Part 3 – Lesson 14

Overview


Over the course of the Part 3 lessons, we have drafted various parts of our investment write-up for CHTR.  In this lesson, we will tie everything together and present below our complete CHTR investment write-up.  For a refresher on what goes into a write-up, refer to Part 3, Lesson 2.  We believe it is important to always create a write-up (even if very basic) for every position in your portfolio.  It helps an investor to stick to a process, stay disciplined, and avoid mistakes.

Charter (CHTR) – Full Investment Write-up


DISCLAIMER: THE BELOW WRITE-UP IS PROVIDED FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND SHOULD NOT BE CONSTRUED AS A RECOMMENDATION TO PURCHASE ANY SECURITY. 

Charter (CHTR)
View: Long
Price Target: $448
Date: August 2018

Background

Charter (CHTR) is the second largest cable company in the United States, after Comcast.  CHTR offers video, data, and voice services to 26mm consumers across 41 states.  After a period of over-indebtedness, CHTR emerged from bankruptcy in 2009, and Tom Rutledge (formerly the COO of Cablevision) was appointed CEO of CHTR in 2012.

Shortly after Rutledge’s appointment as CEO, Liberty Media bought a significant minority stake in CHTR around $100 per share.  After Comcast failed to purchase Time Warner Cable, CHTR stepped in and announced a merger with Time Warner Cable and Bright House Networks in 2016, catapulting CHTR to the second largest cable company in the US.

Following the completion of the merger, CHTR management has been focused on integrating its acquisitions by upgrading all the acquired networks, improving customer service, and moving over acquired customers onto its simple CHTR pricing and packaging.  CHTR stock performed well through the end of 2017 amidst positive earnings results and a flurry of acquisition rumors that several companies including Softbank and Verizon wanted to buy CHTR.

Investment Thesis / Divergent View

CHTR stock has struggled in the first half of 2018 due to a few worse than expected quarterly earnings reports, where pay TV and broadband subscriber additions missed expectations.  With investors already nervous about consumers cancelling their cable TV subscriptions to stream video content online, already poor investor sentiment worsened as investor fears appeared to be confirmed by recent results.

We believe the bear case around consumers going over the top has been fully priced into the stock, providing investors an opportunity to buy CHTR stock at an attractive valuation.  The CHTR long thesis is built around these key elements:

  1. Broadband adds should improve – The recent weakness in broadband adds was not due to a worsening in the fundamentals of CHTR. Instead, it was because CHTR’s IT system had mistakenly approved low credit quality consumers, which ultimately resulted in elevated churn as these consumers rolled off.  Although management explained this issue on the 1Q earnings call, investors are in a ‘sell now, ask questions later’ mindset.  Additionally, when CHTR has made cable acquisitions historically, the improvement in broadband results has not been linear.  The integration of Time Warner cable will ultimately lead to sustainably better net adds, but management has always communicated that some quarters will be bumpy as the company moves legacy Time Warner subscribers onto CHTR’s new pricing and packaging.
  2. Video margins are low – Investors are very concerned about declining video subscribers. However, margins on the video product are very low due to increased distributions costs in recent years.  CHTR’s cash flows and growth are predominantly driven by broadband, not video.
  3. CHTR’s broadband is a must-have product and the best in the market – Broadband has become a must-have product for consumers. Even if consumers are cancelling their pay TV subscription to watch video online, consumers must still have a robust broadband connection.  Broadband connectivity has become a non-discretionary purchase for most consumers.  Additionally, CHTR’s broadband product is the fastest in the market, giving CHTR tremendous pricing power for their broadband.
  4. Capex is declining – As CHTR’s network goes all digital and as more subscribers take broadband only, the capex associated with cable boxes is declining. The lower capex will boost free cash flow over time.
  5. Valuation is attractive – CHTR stock is trading at roughly 14x FCF/share for FCF that will grow 15-20% per year for the next few years.
  6. CHTR management is the best in the industry – Tom Rutledge and the Liberty Media management team are widely regarded as being some of the best in the telecom and media sector.

Valuation

Timeline and Catalysts

We believe CHTR is likely to reach its $448 price target by the end of 2019, which is approximately 16 months from now.  Since CHTR is expected to grow FCF/share at 20%+ for many years, it is possible that CHTR will remain an attractive long investment even beyond the initial investment horizon.

During this time period, we expect CHTR stock will move higher based on the following catalysts:

  1. Earnings reports – the primary catalyst will be the upcoming earnings reports, which should show ongoing momentum in broadband net additions as CHTR completes its integration of the Time Warner cable acquisition. Additionally, we expect investors will not be able to ignore the 20%+ FCF/share growth despite video subscriber losses.  Future earnings reports should demonstrate the earnings power of CHTR driven by broadband additions.
  2. Investor presentations – ongoing management communication to investors should build comfort in the long-term cash flow trajectory.
  3. Stock buyback – we expect CHTR to repurchase a significant percentage of their outstanding shares every year, which should provide a positive tailwind to the stock price and underlying FCF/share.
  4. Acquisition – CHTR has repeatedly been the subject of acquisition rumors. In the fall of 2017, multiple companies including Verizon, Softbank, and Altice all expressed interest in acquiring CHTR at a significant premium.  The financial press reported that Verizon was interested in acquiring CHTR for $400 while Softbank was interested in acquiring CHTR for $540.  CHTR management rebuffed these acquisition offers as they believe the acquisition offers undervalued the long-term potential of the business.

Risks

  1. Increased competition from wireless providers – CHTR is facing potential new entrants into the broadband space as wireless providers (Verizon, AT&T, T-Mobile) build out their 5G networks. Verizon intends to offer fixed wireless 5G internet service, which Verizon believes will provide similar or better speed and throughput vs. fixed broadband (cable).  While we certainly view fixed wireless 5G broadband as an incremental risk, we believe that 1) fixed infrastructure such as cable is more likely to provide faster and more reliable service than wireless and 2) the economics for over-building cable networks with fixed wireless may prove to be uneconomic.  For example, Verizon tried to over-build cable in the mid-2000s with FiOS (and AT&T tried to overbuild cable with U-verse), but ultimately gave up on these efforts because the cost of building new fiber proved to be uneconomic.  It is not yet clear whether fixed 5G broadband can be implemented cost effectively.

  2. Long-term capex needs are higher than anticipated – One of the tenets of the bull case for CHTR is that capex needs will come down over time, particularly as cable box spending is reduced or eliminated. There is risk that cable box spending may persist longer than investors currently expect, or increased network capex needs may arise due to increased competition or unanticipated growth in data consumption (although growth in data consumption would ultimately be positive as consumers place greater value on their broadband connection).

  3. Consumer preferences for higher internet speeds subsides – Today, the greatest use of data over fixed networks is video. If consumption of streaming video slows, CHTR may lose some pricing power on their broadband product.

  4. Higher interest rates – CHTR is a highly leveraged company (4.5x EBITDA), so higher interest rates may place pressure on the company’s interest expense. We believe this risk is manageable over time as CHTR can use cash flow to paydown debt.

  5. Loss of Tom Rutledge as CEO or Liberty Media as an investor – Tom Rutledge is considered one of the best CEOs in the telecom and media sector and is credited with implementing the turnaround and integration strategy for their Time Warner Cable integration. Additionally, Liberty Media (CHTR’s largest shareholder) is considered one of the best telecom and media investors in the industry.  A loss of either of these parties will likely hurt investor confidence in the company.