“It’s the law of nature. Big bubbles get bigger, small bubbles disappear — it’s surface tension, the law of physics; and in business it’s scale economics. It had to happen.”
For twenty-four years, from 1973 to 1996, Malone served as President and CEO of Tele-Communications Inc. (TCI). As one of the famed cable cowboys, Malone used TCI as platform for consolidating the fragmented cable industry and driving free cash flow through economies of scale and leveraged growth. Malone sold his interest in TCI to AT&T in 1999. For a period of time following the sale, Malone was out of the US cable industry but remained active outside the US.
Meanwhile, Charter (CHTR) built up through a spree of acquisitions in the 1990s the expansion accelerated after Paul Allen took control in 1998 and culminated in a $3.5 billion IPO at the height of the telecom boom in 1999. For many years thereafter, the company struggled with excessive debt levels and under-invested in capital expenditures and systems integration, producing customer dissatisfaction and subscriber losses. This ultimately led Charter to enter Chapter 11 bankruptcy proceedings in March 2009.
Charter emerged from bankruptcy on November 30, 2009. In December 2011, highly regarded Cablevision COO Tom Rutledge departed to lead Charter Communications. In May 2013, John Malone’s Liberty Media spent $2.6 billion and bought a 27.3 % stake in the company and got four board seats.
Charter is the nation’s fourth largest cable company. It is also a vehicle for John Malone to reassert himself in the US cable industry.
Malone has been remarkably upfront about his goals for Charter and how they align with his basic strategy. As he said in an interview soon after taking a position in Charter, “This is a unique opportunity to take this vehicle and grow it; through both superior marketing and promotion, in other words organic growth… which can be exceptionally strong for a number of years… and particularly the rate of growth of free cash flow can be very, very strong, which allows it to then access the leverage market in order to do roll-up transactions, particularly where there are horizontal synergies. So the old TCI formula, horizontal acquisitions, synergies, grow scale and then look to form consortia with other cable companies.” (emphasis added)
The Cable Industry
Cable companies provide video, broadband and telephone services to residential and commercial customers on a monthly subscription basis. In addition to selling services separately, companies offer bundled services at a single price. The customers may subscribe for a bundle of two services (“double play”) or three services (“triple play”). Customers who subscribe to a bundle generally receive a discount from the price of buying each of these services separately, as well as the convenience of receiving multiple services from a single provider via a single connection.
The companies generally carry cable networks pursuant to written programming contracts, which continue for a fixed period of time, usually from 3-5 years and are subject to negotiated renewal. Such license agreements often include volume discounts.
Over the past decade, the cable industry has consolidated into six major players that control 85% of the U.S. market: Comcast, TimeWarner Cable (TWC), Cox Communications, Charter, Cablevision Systems and Bright House Networks. There are only ten operators of any size left in the US with that set to drop to 8 if the proposed acquisitions of Bright House and TWC is approved. (See Figure 1.)
Firgure 1, Largest Cable Companies by Revenue, 2014
Source: SEC filings for all companies except Cox and Bright House. Cox data via company website. Bright House data via Charter merger proxy. Note: Revenue for CMCSA and Cox is cable segment only.
Why Is Cable An Attractive Business?
- Predictable Cash Flows – As discussed in greater detail here, the subscription business model produces recurring and predictable cash flows
- High Economies of Scale – Once the high fixed costs of deploying the cable are borne, it costs very little to add each new customer. There are further economies of scale in procurement, marketing, billing and R&D.
- High Switching Costs – Cable companies create disincentives to switching providers by imposing termination fees and bureaucratic roadblocks. Monthly automated payments also encourage inertia.
- High Margins – OIBDA margins are in the high 30s for most scale players (See Figure 2)
Figure 2, OIBDA Margins in the US Cable Industry, 2010-2014
- High Returns on Invested Capital – All of the major companies earned very healthy returns on invested capital. Such returns are unusually high for a capital intensive industry. This is primarily driven by negative working capital which partially offset the huge investment in PP&E. Negative working capital is a typical characteristic of subscription based business which collects from customers before they have to pay suppliers. In this way, suppliers are effectively loaning cable companies on an interest-free basis. This is a much cheaper source of funding than interest-bearing debt or equity.
- Limited competition and high barriers to entry – The high cost of laying cable makes it impractical to create a competing network. As a result, for the average home, a cable operator owns the only data connection into the home with enough capacity to provide that home with high definition video, high speed internet and voice services simultaneously. Because the cable companies are geographically separate in all but a few areas of the country, they compete only with the telcos — Verizon, AT&T CenturyLink, etc. — as opposed to with each other.
Regulatory, Financial and Competitive Challenges Facing the Cable Industry
Despite its long history of success, there are some clouds forming on the horizon. The principal challenges to the cable industry are: (1) declining video revenues, (2) potential broadband competition, (3) increased regulation, and (4) high capital expenditure requirements.
Declining Video Revenues
Much attention has been devoted to the decline of video subscriptions. The concern is certainly real. The Pay-TV business has been hit by two separate but related forces.
The first force is rising programming expenses. In a cable television system, the largest category of cost (~35-40% of total operating expenses) is the fees paid to programmers (VIAB, DIS, DISCA, etc.). (See Figure 3.) These programming costs have risen much faster than the rate of inflation in recent years.
Figure 3, Video Programming Cost as Percentage of Video Revenue, 2010-2014
At the same time, the number of video subscribers is declining. This decline has largely been driven by the rise of “over-the-top” (OTT) video programming. (See Figure 4) This state of affairs was discussed at length here.
Source: Cable One Investor Presentation
These issues are discussed in more detail here.
The State of Broadband Competition
As video revenue declines, the cable companies are betting that high margin broadband services will more than make up the difference. Is this a risky bet considering the number of actual and potential competitors?
The Internet service provider (ISP) industry is part of a larger ecosystem that produces, transmits, and consumes information via the Internet. Consumers obtain access to the Internet by subscribing to ISPs that connect consumers’ computers via “last mile” connections owned by ISPs. Cable companies compete in the area depicted in the blue oval of Figure 5.
Figure 5, Broadband Industry Structure
“Broadband” is an umbrella term that covers all of the always-on types of internet connections: cable, satellite, DSL, and fiber optic service (a.k.a., FiOS). These are the high-speed internet services that keep you constantly connected. The main categories of broadband ISPs include:
- Landline telephone companies, which provide broadband service primarily using two different technologies. The most widely available of the technologies is digital subscriber line (DSL), which was available to about 89% of the population in 2013 but subscribed to by only 21% of households. The other technology, optical fiber, is much faster than DSL but very costly to install. It is available to 24% of the population but only 8% of households had subscriptions in 2013.
- Cable television companies provided Internet access to 43% of households, although it was available to 88% of the population. Cable ISPs use several different technologies, including copper co-axial lines (increasingly using software to increase speeds) and optical fiber.
- Mobile wireless companies have increased the speed of the data services they provide. However, their ability to substitute for wireline ISPs is limited by congestion, transmission sensitivity to obstacles between the user and the cell tower, and constraints on the availability of the electromagnetic spectrum. These companies are sometimes owned by telephone companies that also offer wireline ISP services. Wireless broadband service (including fixed terrestrial service) was available to 99% of the population, while 56% of adults own a smartphone
High Levels of Concentration
“Broadband competition” is largely a contradiction in terms.  The industry is highly concentrated. The five largest wired ISP companies serve over 75%of the market. Within the wired category, cable companies currently have a 60% market share and are adding subscribers at an accelerating rate. (See Figure 6.) In 2014, Cable companies added broadband customers at almost 8 times the rate of their biggest competitors, the telcos. Further the cable companies largely do not compete with each other. Cable companies are primarily clustered into regional monopolies.
Figure 6, Broadband Market Shares
Why is no one able to compete with the cable companies? Is the competitive advantage enjoyed by the cable companies sustainable?
Beginning in 2004, Verizon spent $23 billion upgrading much of its network to the faster FiOS network. By March 2010, Verizon had had enough and essentially conceded to cable. Verison made it known at that time that it would no longer seek to expand FiOS to any new cities. As of 2015, the FiOS network reaches just 19 million passings and the company is not interested in any further spending on the network. As the CFO told investors earlier this year, “I have been pretty consistent with this in the fact that we will spend more CapEx in the Wireless side and we will continue to curtail on the side. Some of that is because we are getting to the end of our committed build around FiOS, penetration is getting higher.”
Similarly, AT&T used fiber optic cables to boost its speed and better compete against cable. However, AT&T employed a hybrid approach whereby the company replaced much its copper wiring with fiber optic cable but kept copper wire in place for the “last mile” connection to the consumer’s home.
What went wrong? Both Verizon and AT&T are stuck with the enormous up-front costs of building a second network (this time, a fiber network) to homes, replacing their old copper lines. To build FiOS, Verizon has to roll in the trucks, rip up the streets, and put in super-fast fiber optic cable. This is an extraordinarily expensive process. It costs Verizon nearly $4000 per subscriber to install FiOS; it costs AT&T about $2100 per subscriber to install U-verse. Verizon and AT&T were never able to generate a reasonable return on these investments.
AT&T didn’t try to build fiber to homes. Its U-verse service uses copper lines in neighborhoods plus fiber to those neighborhoods. As a result, AT&T’s U-verse service can’t compete effectively with cable’s DOCSIS 3.0 data rates; AT&T avoided the cost burden of bringing fiber all the way to homes, but sacrificed speed and competitiveness.
Cable operators responded to the deployment of fiber networks by also offering very high-speed broadband services, including by rolling out DOCSIS 3.0 technology. Because this deployment only required upgrades to the cable operators’ existing plant, as compared to the relatively higher expense of constructing new fiber facilities, these services quickly became more widely available than fiber services. These next-generation cable modem services currently reach over 85 percent of the U.S. population. It was much easier for cable companies to recoup their investment.
The bottom-line: even after billions of dollars of investments by telcos, cable can deliver faster speeds to more households. Cable can deliver speeds of 50 Mbps or better to 80% of US homes. Telcos can deliver those speeds to only about 30% of homes today.
What about the threat of wireless competition?
Another possible competitor to cable is wireless. o survive the hemorrhaging of their wireline businesses, Verizon and AT&T are emphasizing wireless, where margins are greater and where nearly all their operating income is made. Four national wireless carriers, including Verizon, AT&T, Sprint and T-Mobile, provide voice service and Internet access to their wireless customers.
However, wireless cannot match the speeds cable can produce. Wireless can only hope to offer the same capacity if there are towers connected to fiber-lines everywhere – and that is a major capital expenditures that the telcos do not want to incur. Malone himself scoffed at the idea that wireless could compete with cable back in May 2011: “The threat of wireless broadband taking away high-speed connectivity is way overblown. Thhere is just not enough bandwidth on the wireless side to substantially damage cable’s unique ability to deliver very high speed connectivity.”
The following chart examines the costs to a customer if they just watched the ‘average’ monthly viewing on Netflix, or what it would cost if you were to watch the average amount of cable TV viewing.
Figure 7, Relative Costs of Cable & Wireless
Further, the two groups, wired and wireless, seem to have no interest in damaging direct competition and see benefit in cooperating. Nothing shows the existence of this cooperation reality more clearly than the co-marketing, co-development agreement among Verizon Wireless and cable giants Comcast and Time Warner Cable (among others) that was approved by the FCC in 2012. Verizon Wireless, Comcast, Time Warner, Cox, and Bright House Networks reached an agreement on a deal that would:
- Allow Verizon Wireless and the four cable companies to sell each others’ products, allowing them to offer a “quadruple play” of video, internet, voice, and wireless service and eliminating incentives for Verizon to invest in its all-fiber FiOS network
- Form a joint operating entity to develop proprietary technology that will give them a lock on wired and wireless video and internet access
- Transfer $3.9 billion in wireless spectrum from the cable companies to Verizon Wireless
Since then, the convergence of wireless and wired broadband companies has continued apace. Cable companies are moving toward the mobile sector by investing in public WiFi hotspots. (See Figure 8) If combined with wholesale access to telecom networks, this could eventually enable cable companies to offer “quadruple play” services that combine data, video, landline and mobile services. The quad play concept is already fairly advanced in Europe. Another Malone property, Liberty Global, has deployed 6 million WiFi access points across Europe and is on track to hit over 10 million by year end.
Figure 8, Growth in Network of Out-of-Home Cable Wi-Fi Hotspots
In a nutshell, cable sells a service consumers can’t live without, has limited regulatory oversight, minimal competition and has a cooperative industry structure. Given this background, it seems reasonable to conclude that cable companies generally will benefit from increasing consumer demand for greater internet speed and capacity.
High Capex Requirements
One downside to the cable business is high capex requirements. Since 1996, the cable industry has invested nearly $230 billion in building networks and it continues to invest more than $13 billion more each year in maintenance and upgrades. (See Figure 9) Still as discussed above, the costs are much lower than any potential competitors would have to bear and increasing consolidation is reducing the capex per subscriber for the bigger companies.
Figure 9, Cable Capital Expenditures, 1996-2014
Title II & Other Regulatory Threats
For an industry that is very close to being a monopoly, the cable companies are subject to extremely light regulation. And some of the regulations actually increase barriers to entry. For example, local governments and public utilities have created unnecessarily expensive and difficult pre-deployment barriers. Before building out new networks, Internet Service Providers (ISPs) must negotiate with local governments for access to publicly owned “rights of way” so they can place their wires above and below both public and private property. ISPs also need “pole attachment” contracts with public utilities so they can rent space on utility poles for above-ground wires, or in ducts and conduits for wires laid underground.
Nevertheless, a recent development spooked investors. In February 2015, the FCC voted to classify broadband as a utility under Title II of the Communications Act. This classification allows the FCC to block any attempts any attempts by ISPs to discriminate against certain content providers. That is, ISPs would be prohibited from using mechanisms like blocking, throttling or paid prioritization (“fast laning”) to gain fees from broadband hogs like Netflix. It also carries with it at least the specter of rate regulation. But the FCC says it has no intention to regulate rates.
This move by the FCC was seen as a blow to the cable industry, and negatively impacted cable company shares. Despite the headlines, this should not be a major issue for ISPs like Charter. Charter has essentially operated under net neutrality already, without receiving meaningful “gating” fees from content providers. The likely outcome is that consumers will foot the bill for higher broadband usage rather than the content companies. Malone predicts that “we will end up with some kind of volume-based billing where customers essentially in some form or other pay for the capacity that they utilize.”
John Malone’s Cable Strategy
Malone’s strategy for running a cable company has been remarkably consistent over the years. It is based on five central tenets: (1) the benefits of scale, (2) an emphasis on free cash flow over accounting earnings, (3) financing through cheap debt, (4) opportunistic M&A, (5) industry cooperation and (6) tax minimization.
Whether at TCI, Liberty Global or Charter, he has believed that everything good in the cable industry flows from scale. “We became very aggressive in consolidating the cable industry because I saw from the beginning that scale economics was going to determine who was going to survive and who wasn’t.”
Scale drives multiple benefits.
First and foremost, scale creates improved margins through economies of scale. Cable is a business with high fixed costs and low variable costs. As the company adds more customers, fixed costs per customer drops and profitability goes up. Larger cable operators are able to negotiate volume discounts and to spread fixed costs over more customers. As fixed costs are a large component of cable company operating expenses, the largest players have powerful scale advantages.
Scale also allows for increased investment in improving the user experience. Because a larger company can spread R&D costs across a larger customer base, the per customer cost of R&D drops dramatically. Further, these investments should result in increasing FCF as customer churn declines and repair/maintenance (“truck rolls”) goes down. Malone has always shown a willingness to penalize short-term earnings/FCF to improve customers’ experiences and defend long-term competitive positions. At scale, product innovation increases FCF because new services can be done at a profit. (A third option, of course, is that Malone is throwing good money after bad.)
Scale also creates greater leverage with suppliers and the ability to extract volume discounts. This includes everyone from the cable networks to marketing and promotion to equipment manufacturers.
Next, as scale drives FCF up and assets accumulate, the company can lock in lower borrowing rates. Because of the predictability of cash flows, banks are comfortable with cable companies maintaining a debt to EBITDA ratio of 4.5:1.
The company can then use cheap debt to buy up other cable systems and drive yet more scale. The centerpiece of the Malone strategy has always been a disciplined and opportunistic approach to acquisitions. Malone’s playbook since the 1980s has been to use cheap debt to make acquisitions and immediately reap the benefits of economies of scale. Back then, Malone found he could buy rural and suburban cable systems at market prices but scale gave TCI immediate benefits in terms of costs, including programming, equipment, payroll, etc. M&A should be immediately accretive due to scale/synergies. The companies with economies of scale can pay more for a cable company than other bidders and still earn the same or better returns.
An additional benefit of increased leverage is that the interest expense minimizes tax expense.
A longer term benefit of M&A is increased consolidation and rationalization which leads to industry cooperation. That’s a big reason why Malone wants to see mergers between cable operators. “Fewer rational players generally work better together than more,” he says. Back in the 1980s, he states, “we were able to organize the industry on a broad set of joint ventures….We created things like Discovery and Black Entertainment Television and Telemundo” and supported Ted Turner. “That can be done again.”
The Malone Strategy at Work at Charter
Under the prior management, Charter was a diamond in the rough – a neglected asset with plenty of untapped potential for growth. Under Rutledge’s leadership, Charter has accelerated its investment in upgrading its cable systems as well as improving its customer service. Rutledge describes the state of affairs as follows: “Charter was neglected and went bankrupt. And we had to work out all of the deferred spending that had occurred in Charter in order to get moving. So we walked out the plant and — literally all 200,000 miles — and put a list together of all the things that hadn’t been done, and did them.” Charter’s results still reflects the legacy impact of heavy customer losses in the years surrounding the company’s bankruptcy and the company’s inferior product until the recent upgrades.
Since 2011, penetration of the company’s existing customer base has greatly increased. Unlike CABO, Charter emphasizes triple play subscriptions even with the risk of cross-subsidies. Charter’s total PSUs have increased at a 23% CAGR over the past 5 years even though passings only increased at a 9% clip. Total customers have also increase but at a lower rate, 19%.
Similarly, capex spending has jumped dramatically, almost doubling over the past 5 years. Charter’s capex as a percentage of revenue was much higher than its peers. (See Figure 10.) Thus far, at Charter these investments have not resulted in increased profitability. Revenue as increased at just 7% CAGR over the past 5 years and OIBDA at just a 5% CAGR. This suggests that (1) the prior regime woefully under-invested in customer service and technology and Rutledge is forced to play catch up and (2) Charter is operating below optimal scale.
Figure 10, Cable Capex as Percentage of Revenue, 2010-2014
The TWC/BHN Acquisitions
On May 26, 2015, Charter Communications announced its intention to merge with TimeWarner Cable (TWC) and acquire Bright House Networks (BHN). Malone set his sights on TWC soon after taking his position in CHTR and it seems to finally have worked out. The deal is quite complex but equates to approximately $89 billion (see Figure 11). I believe that this deal is transformational not only for Charter but for the US cable industry as a whole.
Impact on Video
The transactions will nearly double Charter’s owned or managed subscriber count and position Charter as the dominant #2 cable operator in the U.S. with over 8 million video customers. It should also be noted that, assuming completion of the AT&T/DirecTV transaction, Charter will become the #4 overall MVPD in the U.S. At this size, New Charter is comparable in scale to Comcast (See Figure 12.) This gives Malone a good position from which to launch his counter-offensive against the cable networks.
Figure 12, New Charter v. Comcast
First, cable goes from an industry that looked look like “Snow White and the Seven Dwarves,” to an industry with two mega-players. With three behemoths, New Charter, AT&T/DirecTV and Comcast combining to form a cozy oligopoly and a united negotiating front, the programmers can no longer pursue a divide and conquer strategy and push through annual fee increases.
Second, industry consolidation also increases the likelihood that the remaining players cooperate on initiatives like TV Everywhere. Malone has stated repeatedly that he believe that the failure to come up with an attractive TV Everywhere, or random access, service was a huge mistake by the cable companies. It provided an opening that Netflix, Hulu and others exploited. In the future, he hopes that the cable industry can work on a unified approach to TV Everywhere to solve this problem.
Third, the rise of OTT should scare programmers and give the cable companies greatly increased leverage. “As a cable provider, I look at — the content companies have pricing power in the cable business, which is an issue for consumers and consumers are being priced out of cable television, because the bundle is big and it’s expensive. And I’d like to have more control over that, more flexibility in packaging. And I don’t have it because of the model we’re in where I don’t have as much to a degree as that one and to some extent, over the top actually helps that to the extent that there’s an over-the-top provider that’s a viable substitution, it moderates what content companies might want to do.”
Impact on Broadband
Charter management is betting much more heavily on broadband than video. “New Charter’s future success depends far more on its broadband business than its video business, based on broadband’s higher gross margin percentages and growth trajectory. . . . “
One likely impact of the deal is a greater push towards metered broadband. Metered broadband is a tiered pricing model where user fees are based on the amount of data consumed rather than speed as is done now. In this way, metered broadband is similar to the pricing methodology employed by the wireless companies. Usage-based pricing has been a hard sell in the wireline broadband world. But consolidation could allow the industry to come together on metered broadband.
A change in broadband pricing strategy could offer incremental upside for Charter and the cable industry over the long term.
Impact on Wireless
New Charter will build on the progress of Time Warner Cable and Bright House Networks in establishing widespread, consumer-friendly out-of-home WiFi networks. TWC currently has 100,000 public hotspots and BHN has 45,000. This will enable New Charter to better meet the competitive challenge of wireless broadband—a challenge the companies perceive to be among their most significant going forward. New Charter plans to deploy at least 300,000 new out-of-home WiFi access points across our footprint within four years. This will expand the existing WiFi network to additional areas heavily trafficked by consumers. New Charter also will evaluate the merits of leveraging in-home routers as public WiFi access points and will have greater resources to devote to such a strategy.
“The Bet You Make”
Will Charter once again end up a company with an unsustainable debt load along with heavy capex spending, tiny margins, and low EBIT and sales growth? Or will the promised synergies and economies of scale kick in and Malone will look like a genius once again?
Charter’s acquisition of TWC and Bright House as well as their continuing high level of capex, represent an enormous bet on the future of cable. An investment in CHTR takes a leap of faith that in the future that capex will come down and the company will generate significant FCF and returns on capital. Given the track record of the principals, this seems like a reasonable bet. Further, Charter believe that the future for cable is broadband services. “We think that demand for those services will be there,” Malone said. “That’s the bet that you basically make when you invest in U.S. cable right now.” Charter simply isn’t ready to completely turns its back on video, particularly as they see consolidation, unbundling and OTT as increasing their negotiating leverage.
The adjusted enterprise value of New Charter after deducting the value of tax assets and non-cable equity holdings is $117 billion (see Figure 13).
Under my base case analysis, this yields an EBITDA/EV ratio for 2016 of 8.14.
This is based on revenue, expense and capex per the Charter merger proxy plus run-rate synergies of $800 million per year as per Charter management.
This valuation seems quite reasonable. I assume the stock is somewhat depressed due to the risk of the acquisition not closing. Merger arbitrage is outside my circle of competence but the likelihood of regulators vetoing the deal seems pretty low and opposition is pretty muted compared to the Comcast/TWC deal.
Further, from a profitability perspective, Charter also has plenty of room for expansion. Charter’s adjusted OIBDA margins of 34%-35% are well below large cable company peer averages of closer to 40%. In large part, we believe this reflects Charter’s high expense to improve performance as it emerged from bankruptcy. Charter’s costs should moderate further going forward. Margins should also improve over time due to the shift toward higher margin Internet services and away from video and price increases.
If New Charter can get to Comcast’s EBITDA margin of 41%, the multiple drops even more. This is not an altogether unreasonable assumption as the two companies will be quite comparable in size (See Figure X) and given the short-term drags on Old Charter’s business.
The best case scenario yields an EV/EBITDA ratio of 7.92 for 2016.
Full projections can be viewed here.
Contact us! I am available for project work. PunchCardBlog@gmail.com
 LMCA’s interest in CHTR and other assets were later spun off into a separate company, Liberty Broadband (LBDRA).
 Google is also a competitor but there subscription numbers do not amount to even a rounding error.
 When analyzing cable industry competition, I am reminded of a comment by PayPal founder and venture capitalist Peter Thiel: “Monopolists lie to protect themselves. They know that bragging about their great monopoly invites being audited, scrutinized and attacked. Since they very much want their monopoly profits to continue unmolested, they tend to do whatever they can to conceal their monopoly—usually by exaggerating the power of their (nonexistent) competition.”
 Interestingly, to get around this problem, Google is pioneering a “demand aggregation” or “build to demand” approach. Google’s selective approach puts their costs 20% below Verizon’s. But, to-date, Google Fiber isn’t even a rounding error in broadband market share.
 Penetration is defined as total customers divided by total passings.