Charter Communications: Cable Cash Flows - [Business Breakdowns, EP. 139]

28:06And at some point when they no longer have access capacity in the network, they're going to be faced with that decision of Where do we go from here? Do we keep investing to create more capacity? Or do we let fixed wireless subs roll off? And so that same capacity can be used for mobile subs where they're paying us 50 times as much. If McDonald's, if five bucks for a hamburger and most customers buy one hamburger, But what if they had a special where you could give 50 hamburgers for five bucks? There'd be a lot of people wanting to do that and then there's only so much beef. Now, a word of zoning on what you mentioned about the mobile data usage, relative to broadband and household data usage.

28:52I was surprising to hear that delta between the two. My first question is, does that largely just relate to television and watching television and that's sucking up most of the data. And two, has that gap been closing over time? I would imagine that the amount of mobile data usage is growing substantially, but I'm curious to hear if that actually plays out with the numbers. Televisions a big chunk of it, but it's not 90 % of it. In terms of the convergence of mobile data usage and fixed, mobile data usage grows a little faster than fixed broadband usage, but again, you may be talking about mobile usage growing at 35 or 40 % and no broadband usage growing in the 20s.

29:34So it's not a huge difference or something that's going to be closed overnight. And the last point we'll get to on the assets before we move to the business model itself. We talked a little bit. These have become somewhat geographic monopolies, regional monopolies. Does anything change now in terms of what you mentioned with fixed wireless or is there anything else going on in the environment that would loosen the control that they have as a regional monopoly versus before. Any changes in the environment in terms of what's possible with fixed wireless that reduces the power that they have as a regional monopoly.

30:09First of all, this isn't a local monopoly, although sometimes it gets described that way. It's a local business in general where there are few options, but remember fiber overbuilders, fiber option is available in about half charter's markets today. They then fixed wireless in another good portion of their markets, not all, but in a good portion of their markets. So there are options about at least half the time. There's another option. That's good for consumers because there's choice, there's competition, it's making charter get better and it's making the fiber guys get better. The pace of fiber deployment is not picking up, but their overbilled penetration as a percentage chargeers footprint has gone up from 3035 % a decade plus ago to closer to 50 % today and it's probably going up over 60.

31:01It hasn't been anything near a disaster economically going from 35 to 50. We don't think going from 50 to 60 is going to be a disaster either. But it's something to keep an eye on and it's something management keeps a very close eye on. And in the case of charter differently than some of their cable competitors, they've been very careful to drive penetration and not give customers a reason to switch. So you'll hear about an alt east gouging on price and having very high average prices. Charters on the other end of the spectrum and John can give some specifics on this but they charge on average a lower price to make that switching a tougher bargain for the fiber competitors.

31:41It's hard to get a very good sense of my nutritional business you'd want to know what do they charge per month versus alt -E, circumcast, or the Vibro Overbuilders. I think because these companies sell multiple products and they may have different price points in different geographic regions, or if you call up, depending on how hard you complain, the easiest way to think about it is on an EBITDAB per subscriber basis, who is making the highest profits and who is in a more reasonable spot. And so that's where, by the high level, I think it's easiest and clear to see that many of the other public cable companies make about 25 % more ebit .per subscriber than Charter does.

32:24And that's either an opportunity for Charter over time as they get closer to full penetration and they don't need to operate for more penetration or it could be a risk for some of the other cable companies. We can shift a little bit into the financial model here. When you think about the business, that margin piece is a big piece of it. Are they offsetting that lower margin with more scale when you think about just how you actually think about the model of this business using some type of subscriber rate against that EBITDA margin? How do you frame it in your own heads in terms of how you analyze the business?

33:02It's exactly right. So many investors have become used to valuing these businesses as a multiple of EBITDA. And that doesn't give charter full credit for its strategy, which is to have lower prices. Like I said, lower EBITDAW per subscriber, but to drive penetration. And what penetration where it really helps you is below the EBITDAW line. It helps you above things like scaling, programming costs, or being more efficient with customer service. But where it really helps you is leveraging all of those expenses or capital expenditures that you do to maintain your network. It doesn't matter a lot of the times how many customers you have, but if you have more customers, your CapEx per subscriber is lower.

33:49And so when investors are putting a multiple on EBITDA, which is what is the simple rule of thumb metric in the industry, they're not differentiating between their smaller cable operators that have twice as much CapEx as a percentage of EBITDA that charter does. And I guess the other side of the multiple equation would just be in terms of the visibility in that EBITDA and to the extent that you have a strong feeling that those subscribers will stick around versus maybe more price gouging will result in more subscriber churn. I mean, does that EBITDA margin or lower pricing show up in more customer loyalty relative to peers as well?

34:30Well, they don't disclose churn, but I do think it's clear that there is a benefit to it, and you can see it in penetration. And there's smaller operators that are growing at a much lower rate and have grown in a much lower rate than chartered, despite seemingly having more opportunity. And charter has one of the highest penetrations in the industry, and we think one of the reasons for that is the low prices. I think it's also because they do a good job investing in customer service, providing apps and video products that their customers want to use as well. One of the biggest trends I think over the past 10, 20 years, it's been e -commerce and then cutting the cord is another very popular in -vogue trend that's been going on for a long time.

35:16I'm just going to leave it as a very simple question. What impact has that had on spectrum charter? Good or bad? So core cutting lately is not a huge impact on Charter. The linear TV business became competitive on a nationwide basis decades ago when the satellite TV companies started competing. The margin that you get for transporting the packets and packaging the service became two nationwide competitors, right? a very long time ago with direct TV and dish. Cable TV penetration actually peaks in the year 2000 and over the next, ensuing 10 years, satellite went from 15 % to 35 % of the market.

35:58Although it was still, and still is today a large percentage of the revenue for the cable companies, it's a pretty small percentage of the EBITDA. And if we just zone in on a particular recent case study where Spectrum had a standoff with ESPN. And there has been this long history in terms of value chain extraction going on. And much of that being focused on what ESPN has been charging. Can you just get into that a little bit in terms of what was happening? And honestly, from a shareholders perspective, what were you hoping for or what were you looking for in terms of the outcome of that event?

36:37I want to start by applauding Chris Winfrey for taking a stand against is probably the most important media company right at the beginning of the NFL season during an important college football weekend. And I think the US Open tennis tournament was going on at the same time. While TV may not be a big part of the economic equation for Charter's bottom line, it is a service that a lot of their customers take and value. At a very high level, he created upside -off anality to longer the duration of the linear TV business and potentially create a more profitable role for the distributor. I'm glad you brought this up, Matt, because I don't think this agreement, in this case study, if you will, is getting enough attention.

37:18I think there's two important things that happened here. Number one, this is really good for consumers, potentially. This is one deal, one time, but it's pretty good for consumers. I think what the charter folks were worried about was increasing media costs for consumers. It's a good thing for consumers because a lot of these cable networks were double dipping. You sign up for Disney Plus and then you're paying for the Disney channel on your cable bundle. And that's double dipping. It's the same content for the most part and you're paying for it twice. And that's not okay long term. This deal helps limit that.

37:55Number two, it's really the first time in one of these disagreements on carriage where we've seen the leverage shift to the distributors from the content owners. And this was a powerful content owner. And I think this market power isn't due to some sea change and market dominance of charter. It's really about indifference, which sounds odd. But as we discussed, the economics are passing through linear cable TV channels has become more of a rounding error for the cable companies from an economic standpoint. And so they have little to lose here. So they have this economic indifference that kind of gave them the ability to negotiate in a very different way and the result is you're getting a better result for consumers and now charter and hopefully the broader cable industry will be able to participate as a marketing agent in the upside and be a little bit more agnostic as to whether you're streaming cable television channels or you're getting them through charter because they're going to be getting a marketing fee for that for instance and you can see that in their response to Disney shutting down their service in that they're sending QR codes to sign up for YouTube TV to their customers.

39:08Who does that? And this would never have been done 10 to 15 years ago, but it's emblematic of the economic indifference they had to how far this business model had come. Can you just give a quick summary in terms of any of the relevant details? I think the reported numbers are that Charter Pays Disney ESPN 2 billion a year in order to carry that channel. And that was flat or up slightly, but what were the other key details within that agreement that ultimately came to be? None of the financial details of the new agreement have been disclosed. Charter did disclose how much they were paying Disney in total.

39:47Before, I think what's important is that all Charter's video subscribers will get Disney Plus included as part of their package. Higher tier subscribers will get ESPN plus included and that really eliminates that double dipping. And in return for charter delivering so many incremental customers to Disney for those services, they're getting a wholesale rate that's very attractive. The other thing that they're getting is Disney is dropping some of its channels that aren't watch very often. One of the things that over time, away that the cable networks extracted value from the ecosystem was to create more channels, bundle them together with channels that you absolutely had to have, like ESPN or ABC in the case of Disney, and charge money for those channels.

40:38And always hard to attribute how much money do those channels make versus are they really riding off the co -tales of these other channels. But what one of the things Trader got, which again we think is good for consumers, is that But those low calorie channels are coming out of the package as a way to pay for the content that consumers actually care about. If the cable bundle was a thing of beauty, maybe not necessarily for consumers, but from a business model perspective, was an incredible creation. And for the life that it had during that particular period, it really was something. If you were to see this shift where people were canceling cable packages and strictly just focusing on internet, which I think in terms of cutting cord, you might keep the actual customer themselves.

41:22They're just only using internet. Now, is there a much different margin profile in terms of those customers versus those that are signed up for the entire bundle? The economics are pretty similar to charter. The difference is that you don't have those passed through programming costs, so the margin steps up, but the dollars are similar. The thing that's good for the cable companies is that as consumers, transition to streaming, they consume more and more data. And the principal asset here is advantaged versus its competitors as consumers use more data. So fixed wireless and DSL can't keep up as technologies, as data usage continues to grow.

42:05And video is one of the key drivers of that. The capital density of the broadband business is lower than including it with the TV business. So when we made the investment in Charger in 2015, one of the components of our thesis was that the capital intensity of this industry is actually declining. And you've seen that over that time, as we've unplugged cable TV bundles, you've seen the capital intensity of the industry fall, margins rise, and EBITDA growth, and free cash for a more importantly accelerate. And John can give you the growth algorithm of that and how that's going down. Yeah, so from 2016 to 2022 charter grew customer relationships 3 .4 % a year revenue only grew 0 .3 % a year because this high revenue Productive video started shrinking out of the system, but EBITDA per customer relationship grew 3 .3 % So when you think about adding those two together your EBITDA growth was let's call it mid -sixes maybe 7 % over that same period of time and CapEx declined 7 % cumulatively.

43:14And so your EBITDA, less your structural CapEx, grew at about 11 and a half percent a year. And then when you look at that on a per share basis, because Charter maintains a constant leverage ratio and uses that capital to buy back stock, they're operating profit per share or grew 23 % per year. Very interesting, just in terms of the productivity or efficiency within the system that you're able to realize. Before we jump on, I do want to touch on phone slash mobile as part of a bundle. How important is that piece of the story? And I know they've entered into being a MBNO, which is beyond my scope of understanding, but I was hoping you could explain what that exactly means and how important that is in terms of the overall bundle and what they're selling.

44:02First of all, we don't view the wireless business as a great business. It's quite competitive nationwide. There's high fixed costs. There's low marginal costs. We went into this thinking, a little bit skeptically thinking this is unlikely to be a great business, but it's a nice thing to maybe reduce churn. And then when Comcast and Charters sold Spectrum to Verizon in 2011, they signed an MVNO agreement that effectively gave them a very competitive marginal cost with no capital requirements. And an evergreen toll on Verizon and Verizon has to go by spectrumed increased capacity and grow its data going through the system.

44:41Charter and Comcast, they don't have to pay for that in this agreement. It's a marginal cost model. So from a cost standpoint, they're actually in a pretty advantageous position. And that advantageous position, and John can get into the details on how this works, actually improves as you get into certain areas of the country. And they have perfect data on where this is, and so the cable companies can mine their customer bases to find the most advantageous regions. And their success signing up customers to date has been shockingly good. And this has gone from a money losing operation to a nicely profitable operation.

45:18But it's early days, and it's pretty small in the grant scheme. John, maybe you want to get into some more detail on that. So separate from having that advantaged perpetual MVMO with Verizon that they got through that unique spectrum deal, the cable companies are an advantaged MVMO because they can offload more traffic from mobile phones onto the cable network just through the Wi -Fi that you have in your home and through the Wi -Fi that they've already deployed in public like spaces where we think it might get even more interesting going forward is that if you think about the usage of mobile phones, 60 % of the network traffic happens on 3 % of the land area.

46:03So charter and Comcast have the opportunity to selectively choose where to deploy their own wireless networks using shared and licensed spectrum that they got in a government auction and called CBRS and overbilled, if you will, the wireless networks, but only where the economics make sense. And then in the rest of the country where it may be rural and expensive or there just may not be a ton of usage, they can keep that variable cost model and not have to deploy a cat vaccine in -sign. If I'm to think about just simple customer behavior, is the idea of a customer just having one service provider and being able to have an all -in -one solution, a piece of the puzzle here, I personally have a different cell phone provider or mobile provider than I do, cable provider, but how relevant is that in the overall equation?

46:59I think there's some benefit to that, but if you discount that way, maybe there's more of a benefit to it, but is that really a source of structural advantage? I don't think so. I think that the structural advantage really comes from the network asset that the cable company's own and using that asset to create a lower -cost, better product that consumers, I think, will gravitate to over time. The interesting analogy here is what happened with landline phone where once the cable companies entered that market in the early 2000s, they started rapidly taking share because they had a lower -cost product than the incumbent and telephone companies.

47:37And today, Comcast in charter, the largest landline phone companies in the world, well, that's not something necessarily to brag about. Today, it was a very valuable market that the Gable companies took over. And we think something similar can happen in the wireless market. Yeah, it seems to continuously come back to the infrastructure asset that they own in terms of being the differentiating piece, which makes a lot of sense. If we shift gears a little bit to the expense out of the equation, we touched a little bit just in terms of the cost to serve the content and some of those carriage fees.

48:10What are other major costs that factor into the business? Programming cost pass through, as you mentioned, is a big one. The other costs are running and operating the network, customer service. So whether that's outages, answering customers' questions, your Wi -Fi doesn't work, your television is not working, that's actually a very big cost. And one that the cable companies are continuously improving through the use of technology over time. The wireless MBNO cost is becoming a bigger cost as that business rapidly grows. It's again a cost that we think is a very good cost to have in the system.

48:50So if I were to dumb it down a bit, the content cost is essentially tied to the number of subscribers. So that's just going to match to variable cost in many ways. And the overhead had costs, the fixed costs would be associated with running the network, the customer service, and everything associated with that. Is that a fair way to categorize it? You're exactly right that the programming costs are mostly a pass -through, while a lot of the other costs that Charter has are fixed and thus can scale as the customer base grows. For the mobile business specifically, we think that the NBNO costs are about 30 % of incremental service revenues.

49:29They're pretty small and the business, one of the things that's gotten us more excited the more work we've done is that we think the business can have margins that are approaching the company's average. Whereas in the beginning we thought maybe this will be just a little bit of a break even business. Traditional MVNOs had a roughly 10 % EBITDA margin and this will be a little better. As we've learned more about the business, we really think this can be a significant margin generator for the companies. And then can you just provide a snapshot of what this looks like from a free cash flow perspective and then tie in the cap expan in terms of what is maintenance versus what's a reasonable way to think about that flowing through the business?

50:13So charter generates about $22 billion dollars of EBITDA right now. The company is spending about $11 billion this year on CAPEX. That is a big step up. It includes a network upgrade, a rural build out, and a little bit of mobile CAPEX. Mostly for stores right now, but we'll transition to building some of the network. The way we think about the maintenance CAPEX of the business is to take out those growth investments that are new. And then the perennial growth investment, which is extending the network. And so each year, charter grows its passings about 2 % a year, which you can think of that is about half of that coming from household growth, population growing, about 1 % a year.

51:00And the other half coming from charter seeing opportunistic ways to increase its footprint. And so when you take out So all of those pieces, and arguably this is conservative because there's growth cat backs embedded in other parts of the spend like in new customer premise equipment or scalable infrastructure that you're spending to add on new customers. But just simplistically, I think the easiest way to think about it is excluding those big buckets. And that gets you to a structural cat backs. That's about 12 % of revenue or quarter of EBITDA is the right zip code there. understood. Tony, you touched on a bit of this earlier in the conversation just around how these businesses are valued, how charters valued.

51:44Seems like there's an EBITDA methodology that goes into this, but how would you describe the market's framework for thinking about this type of business? Yeah, as John said very well earlier, the obsession with EBITDA, it's an interesting simplification, but we have to understand that it's a simplification and there's limitations to it. The typical rule of thumb was you buy cable stocks at six times EBITDA, you sell them at eight times. And that's a historical thing. And charter today is selling for around seven times EBITDA. There's a number of reasons why six to eight is too low for what we're seeing today.

52:17We've talked about the broadband transition and that being a bigger component of the business. The capital intensity is less so the free cash flow per dollar of EBITDA is going up. And that means the multiple you pay for that EBITDAH should be going up. The second thing is Charter's largest partner, the US government, no longer a charge is 35 % of your profits, they charge 21. And EBITDAH is a pre -tax number. That means that the EBITDAMulti will go up 20%, 25%, something like that. So there's a couple of reasons that there's an EBITDAH shortfall. If you think about it in that six to eight historical range, there's just a couple of very good reasons that those are no longer valid Is the best way to put it.

52:59We think nine times is a better multiple and in terms of the outlook for ebit .dye itself When you're thinking about top line whether subscriber count their ability to Win on pricing and the margin profile of the business They certainly have a gap between where they are versus competitors Do you think of either of those things driving a different EBITDA growth profile versus what you've had historically? The difference between Charter and its competitors in margins in our opinion and free cash flow today because of these growth investments is The mindset of the management team is one that's more along the lines of let's maximize the value of this business over the next 20 years And that includes making growth investments today and tomorrow to grow the value of the center prize by increasing our passings, keeping our price competitive and doing things like that.

53:51It's a different mindset. The rural expansions and other one where the government's offering some interesting incentives and they see an opportunity and have tested it and they're getting good returns so they're going after that growth. And while that limits free cash flow today, it's building value in the future. And so we like that as long -term investors. we're looking at this and saying these are higher return opportunities that management's taking advantage of at the cost of not getting the cash today. Are you suggesting that short -term investors might be pressuring them to operate a little bit differently?

54:22You do see the difference in the strategy between the Comcast and a charter today in their growth investments and the margins of the business as we talked about earlier. We're very comfortable with this strategy and we can get into management alignment when we get to management, but we think they're doing this for the right reasons, and it's not a function of them being sloppy or fat and bloated on the cost side of the house. We think over the next few years, there's tailwinds for the whole industry as this network upgrade winds down as fixed wireless goes from being a share taker to flat to maybe at someone being a share donor.

54:59And then we think specifically at Charger because of the products that they're offering at a discount to drive wireless growth, like Spectrum 1, which is $50 a month for a new customer, where for a year you get broadband, Wi -Fi, and a free mobile line. That depresses your earnings. They've also made investments in customer service and to increase the tenure of their customer service reps and their marketing team, which will pay dividends down the road. So we think the whole industry is well positioned, but that charter, the the EBITDA growth has been unusually depressed and is said to inflect going forward.

55:36And then on the opposite side of the ledger risks here, there's obviously execution risk as it associates to anything, but what other risks would you point to in terms of the story playing out? Two that come to mind to me immediately, we've talked about the competitive risks. The other ones are technology risk. So we wake up tomorrow and Elon Musk has figured out how to deliver very cheaply, very high speed internet with very little capital required. If a substitute comes out of nowhere for some reason where we've cracked some physics barrier and we're able to do that wirelessly and compete with the kind of bandwidth the cable has, we don't see that coming but if something like that happened, that's a risk.

56:17That's a left field, crack the code kind of a thing. And then the other one is regulatory. We can't forget it's more lightly regulated than utility back to the infrastructure idea, But there are regulators here and so you've got to be cognizant of a regulator having the ability to change the rules of the game in a way It's just a contagious to a equity holder just to clarify We do not think that Starlink is that risk or a big risk to the cable companies today Starlink is a great product for rural customers that were previously served by geostationary satellites that are something like off the top of my head over 20 ,000 miles away from Earth.

56:57This new product they call LIA or low -Earth orbit satellites of which Starlink is the first but there will be more. It's only a few hundred miles away and so it provides a service with higher capacity and lower latency. It's a very expensive product though because you need so many more satellites to cover the entire Earth. And those satellites do not have an indefinite life. With some people thinking they may only last five years. So you can see it today in the way the product is priced. It's much more expensive than traditional cable. It provides a lower speed with a higher latency. So while it's a great product for the world, we don't think it's a risk to the US cable businesses.

57:38I think the big trend in broadband is that everything is going wireless and the networks are getting closer and closer to their customers. and no one is closer to the customer or deeper in the neighborhood if you think about it that way than the cable businesses. You didn't bring up Starlink, it was on my list. I'm surprised to hear five -year useful life for something along those lines, but I imagine the environmental issues up there can be quite intense and something you can't control for. The other question I had on risks are just impact to the business and it's a sign of the times, but understanding the amount of compute capacity that something like AI requires and the intensity that it's putting on some of the systems, does that play into the cable in any potential way, just in terms of how much data is required?

58:27Is that all happening on site? So it's not impacting the wires. It's a question from somebody way outside of this world that I'm curious about. We think anything that increases data usage and requires low latency networking is an advantage for the cable companies. I think specifically to AI, it's early days. We don't know how that's going to play out yet. How much to your point of that compute will be taking place locally versus in the cloud. You can imagine if it's in the cloud, that network connection becomes more important. So we'll have to see, but I think the broader point here is that as time goes on, we come up as a society with new use cases that require higher capacity lower latency networks, and we don't know exactly what those are going to be, but when they come, the cable companies are well positioned to provide that service to customers.

59:24Well, this has been an excellent conversation. I've peppered you with more questions about the asset inside of business than I think I have on any business breakdown So I appreciate that but I think based on the answers that is the most important piece of the story here I wanted to close with our closing question that we always ask about lessons that you can take from this Investment and looking at this business or at this industry that you think you could apply elsewhere So what would those lessons be from looking at charter? I think one lesson for us that we think a lot about internally is we talk about why companies make money instead of how they make money and going back to our original investment and the kind of key differentiated view was that this is not a linear TV business which us and everyone else agreed was going to have a tough path forward but instead was a broadband and infrastructure company, a utility, if you will.

1:00:25Yeah, two things I would add to that. Number one, we talked about this briefly, but I think it's really important. As an investor, when you're looking back on investments that have worked well like Charter has, one of the common themes can be, the business is getting better or not worse. And this shift to broadband and the more data is good, position that they have, has really improved the business. John went through the math of how the EBITDA and the free cash flow leverage it works. And they've done a good job. And then the second thing is management. When you have management that's aligned with this sphere of influence from John Malone and thinking about real per share value and maximizing that over years, not quarters, they make a lot of really smart decisions, both on the M &A side and then on the capital allocation side.

1:01:10And they've leveraged returns to shareholders like us to real business owners by allocating capital really wisely I'm top of running the business and they take all that free cash flow and they turn a dollar in the two dollars And they do it every year and over time that compounds and shareholders like us are a lot better off when management Spaking really smart decisions not just on the income statement But with the leftover residual free cash flow business and these guys have done a exemplary job and the alignment is terrific. Chris Wimfree the CEO, if the stock hits $1 ,000 by 2029, he stands to make $400 million.

1:01:51Tom Rutledge had a similar contract way back when, and this management team, like Tom Rutledge, chose to make a lot less money today with the hope that they make a lot more money tomorrow by taking care of shareholders the right way. We like that sort of alignment. Absolutely. It always comes back to alignment, but some great lessons there, both at a very micro level, more industry level and even more higher level strategy. So thank you very much, Tony, and thank you, John. This has been an excellent conversation and appreciate you joining us on Breakdowns. Thanks, Paul. It's been a real treat.

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