Charter: Continuing to Turn the Corner in Q2; Reiterate Buy

Company Update (CHTR US) (Buy)

Highlights

• Residential revenues grew 4.1% year-on-year excluding Video

• EBITDA was flat despite 2022 costs step-up & weak ad market

• Internet net adds were 77k, despite Q2 seasonal weakness

• FCF Yield was 2.9%, or 7.1% adjusted for tax and rural CapEx

• We see 53% upside (18.7% p.a.) by 2025 year-end. Buy

Introduction

Charter reported Q2 2023 results on Friday (July 28). Shares were volatile throughout the day but eventually closed down 1.0%; they have been volatile for the past 12 months too, down 8.2% overall but up 16.2% year-to-date:

Charter Share Price (Last 1 Year)

Source: Google Finance (29-Jul-23).

We have been following the U.S. Cable sector for nearly a decade, and first published our research on Charter online with a Buy rating in January 2020. After initially gaining nearly 60%, Charter shares have disappointed since late 2021 and, despite rebounding more than 30% since September 2022, remain 23% below the price at our initiation. (For a recap of our current investment case, see the first Charter article we published on Substack in May.)

Q2 2023 results shows Charter continues to turn the corner. Adjusted EBITDA was up 0.2% year-on-year, despite a step-up in OpEx in H2 2022 and a weak ad market. Excluding low-margin Video revenues, total residential revenues were 4.1% higher year-on-year and 0.7% higher sequentially. Internet subscriber net adds were a positive 77k and flat sequentially, despite Q2 seasonal weakness. Free Cash Flow (“FCF”) will be burdened by a one-off CapEx program until after 2025, and cash taxes were seasonally high in Q2, but run-rate FCF still implies a FCF Yield of 2.9%. Normalizing cash taxes and excluding the subsidised rural initiative, run-rate FCF Yield is 7.1%.

EBITDA margin should expand again in H2, revenue growth should accelerate further as benefits from the current CapEx program materializes more fully, and CapEx normalizing from 2026 will help FCF significantly. We believe total FCF can reach $8.3bn in 2026 (similar to 2021, with a 26% growth in EBITDA offset by the absence of cash taxes in 2021), and FCF/Share can reach $70 (thanks to buybacks reducing the share count by 40%). With shares at $395.38, our forecasts indicate a total return of 53% (18.7% annualized) by 2025 year-end. Buy.

Charter Q2 2023 Results Headlines

Adjusted EBITDA was up 0.2% ($13m) year-on-year in Q2 2023 (compared to 2.6% in Q1), with good growth in core revenues being offset by a step-up in OpEx since H2 2022 and a weak ad market:

Charter Revenues & EBITDA (Q2 2023 vs. Prior Periods)

Source: Charter results releases.

Excluding low-margin Video revenues, total residential revenues were 4.1% higher year-on-year and 0.7% higher sequentially. This was driven by solid Internet revenues (up 3.1% year-on-year and 0.3% sequentially) and strong growth in Mobile Service revenues (up 29.9% year-on-year and 8.5% sequentially), offset by a decline in Voice Revenues.

Residential Video revenues fell 6.6% ($296m) due to Video customers falling 5.1% year-on-year and a mix shift to lower-priced packages. This was largely offset by Programming Costs falling 7.8% ($232m) year-on-year.

SMB revenue growth was only 0.2% year-on-year, despite SMB customer growth of 1.7%, “primarily” due to a higher mix of lower-price Video packages (Video revenues are low-margin) and fewer Voice lines per SMB customer.

Enterprise revenues grew 3.1% year-on-year as reported, or 7.2% excluding low-margin wholesale revenues.

Advertising Sales were down 16.5% ($76m) due to political advertising in the prior-year quarter and a weak ad market. Core advertising revenues, which exclude political ads, fell 3.5% year-on-year.

Other revenues grew 28.6% ($148m) year-on-year largely due to higher mobile device sales; this was part mirrored by a higher device costs that were reflected in the 15.4% ($182m) year-on-year growth in Other Costs of Revenue.

Cost to Service Customers and Sales & Marketing costs both grew 3.6% year-on-year, more than revenue growth, due to the step-up in OpEx in H2 2022 after a decision to spend more on the workforce to improve retention and skill level. This was described as a one-off step-up that will be lapped by H2 2023, and both cost lines fell sequentially from Q1.

The share count fell by 9.0% year-on-year but by only 1.0% sequentially, because buybacks have been scaled back with the decision to accelerate CapEx and with lower EBITDA growth enabling less new debt. Charter spent $378m on buybacks and paid back $51m of long-term debt in Q2 2023, compared to $4.3bn of buybacks and $925m of new long-term debt in the prior-year quarter. (Q1 2023 saw $1.0bn of buybacks and $364m of new long-term debt.)

We believe these financials show that Charter has continued to turn the corner.

Turning the Corner in U.S. Broadband

Charter’s Internet subscriber net adds were a positive 77k in Q2 2023, and flat sequentially despite Q2’s seasonal weakness (due to disconnects by students in college towns and snowbirds in Florida):

Charter Customer Net Adds by Category (Since Q4 2019)

Source: Charter company filings.

Internet customer count was up 1.1% year-on-year and 0.3% sequentially, though both lagged the growth in household passings. The Rural Construction Initiative contributed 68k of new passings and 26k of Internet net adds in Q2.

Charter Customer Numbers (Q2 2023 vs. Prior Periods)

Source: Charter results schedule (Q2 2023).

External market activity was still low in Q2 2023, but Charter benefited from higher Internet gross adds (with churn still at near record lows), which it attributed both to its own efforts as well as slower competitor fiber overbuild, as CFO Jessica Fischer explained on the call:

“Internet churn remained near record lows for the second quarter and flat year-over-year. and Internet gross additions improved year-over-year. The year-over-year improvement in Internet net additions was driven by tailwinds from our rural construction initiative, the continued success of our Spectrum One product, better sales yields from higher-tenured employees, and a slower pace of fiber overbuild in our footprint during the quarter.

Despite the year-over-year improvement in net adds, overall market activity remains well below pre-COVID level, partly driven by very low move rates. We also continue to see some impact from fixed wireless access competitors in the price-sensitive customer segment of residential and SMB.”

Fixed Wireless net adds at T-Mobile and Verizon were both slightly lower sequentially in Q2 2023, but remained substantial (at 509k and 251k respectively). Fiber broadband net adds at AT&T and Verizon likewise were both slightly lower sequentially, though their broadband net adds remained small or negative due to continuing non-fiber losses:

Wireline & Fixed Wireless Broadband Net Adds - Key Players (Since Q4 2019)

NB. ATUS has not yet reported Q2 2023 figures. Source: Company filings.

Charter stated that their Internet ARPU grew by 2.5% year-on-year. This is 2 ppt lower than at Comcast, where Broadband ARPU grew by 4.5% year-on-year but residential Broadband subscribers were flat, resulting in Broadband revenue growth of 4.4% (1.3 ppt higher than Charter’s). Combined, Comcast residential Broadband and Mobile revenues grew by 6.1% year-on-year, 1.2 ppt higher than Charter’s.

Charter has implemented price increases (in November 2022 and April 2023, as well as in August 2022 for non-autopay customers), but this was partly offset by the discounted Spectrum One bundle (with its discount allocated to its broadband and mobile components). Charter is pursuing a more conservative pricing strategy and its CFO reiterated on the Q2 call that “our strategy is never to sort of grow the business just based on price”. We prefer Charter’s approach, which protects the Internet subscriber base and helps generate incremental revenues through Mobile.

Charter’s current accelerated CapEx program was only announced in December 2022, so its benefits have likely not yet fully materialized. We also expect competitor Fixed Wireless programs to start having capacity problems eventually. These should help Charter’s Internet revenue growth to reaccelerate further in due course.

Charter Valuation: 7%+ Adjusted FCF Yield

For Charter’s valuation, we focus on Q2 2023 run-rate cashflow because the accelerated CapEx program was only initiated in December 2022 and tax losses enabled Charter to avoid federal cash taxes until Q2 2022.

Free Cash Flow (“FCF”), as defined by management, was $668m in Q2 2023, $1.0bn lower year-on-year due to higher CapEx ($641m, including $245m higher rural CapEx) and higher taxes ($405m), offset by working capital ($110m):

Charter EBITDA & Cashflows (Q2 2023 vs. Prior Periods)

Source: Charter company filings.

Our definition of FCF further deducts non-cash Share-Based Compensation, which reduces the number to $500m. This is equivalent to an annualized FCF/Share figure of $11.57, implying a FCF Yield of 2.9%.

Cash taxes were seasonally higher in Q2, while working capital was a cash inflow this quarter. Adjusting out these items, as well as $541m of Rural Construction Initiative CapEx, give a FCF figure of $1.21bn:

Charter Adjusted FCF & FCF/Share (Q2 2023 vs. Prior Periods)

Source: Charter company filings.

The Q2 2023 run-rate FCF/Share figure is thus $27.99, implying a FCF Yield of 7.1%.

FCF Growth Should Re-accelerate

EBITDA margin should expand again in H2, once Charter laps the step-up in OpEx last year, and revenue growth should accelerate, as recent initiatives like Spectrum One (launched in October 2022) continue to bear fruit. CFO Jessica Fischer reiterated this point explicitly on the call:

“We believe our financials will improve as we move later into the year with additional revenue growth in Internet and mobile that will begin showing in Q4 and lower service cost per customer as we realize the 10-year benefits of our investment in employees and lap last year's labor step-up”

Long-term, we also expect benefits from the current accelerated CapEx program to materialize more fully.

The completion of the current CapEx program in late 2025 or early 2026 itself will be a significant tailwind to FCF. Combined, Line Extension (which includes the Rural Construction Initiative) and Upgrade/Rebuild CapEx (which includes upgrading the network to at least 1 Gbps symmetric speeds) were $430m higher year-on-year in Q2 2023:

Charter CapEx By Category (Last 5 Quarters)

Source: Charter results presentation (Q2 2023).

Returning these CapEx lines to 2022 levels alone would increase FCF by $1.7bn (annualized), and management actually expects CapEx excluding Line Extension to “decline to below 2022 levels and continue to decline thereafter” from 2026.s

Charter FCF Forecasts

We keep our FCF forecasts unchanged, which include group EBITDA growth of 1.5% in 2023 and 5-6% thereafter, driven by Cable EBITDA growth rebounding to 4.5% and Mobile generating $500m of EBITDA by 2025:

Illustrative Charter Cashflow Forecasts (2022-26)

Source: Librarian Capital estimates.

We believe total FCF can reach $8.3bn in 2026, similar to 2021, with growth being offset by the absence of federal cash taxes in 2021 when historic tax losses still fully offset earnings.

Charter Stock Forecasts

We reduce our buyback assumptions and keep our other assumptions unchanged. Our assumptions include:

• Share count to fall by 4% in 2023 (was 8%)

• Share count to fall by 8% in each of 2024 and 2025 (was 10%)

• Share count to fall by 15% in 2026

• 2025 FCF Yield of 4.5%

The assumptions imply the share count will fall by 31% between 2022 and 2026, with buybacks returning to more substantial levels once EBITDA growth re-accelerates.

We look at a 2025 year-end exit as part of our standardized methodology, w We assume a 4.5% FCF Yield to reflect expectations that FCF will recover substantially in 2026 with the end of the current accelerated CapEx program. Relative to 2026 FCF, our exit assumption implies a 9.8% FCF Yield.

Our updated 2026 FCF/Share forecast is $69.56, 8% lower than before ($75.85)

Illustrative Charter Return Forecasts

Source: Librarian Capital estimates.

These imply Charter’s share price will be at around $605 at 2025 year-end. With shares at $395.38, our forecasts imply a total return of 53% (18.7% annualized) by 2025 year-end.

We reiterate our Buy rating on Charter.

Ends

Stocks mentioned: CHTR 0.00%↑ CMCSA 0.00%↑. We are long CHTR.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.