Please refer to Important Disclosure Information at the end of this note.
Given the volatility over the past week, it’s worth going back to basics and sharpening our pencils. At Burr Capital LLC, we look for good businesses with strong recurring cash flows, excellent management teams, and shares trading at a large discount to intrinsic value.
We believe, cable businesses check these criteria. They are pseudo-monopolies in the guise of duopolies, with contractually recurring cash flows, and some of the best management teams of any publicly listed company. US cable companies are materially under-earning and are trading at large discounts to their intrinsic value. As their earnings power normalizes (leading to better performance) AND the market re-evaluates the quality of their cash flows (greater recognition), this growth-on-top-of-growth dynamic, could lead to super-normal equity returns over multiple years.
A Remarkably Good Business
A typical US home is wired with a coax cable from the local cable company and a twisted pair copper wire from the incumbent telecom provider. The twisted pair copper was designed for voice transmission (traditional phones) and was never designed to handle the exponential growth in internet traffic, which is driven by online video from the likes of Netflix (source: Cisco Visual Index).
The coax cable from the cable companies is a fat pipe, far superior to twisted copper, and capable of transmitting many gigabytes (GB) of data. Initially used for traditional "linear" TV, this bandwidth is increasingly getting re-purposed for internet data.
There are enormous barriers to entry in this duopoly business. It can cost $1,000-4,000 per household to wire a home for a 3rd service or as much as $4 billion to wire just 1% of US households. The returns on capital to become the 3rd cable provider to the home are hard to justify.
So as the internet increasingly becomes the core product in the home, cable finds itself in an almost unassailable monopoly-like position.
Stable Recurring Cash Flows
Love them or hate them, we’re increasingly dependent on our cable provider for our internet needs. Cable companies enjoy customer-captivity and contractually recurring cash flows. We pay our provider on a monthly basis, usually with some auto-pay feature. Few businesses have cash flows of this quality. Essentially, cable companies are making money everyday just by turning on the lights.
Cable companies are classified as consumer discretionary while their internet services are anything but discretionary. That realization could drive a whole new class of shareholders looking for utility-like stability which could translate into higher prices for cable stocks.
Excellent Owner/Operator Management Teams
Cable companies have some of the best owner/operator management teams of any publicly-listed business.
Liberty Global (LBTYA/K), Liberty Broadband (LBRDA/K), and Liberty Ventures (LVNTA) all have John Malone, of whom much has been written. Malone is one of the greatest capital allocators of our time. When he ran TCI, the stock appreciated 900 times. More recently, Liberty Media returned 15x the initial investment. For more on John Malone and other great capital allocators, please refer to The Outsiders by William Thorndike.
Charter (CHTR) is run by Tom Rutledge who is viewed as the best cable operator in the US cable industry. The CFO, Chris Winfrey, is highly respected in the industry. Cable companies usually have large tax shields and an excellent CFO, like Chris Winfrey, knows how to take full advantage of these tax shields. Charter is also backed by Malone via Liberty Broadband, which owns around 26% of Charter shares.
Levered Equity Returns
When you pair a good business with an excellent manager, the returns can be magical. A recurring cash flow business with prudent amounts of debt can produce superior levered equity returns. The quality of cable company cash flows enables leverage as high as 5 times. Not too many businesses can support that level of leverage.
As value investors, we prefer a ‘B’ student becoming an ‘A’ student than an ‘A’ student becoming an ‘A+’ student. When a 'B' student becomes an 'A' student, we get the dual benefit of better performance and greater recognition which can lead to above-average returns. Cable companies are B’ students becoming A’ students. And they have numerous levers to make that happen.
Take Charter as an example: It’s a pseudo-monopoly business that should have dominant share in its cable footprint yet it only has around 50% market share. Charter also pays too much for programming rights (what they pay the media companies to transmit the TV channel) on a per subscriber basis which should ease over time because cord-cutting and over the top (OTT) will diminish the bargaining power of media companies. Finally, their capital expenditures and service costs are running above normal and will come down over time.
Adjusted for these characteristics, Charter's normalized cash flow (FCF) is around $30 per share. What this means is, when one has fully right-sized their expense structure and they have achieved a more normalized market share, their FCF would be around $30 per share.
Cable stocks remain materially undervalued because the market groups them with media stocks that are under threat from over-the-top services, like Netflix. At its current price, a stock like Charter (CHTR) is very cheap trading at only 6 times its normalized (longer term) FCF of $30. Even at a modest 10x below market multiple, we arrive at a $300 stock, which is 70% higher than the current share price. If the market begins to appreciate the quality of the cable’s cash flows and the shares garner a more reasonable “market-like” multiple of 15 times, we arrive at a $450 stock, 150% higher the current share price.
Monopoly businesses have pricing power. Cable companies are pseudo-monopolies that haven’t even begun to flex their pricing power. Today, prices go up because they pass through the cost of programming. That will change. Like the railroads, cable companies will mature and begin to push through inflation-plus pricing which will flow through to the bottom line.
With a business that’s normalizing, with long-term pricing power, cable companies could grow their cash flow at super normal rates for many years to come.
Recent Controversies Around Over-The-Top
That brings us to the recent concerns raised by Disney (on August 5th) around over-the-top (OTT) and Netflix.
What does OTT or Netflix mean for cable? Not a lot in the long run. If a subscriber "cuts the chord" they will be forced to use more internet broadband, making their cable internet service more valuable. Cable companies are allowed by the FCC to raise prices based on usage ("usage based pricing"). Over-the-top internet usage in the developed world is currently running at around 20 minutes per capita per day versus 285 minutes of linear traditional video. Cable will have a lot of pricing upside as internet usage continues to grow at exponential rates.
Sure, the transition will not be easy and cable companies will feel some initial pain because they make good margins (40% estimated margins) on TV services today. But they will pick that up (and more) over time in internet usage where they make 90%+ margins!
The risk to any monopoly is when their pricing power gets regulated. We are not there yet with cable but it’s a longer-term risk. It is worth noting that when the FCC classified cable as a Title II “utility” they did not regulate pricing, effectively taking that risk off the table, for now.
So How Do We Invest in Cable?
There are many ways to invest in cable and here are a few. Owning a basket of cable stocks may make sense to reduce idiosyncratic risk stemming from country-specific regulation and M&A.
- Charter (CHTR) shares and its derivatives: Liberty Broadband (LBRDA/K) shares is a levered way to own CHTR and be more directly aligned with Malone. Liberty Ventures (LVNTA) shares or Time Warner Cable (TWC) shares are alternate ways to own CHTR even more cheaply.
- Other US domestic cable companies: Comcast (CMCSA) is a play on the same cable theme however NBCU, a media asset, complicates the thesis. Cable One (CABO) is a pure-play cable internet provider and a potential takeout candidate.
- Liberty Global (LBTYA/K) and Altice are ways to participate in cable consolidation and the health of the European consumer.
- The LiLAC tracking stock (LILA/LILAK) is a way to participate in cable consolidation in Latin America.
Important Disclosure Information:
At the time this report was submitted for publication, the principals and clients of Burr Capital LLC owned securities issued by Charter (Ticker: CHTR), Liberty Broadband (LBRDK), Liberty Global (LBTYK), Time Warner Cable (TWC), Liberty Ventures (LVNTA), Cable One (CABO), Comcast (CMCSA), and LiLAC (LILAK).
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Burr Capital LLC), or any non-investment related content, made reference to directly or indirectly in this research will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this research serves as the receipt of, or as a substitute for, personalized investment advice from Burr Capital LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Burr Capital LLC is neither a law firm nor a certified public accounting firm and no portion of the research content should be construed as legal or accounting advice. A copy of Burr Capital LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request.