“In nature and in business, specialization is key. Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people specialize in the business world – and get very good because they specialize – frequently find good economics that they wouldn’t get any other way. . .”
On November 13, 2014, Graham Holdings Company (GHC) announced plans to spin off its cable subsidiary, Cable One (CABO). On May 26, 2015, Charter Communications announced its intention to merge with TimeWarner Cable (TWC) and acquire Bright House Networks (BHN).
What did these announcements have in common other than the obvious link to the cable industry? Some prominent figures in the value investing community were involved in both announcements. John Malone’s Liberty Broadband owns 26% of Charter. Donald Graham owns 4% of CABO and a majority interest of GHC. A third CEO featured in The Outsiders, Warren Buffett owns 5% of Charter and 2.2% of GHC through Berkshire Hathaway. Further, value investors Tom Gayner and Wally Weitz sit on the CABO board of directors.
Beyond that, the two companies have little in common. Once the dust settles, New Charter will be a behemoth with 24 million customers and revenue of $36 billion. CABO has just 687,000 customers and revenue of $814 million – barely 2% of the size of New Charter.
Similarly, Charter and Cable One present two very different visions of the cable industry. Charter’s strategy is based on scale advantages and aggressive growth through acquisition. CABO’s strategy, following Munger’s vision above, is based on a heightened focus on its unique customer segment and disciplined capital allocation. Which company is more attractive for investors? And what can the contrast between these two companies tell us about the industry? Is cable an industry where specialization leads to good economics? Or, is it an industry where scale drives success?
Cable ONE, is a collection of small market cable systems focused on less competitive rural areas in the South and the West. This segment of cable customers has lower household income and higher sensitivity to price than other segments. CABO is the tenth largest cable system in the US based on 2014 revenue and customers.
Despite being a sub-scale rural cable system, CABO believes it can still generate steady cash flows and good returns on capital. (See Figure 1.) To achieve this, CABO rejects the Malone strategy based on massive economies of scale. Given its customers base, it makes no sense for CABO to pursue the same strategy as Charter.
In its relentless focus on a niche market (rural broadband), CABO reminds me of a Michael Porter case study, Carmike Cinemas (CKEC). Porter describes Carmike’s approach in his seminal article “What is Strategy?”:
Carmike Cinemas, for example, operates movie theaters exclusively in cities and towns with populations under 200,000. How does Carmike make money in markets that are not only small but also won’t support big-city ticket prices? It does so through a set of activities that results in a lean cost structure. Carmike’s small-town customers can be served through standardized, low-cost theater complexes requiring fewer screens and less sophisticated projection technology than big-city theaters. The company’s proprietary information system and management process eliminate the need for local administrative staff beyond a single theater manager.
Carmike also reaps advantages from centralized purchasing, lower rent and payroll costs (because of its locations), and rock-bottom corporate overhead of 2% (the industry average is 5%). Operating in small communities also allows Carmike to practice a highly personal form of marketing in which the theater manager knows patrons and promotes attendance through personal contacts. By being the dominant if not the only theater in its markets-the main competition is often the high school football team-Carmike is also able to get its pick of films and negotiate better terms with distributors.
Figure 1, More Than One Way To Skin a Cat, Returns on Invested Capital in the US Cable Industry, 2014
Like Carmike, CABO’s contrarian strategy is built around the unique circumstances of its customer base. It has made the difficult trade-offs that constitute real strategy rather than trying to be all things to all people.
An Aggressive Turn Away From Video
First and foremost, CABO made the difficult decision to de-emphasize video and voice services. While data is surpassing voice and video as a profit source for all cable companies, CABO alone is willing to raise prices and let the chips fall where they may. Fundamentally, CABO does not believe traditional pay-tv can be profitable. (See Figure 2.) Programming and retransmission costs simply chew up any profit. Therefore, any attempt to maintain a video offering with the current economics is a misguided attempt to grab market share at the expense of profitability. Even it made sense to offer video as a loss leader in the past, it makes no sense now as more and more homes are going broadband only. Put simply, CABO has “declined to cross-subsidize our video business with cash flow from our higher growth, higher margin products. . . .”
Source: Cable One Investor Presentation
Accordingly, the number of video customers dropped by 25% from 2012 to 2014. The number of more profitable HSD subscribers has grown over this period, albeit at a slower pace. Opting to consciously shed customers puts CABO far outside the cable industry mainstream. As the company stated: “While this strategy runs contrary to conventional wisdom in the cable industry, which puts heavy emphasis on video customer counts and maximizing the number of PSUs per customer by bundling services, we believe it best positions us for long-term success.”
CABO feels strongly enough about this pivot away from video that it can play hardball with programmers pushing through price increases and even walk away if they cannot reach an agreement. CABO actually dropped Viacom and its bundle of channels after Viacom tried to push through a fee increase. “Cable ONE is really not pushed into a corner by increases in programmer pricing. We have shown, as we did in March with Viacom, that we are willing to drop people where we don’t think the value to our customers is equal to the money being demanded.” (Interestingly, on the Q2 earnings call, management reported that dropping Viacom cost them just 2% of video revenue. This provides some evidence that Viacom might be a loser in the changing pay-TV landscape.)
Lifetime Value Approach to Customer Acquisition
A second facet of CABO’s strategy is a lifetime value approach to customers. This is the anti-thesis of the Malone economies of scale approach. Over the past three years, the company introduced rigorous analytics to determine the expected life-time value, or “LTV”, of current and potential residential customers. By focusing our sales, marketing and service efforts on residential customers with a high LTV, they significantly reshaped the customer pool. This has enabled CABO to earn higher profits with fewer customers and PSU subscriptions. Reducing the number of low-LTV customers, significantly reduced churn, bad debt expense and other costs.
From 2011 to 2014, CABO experienced a 60% reduction in bad debt; a 21% reduction in the frequency of telephone customer service calls, resulting in a 21% headcount reduction in telephone customer service personnel; a decline of 21% in the frequency of technicians being dispatched to customer locations, resulting in a 13% headcount reduction in the staff devoted to that function; and an overall headcount reduction of 308, representing a reduction, primarily through attrition, of more than 13% of total workforce (now 2,022).
Low Cost Structure
Since implementing their LTV strategy in 2012, CABO has the lowest cost (operating expense plus capex) per customer in the industry and the second lowest cost per PSU. (See Figures 3 & 4.) It also maintains very competitive operating margins. As the company explains, “This is the antithesis of normal cable economy-of-scale expectations, where higher volumes are expected to create lower costs per PSU and increase operating margins.” Rather than increasing our size and seeking cost savings through economies of scale, they have achieved cost savings through operating efficiencies keyed to the unique characteristics of their market.
Figure 3, Cost Per PSU, 2010-2014
Figure 4, Cost Per Customer, 2010-2014
A Disciplined Approach to Capex
Unlike other cable companies which waste million on developing new technology, CABO faces no pressure to make such investments in its market. Instead, CABO is able to only introduce new technologies when they have proved themselves in bigger markets and are available on more favorable economic terms than typically paid by the earliest adopters.
In this way, CABO’s highly disciplined approach to capital allocation sounds a lot like the approach adopted by a young John Malone. According to The Outsiders, Malone saw “no quantifiable benefit to improving his cable infrastructure unless it resulted in new revenues. To him, the math was undeniably clear: if capital expenditures were lower, cash flow would be higher. As a result, for years Malone steadfastly refused to upgrade his rural systems despite pleas from Wall Street. As he once said in a candid aside, ‘These [rural systems] are our dregs and we will not attempt to rebuild them.’ This attitude was very different from that of the leaders of other cable companies who regularly trumpeted their extensive investments in new technologies.”
CABO’s geographic market protects it from competition. It is difficult for any private operator to justify overbuilding a fully upgraded fiber-optic cable network in a poorer, low population density area with an incumbent operator already present.
CABO does have DSL competition. CABO estimates that 25% over built but this is largely DSL. CABO is confident that its offering will win out over DSL.
Can CABO Grow?
I see a pretty clear road map for CABO to double unlevered, pre-tax FCF from 2014 to 2024. The principle drivers are as follows:
- Margin expansion – OIBDA margins could expand by as much as 8 percentages points (37% to 45%) as low margin video and voice services drop off and high margin HSD and business services expand. I see HSD and business services increasing to 77% of revenue from 42% in 2014. Clearly, 45% is a very high OIBDA. Comcast currently has the highest OIBDA in the cable industry at 41%. But, I think a 45% margin is realistic for CABO as they evolve into a monopoly provider of HSD services. Margins increased from 34% in 2012 to 36% in 2014 and I expect this trend to continue for some time.
- Capex Normalization – Several capital-intensive initiatives are scheduled to wind down by the end of 2015. Accordingly, I have project industry average capex of 17% of revenue from 2016 forward. This is down from 20% of revenue in 2015.
- Untapped Pricing Power – From 2012 to 2014, CABO’s residential HSD ARPU rose 5% without the benefit of raising prices. Recently, after nearly five years without taking a rate increase, CABO announced that it will increase rates on residential data plans by $5.00 per month beginning with October 2015 billing statements. Again, as a monopoly provider of HSD services, CABO should have a great deal of pricing power. Accordingly, I forecast a 3% CAGR in HSD pricing.
- Increase in Penetration – CABO can increase penetration of their existing customer base. Their HSD penetration of homes passed is much lower than other cable systems creating a large upside opportunity. (See Figure 5.) I forecast a fairly modest 3% CAGR in retail HSD customer growth, increasing penetration to just 35%.
Figure 5, Data Penetration of Homes Passed, 2014
- Unit Growth – I forecast a modest 1% annual growth in homes passed plus a 2% CAGR in residential HSD customers and 3% CAGR in business services customers.
- Revenue Growth – Drivers #3-#5 combine to produce an overall revenue CAGR of 3% as growth in data and business services offset drops in video (-6%) and voice (-24%).
- Expense Reduction – I assume no benefit from expense reduction creating the potential for an upside surprise.
What Is CABO Going To Do With All This Free Cash?
This rapid increase in free cash raises another question: What is management going to do with all the cash? CABO’s current high returns on capital will be eroded over time unless management can find reinvestment opportunities offering similar rates of return. A company that can find plentiful reinvestment opportunities is a so-called “compounding machine.” It will compound the value of its equity for many years to come and increase intrinsic value accordingly. CABO does not seem to have many such reinvestment opportunities available to it.
Interestingly , Tom Gayner, CIO at Markel and a director of CABO, stated that “a perfect business is one that earns very good returns on its capital, and can take that capital that it makes and then reinvest that and keep compounding at the same sort of a rate year after year after year.” He then goes on to state that “the second-best business in the world, is one that earns very good returns on capital. It can’t reinvest it, but the management knows that. They’re intellectually honest that they have to do something else with the money. And what are their choices? Well, they can make acquisitions, they can pay dividends, they can buy their own stock. But they are thoughtful and they know that.” CABO would seem to fit clearly into this second category.
CABO management seems to have four options available for its cash.
Option #1 is, of course, allocating cash to investments that will have a return equal to or greater than the company’s current ROIC. As Buffett put it, “A company’s management should first examine reinvestment possibilities offered by its current business – projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors.”
CABO management seems to be reluctant to pursue this option as they should be. In the past few years they have made substantial investments to improve the speed of its network. Data speed is they factor separating CABO from its competitors. With the moat widened already, there would seem to be few additional opportunities to invest funds at a 30% or greater return (CABO’s current ROIC). One possibility is investing in fiber to the home. But, installing fiber is very expensive with uncertain returns. As stated earlier, given their less affluent nature of their market, it is best to err on the side of caution.
Option #2 is to use the cash for acquisitions, either bolt on acquisitions or acquisitions not directly related to the current business. It has been well-documented that companies have spotty acquisition records at best. Therefore, I was happy when I read that the CABO CEO saw limited M&A opportunities. It is for the best.
The third option is to return the cash to shareholders via dividends. Accordingly, CABO has announced a $6 per share dividend. This will chew up about 19% of my estimate of 2016 FCF (OIBDA less capex). This is certainly a worthwhile use of cash when there is a belief that shareholders have better options for investing the cash than management. For example, See’s Candy has few investment opportunities. As a result, the best use of See’s free cash is to send a check to Omaha where Buffett can invest it wisely. I believe that a similar situation exists here. I hope the dividend will increase annually and only cut very reluctantly.
The fourth option is to return the cash to shareholder via share repurchases. While not sexy, aggressive share buy can have a dramatic impact on per share value. On VIC, Cuyler1903 lays out a reasonable case for CABO repurchasing 27% of its shares outstanding by 2018. He estimates that this would increase the share price to $563 – approximately a 33% increase over the price on September 2015. Further, share repurchases signal to the market that management takes its capital allocation role seriously and will not fritter away earnings on silly diworsification efforts or misguided acquisitions.
But, buy-backs are not an unadulterated good. In his 2011 shareholder letter, laid out a two-prong test to determine whether a stock repurchase makes sense:
- Does the company have ample funds to take care of the operational liquidity needs of its business?
- Is the company’s stock selling at a material discount to the company’s intrinsic business value, conservatively calculated?
There is no doubt that CABO passes the first prong of the test. CABO has announced that it will borrow up to 3-4 times EBITDA – a more conservative position than Malone takes. A cable company with strong cash flows should be able to support this level of debt without any problem.
The second prong of the test is more problematic. Valuation matters. Historically, managements tended to ramp up buybacks in bull markets, when stocks are most expensive, and to reduce them in bear markets, when shares sell at bargain prices. (See Figure 6.) And, as is the case with any investment, shares repurchases financed with debt can only make a bad situation worse if the economy or business sours. The success of buybacks, like any investment decision, depends largely on the price paid. That’s why it’s important to consider the valuation of a company when assessing the quality of its buyback decisions. Companies that execute share repurchases, and that are attractively valued, deliver much better returns on average.
Source: Woodford Funds
CABO is certainly not a screaming bargain by normal valuation metrics. As of 9/22/15, it commands a trailing P/E of 18.14, a Price/Book of 6.02, a EV/EBITDA of 10.10 and an unlevered FCF yield of 5.38%. Beyond these common yardsticks, even assuming a 9% growth rate over many years as I forecast, the company is not deeply under-valued. Is this an appropriate time to undertake a buyback? Is it possible that management knows something we do not? Managements are human and full of human biases. But at least they are likely to know more about their own current business than about future investments. Still, in most cases I would discount the enthusiasm of management. But, as demonstrated above, at least one of the directors has thought long and hard about capital allocation and voted in favor of a $250MM stock buy-back program. Given the pedigree of Gayner and the others, I am predisposed to listen to them.
Reinvestment Dynamics at Charter and CABO
The contrasting approaches to capital allocation at Charter and CABO are illuminating.
In de-emphasing video, is CABO skating to where the puck is going or are they turning their back on an important revenue stream? Will they look like geniuses in a few years when OTT dominates video distribution?
Charter is willing to spend on capex and acquisitions and take on lots of debt. It offers no dividend and no repurchase program. 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?
To be sure, 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.
CABO is a small cable system in a rural environment with less affluent customers. Given this set of circumstances, it is unlikely that investments will be recouped. Thus, in a slow growth scenario, it makes perfect sense to focus on operational efficiencies and return as much cash as possible to shareholders.
Nevertheless, as Gayner laid out above, all things being equal, the opportunity to own a “compounding machine” is more attractive. As Warren Buffett wrote: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” But the risk-adjusted return might be much higher at CABO.
 Form 10, page 2.
 Ibid. pages 2-3.
 December 8, 2014, Graham Holdings Co at UBS Global Media and Communications Conference
 Form 10, page 3
 The Outsiders, page 41.
 “What we’re not doing, which is another important part of the analysis, we are not chasing volume there either. Even though we are HSD-centric in our residential thinking, we’re still going for the more profitable part of the market rather than just trying to build up our volume of HSD. So if we can grow just 2% or 3% in units, but do it persistently for a long period time, we are thrilled. Rather than having 5% to 7% growth in one year, but a lot of that coming in at ARPUs down in the 30s or something of that sort.
On the broadband side, we would love to get a little bit from ARPU, a little bit from usage-based billing, and a little bit from rate increases. To not be too specific, but it’s a combination of all three of those, a little bit each year, that we think particularly with our low penetration — we have a lot of upside opportunity — gives us quite a few years of nice single-digit opportunity if we execute well and get a little bit from each of those three sources.” CEO Tom Might, Q2 Earnings Call
 Tom Gayner, “Evolution of a Value Investor,” Talks at Google, June 22, 2015.
 2012 letter to Berkshire Hathaway shareholders.
 More from Buffett: By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders.”
Letter to Berkshire Hathaway shareholders, 1984
 Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter