues by 4.5%, net income by 15%, and free cash flow by 37% (due to the aforementioned reduction in capital expenditure). The company still has plenty of runway for growth, with 52% homes passed penetration and “a completely built, completely paid-for network in front of 48% of homes that we pass or 24 million homes that we have no relationship with, and that’s our opportunity.”
To the third part of the thesis on capital allocation, in the words of John Malone, chairman of Liberty Media, Charter is a “clear, pure play, leveraged, free cash flow growth, buyback story.” The company has taken advantage of its stable cash flows to lever up and buy back shares. Since September 2016, the company has bought back 21% of its shares outstanding for $21.7 billion, at an average price of approximately $330 per share.
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