Charter: FAQ on Disney “Blackout”; “Not a Classic Carriage Dispute”

Company Update (CHTR US) (Buy)

Highlights

• What has happened? Where do Charter and Disney disagree?

• How important are Charter and Disney to each other?

• How will this directly and indirectly impact Charter?

• What happens next? What final outcome do we expect?

• Are Charter shares still attractive?

What has happened?

On Thursday (August 31) evening, Disney removed access to all its programming from Charter Video subscribers. The “blackout” affects 19 Disney channels, including ESPN, the Disney Channel and National Geographic, as well as ABC on-demand programming and 7 local ABC stations in New York, Los Angeles, Chicago, etc. Disney was acting on the expiry of its previous agreement with Charter, after the two sides failed to reach an agreement despite “months” of talks.

On Friday (September 1) morning, Charter held a conference call to discuss the matter. Their presentation title included the phrase “Moving Forward, Or Moving On”, and management repeatedly stated that this was not a typical carriage dispute as well as referenced the possibility that Charter may end up dropping Disney content permanently.

Charter CEO Chris Winfrey described the “blackout” as the first such event of scale since he joined Charter in 2010.

What do Charter and Disney disagree on?

The main disagreements are on penetration payment minimums and the status of Disney DTC (Direct to Consumer) apps for Charter Video subscribers. In effect, the two sides disagree on who should take the downside as linear Video subscribers continue to be cannibalised by streaming services, including Disney’s own current and future DTC apps.

According to Charter, Disney has offered a “traditional long-term deal” with price increases, higher penetration minimums and the mandatory inclusion of Disney channels in more Video packages. (Penetration minimums allow programmers to get paid for more subscribers than they actually get, while inclusion in more packages means programmers get more subscribers even if consumers do not actively want their content.) These have been common features on content deals in the past, so the disagreement is one on numbers, not structure; and Charter stated they have offered to accept Disney’s price increases but asked for lower penetration minimums and more flexibility in Video packages:

Negotiating Positions (Disney vs. Charter)

Source: Charter Disney dispute presentation (01-Sep-23).

More fundamentally, Charter has demanded Disney ad-supported DTC apps to be included as part of linear Video bundles. This would mean that, where a customer has already paid for content on their linear Video package, they can also access that content on a DTC app free-of-charge (instead of paying for the same content twice). Without this, Charter would have guaranteed to continue paying Disney for a fixed number of linear Video subscribers even as its actual Video subscriber number continues to leave, including when customers switch to Disney’s DTC apps. In the Q&A section of the call, Charter specifically referenced Disney’s flagship ESPN channel which, while currently only available on Cable TV, is widely expected to be made available on DTC apps soon, based on comments by Disney executives:

Recent Press Coverage on ESPN DTC Plans

Source: The Information (24-Aug-23), CNBC (13-Jul-23), The Wall Street Journal (18-May-23).

Charter has also offered to help Disney sell its DTC app to its Internet customers, in return for a revenue share. How attractive this is to each side depends on the terms, which have not been disclosed.

Both Charter and Disney claim to have offered a short-term contract extension to the other side to enable talks to continue without a “blackout”. Charter stated that its offer included “incremental relief” on some contractual terms, while Disney stated that Charter “declined Disney’s offer to extend negotiations”.

What happens next?

Negotiations have stopped for the time being. One or both of Charter and Disney will have to move from their existing positions for talks to resume and an agreement to be reached, but there is little visibility on when or how this will happen.

Charter executives stated they would like to reach a new partnership with Disney but were also ready to “move on” without Disney and “pivot to other video models”. They further stated that, the more time passes, the more likely Charter would permanently drop Disney content (given more customers would have moved to alternative content or sources).

In the meantime, Charter is helping its Video customers find alternative sources for the same Disney content, including other DTC apps like Roku. It expects to provide rebates (in the form of credits) to compensate them for the loss of Disney content, with CEO Chris Winfrey committing to doing what is morally fair and more than what is legally required. It will also help customers downgrade their Video products.

How important is Disney in Video?

Charter stated that only around 25% of its Video customers “regularly engage with Disney content”, of which about half are “highly” engaged. Disney in turn stated that “in the average month, 71% of Charter subscribers tune into Disney’s networks or stations”, which does not specific the level of interest among those who “tune in” and implies an average 29% of them do not watch any Disney content at all.

Some Disney programming, notably the flagship ESPN channel, is unique and only available on Cable TV packages; customers interested in such programming may decide to switch provider, though alternatives do not exist in many locales. (As of Q3 2022, only 44% of Charter’s residential passings have a 1 Gbp+ broadband competitor, which is a good proxy for the percentage of locales where there is a realistic alternative.)

Other Disney programming is less unique, and customers may opt to watch other content instead. Such non-unique Disney programming is also available on DTC apps like Roku, or Disney’s own Disney+ and Hulu. Video subscribers may keep their current Charter packages (which will become cheaper) and add such apps on top.

Management speculated Charter “could have a smaller but much more attractive Video business” without Disney.

How important is Video to Charter?

Charter makes a small (but declining) profit in Video, and values it more as a tool to enrich its overall relationship with each customer, improve retention and cross-sell more connectivity products. However, Charter’s natural operational leverage can mean any revenue loss will have a disproportionate impact on EBITDA.

As of Q2 2023, only 45.6% of Charter customers take a Video product, compared to 94.9% who take an Internet product. Over the past 5 years, Charter has lost about 10% of its Video customers, while the industry has lost “almost 25%”.

Charter Total, Internet & Video Customers (2017 to H1 2023)

NB. Includes both residential and SMBs. Source: Charter company filings.

As of H1 2023, Residential Video revenues represented 31% of Charter’s total revenues (96% of Video customers are Residential). However, Video profit contribution is far lower because its revenues are low-margin, with Programming Costs absorbing 66% of Residential Video revenues. The difference between Residential Video Revenues and Programming Costs was $5.81bn in 2022, compared to the $22.9bn of high-margin Residential Internet Revenues:

Charter Selected Revenues, Costs & EBITDA (2017 to H1 2023)

Source: Charter company filings.

The $5.81bn figure, a worst-case scenario number for Charter losing all its Video subscribers, is equivalent to 26.7% of Adjusted EBITDA, but is likely a significant overestimate, because there are other variable costs such as marketing, customer service, etc, which are not deducted in our calculation. (At other Cable companies, removing Video from customer bundles tend to result in an accounting increase in broadband revenues, as the bundle discount is unwinded, but Charter stated that it has already removed its bundle discount some years ago so any effect will be “minimal”.)

Charter’s presentation stated that Video would be “significantly and video ultimately cash flow neutral without structural changes”. This does not specific Video’s current cashflow profile but implies that its contribution is already minimal.

What is the direct financial impact for Charter?

The immediate financial impact is that Charter will provide rebates (in the form of credits) to compensate Video subscribers for the loss of Disney content. (Charter stated this will “largely” be offset by the removal of payments to Disney for said content.) Management has not decided if such rebates should be automatic or made as requested, but CEO Chris Winfrey has promised Charter will act fairly and beyond what is legally required.

In addition, there will be disruption to advertising revenues generated on Disney channels. Charter Ad revenues totalled $1.89bn in 2022 (higher due to political ads U.S. mid-term elections). However, only a fraction of this is Disney-related and management expects to shift ads to non-Disney channels and mitigate at least some of the revenue impact.

Charter Revenues, Costs & EBITDA (2022 vs. Prior Year)

Source: Charter results release (Q4 2022).

There will be other one-time costs, including to handle additional customer calls, but these have not been quantified.

Longer-term, there is a risk that Video revenues will be lost permanently if/when Video subscribers drop or downgrade their packages. This risk is modest, assuming Charter’s assertion that only 25% of their Video customers actively engage with Disney content is correct. Any loss will be offset by the elimination of $2.2bn of programming costs previously paid to Disney each year, as well as potentially by the customer upgrading their broadband to use DTC apps.

However, Charter’s natural operational leverage can means any revenue loss will have a disproportionate impact on EBITDA. The large portion of Charter costs that are relatively fixed represents a positive when revenues grow, but a negative when revenues decline.

What is the potential indirect impact for Charter?

Losing Disney content may also impact Charter indirectly through its Internet customer numbers.

With the “blackout”, Charter is currently not able to offer something (Disney programming) it used to offer, and this is by nature negative. In addition, anything that draws customer attention to existing subscriptions tends to be negative for retention. However, we believe the impact will be modest. As explained above, only 45.6% of Charter customers have a Video product, and Charter believes only 25% of them actively engage with Disney content.

Charter’s main competition are telco fiber and fixed wireless. Against telco fiber, Charter now has a modestly inferior Video product, but Charter has been reasonably successful in gaining/holding market share here in recent quarters and its overlap with 1 Gbps+ wireline competitors (primarily telco fiber) is only 44% (as of Q3 2022). Against fixed wireless, which is generally a broadband-only product with no traditional video component (though some bundle DTC apps such as Netflix and Apple TV), Charter still has a superior product; it has been losing some low-end, price-sensitive customers to fixed wireless, but not having Disney programming should not make much of a difference.

Charter Customer Net Adds by Category (Since Q4 2019)

Source: Charter company filings.

Charter expects the “vast majority” of affected Video customers to stay with Charter, though “some” may be impacted. CEO Chris Winfrey stated that on the call that he "had not really thought about this as a significant risk to our broadband and connectivity solutions”, and confirmed that Charter still aims to have "higher Internet net gains vs. last year" in 2023.

How important is Charter to Disney?

The situation for Disney is similar as that for Charter. Disney’s exposure to Charter is a small part of its revenues, but its loss may have a disproportionate impact on earnings because of Disney’s large fixed costs.

Disney generated $12.1bn of EBIT in FY22, including $8.52bn from Linear Networks and $7.91bn from its Parks, Experiences & Products segment, offset by Direct-To-Consumer losing $4.02bn:

Disney Revenues & EBIT By Business (Since FY20)

Source: Disney company filings.

Charter stated that it is paying around $2.2bn of programming costs to Disney each year; both companies also generate revenues from ads displayed on Disney channels.to Charter Video subscribers. Disney had $3.89bn of advertising revenues from its U.S. cable channels during FY22, and Charter’s 14.7m Video subscribers (as of Q2 2023) represented about 20% of the U.S. total (of 71.9m), which implies it contributed about $0.8bn of Disney’s ad revenues.

It is unclear how much Disney’s expenses will fall because its content has been removed from Charter subscribers; certainly there are costs associated with advertising revenues. And Disney will be able to regain some of the lost Charter revenues through its DTC app and other MVPD (Multichannel Video Programming Distributor) partners.

However, in the worst-case scenario, the $2.2bn of programming cost payments and $0.8bn of U.S. ad revenues related to Charter could mean a decline of nearly 25% ($3bn) in Disney’s EBIT.

What is the likely final outcome?

We expect Disney and Charter to come to an agreement eventually, as there is simply too much money at stake for both sides. We believe the final outcome will be more favourable to Charter than to Disney, because Charter has more staying power while Disney is already under significant pressure from shareholders.

Over the past year, Charter shares have recovered 6.4%, while Disney shares have lost 25.8%. Following the “blackout”, Chater shares fell 3.6% and Disney shares fell 2.4% on Friday:

Charter & Disney Share Performance vs. S&P 500 (Last 1 Year)

Source: Google Finance (01-Sep-23).

Charter generates most of its profits from its Internet business, and Video is a relatively low-margin sideline. It has a long-term strategy of gaining a larger share of household connectivity budgets, and is progressing with a rapidly- growing Mobile business, subsidized new-build in rural areas and an upgrade of its network. Management is stable and has a record of thinking long-term, backed by supportive shareholders including Liberty Broadband and A/N, which respectively hold 27.6% and 12.5% of Charter’s voting stock. Charter can take the short-term pain of a Disney “blackout” and indeed of a transition away from Disney content.

Disney generates a substantial part of its profits from U.S. cable channels; its previous arrangement with Charter allows Disney content to reach a large number of customers, including many who do not actively want it. Disney’s other big profit generator is Parks, but this may be over-earning and is at risk from a potential U.S. downturn. Its strategy of rapid expanding in DTC streaming generates substantial losses is widely seen to be in need of revision, and it is struggling to find an answer to strategic threats including rising content costs, over-supply of programming and new competitors such as Amazon and Apple. It has had to bring back Bob Iger as CEO in November 2022, shareholders are restless, and it has only just beaten off one activist investor’s attempt to gain a board seat in February (Nelson Peltz’s Trian Partners, with 6.43m shares, or 3.5%). Disney has other problems to deal with, and can ill afford a prolonged standoff with Charter.

Are Charter shares still attractive?

We believe Charter shares are attractive, but the risks are now higher and the upside may now take longer to materialize.

The bull case for Charter is a return to double-digit Free Cash Flow (“FCF”) / Share growth, based on the company  gaining share in household connectivity budgets, operational leverage and share buybacks. The underlying strength of Charter’s business is its low-cost incumbent connectivity infrastructure already reaching 56.2m households, enhanced by economies of scale, but it can still be vulnerable to competition because incremental costs are low and the industry has excess capacity. Subscriber net adds have slowed to near zero since Q2 2022 and pricing has been weak, but we expect things to improve with Charter’s rural expansion, network upgrade, fixed wireless competitors exhausting their spectrum and industry subscriber gross adds returning to pre-COVID levels. As we explained in our review of Q2 2023 results, Charter appears to be turning the corner but progress is slow, with total Residential Revenues excluding Video growing 4.1% and EBITDA growing just 0.2% year-on-year. We had expected EBITDA growth to accelerate from Q3 once marketing and staff investments made in H2 2022 are lapped; the Disney “blackout” may now delay this.

We believe Charter’s real current FCF Yield, excluding one-off CapEx, is somewhere in the high-single-digits.

Valuation is currently distorted by the large CapEx program announced in December 2022 and expected to be completed by 2025 year-end. As of Q2 2023, Charter has an annualized FCF run-rate of $11.57 per share, implying a 2.7% FCF Yield; normalizing for seasonal tax payments and working capital, and excluding CapEx for the Rural Construction Initiative, we estimate Q2 2023 run-rate FCF/Share to be $27.99, implying a 6.6% FCF Yield.

Charter Adjusted FCF & FCF/Share (Q2 2023)

Source: Charter results materials (Q2 2023).

(FCF was $5.54bn in 2022, equivalent to $32 FCF/Share on the latest share count. This figure is after $1.79bn of Rual Construction Initiative CapEx but does not reflect the higher CapEx since December 2022. It gives a FCF Yield of 7.6%.)

We have not adjusted out network upgrade CapEx, in effect conservatively assume Charter will have to continue upgrading its network over time to stay ahead of competition. Network upgrade CapEx was $392m in Q2 2023, $203m higher year-on-year, and this difference is worth another 1 ppt in FCF Yield.

Charter CapEx by Category (Last 5 Quarters)

Source: Charter results presentation (Q2 2023).

Our existing forecasts see Charter’s total FCF grows to $7.9bn and its FCF/Share grows to around $66 in 2026, helped by EBITDA growth, a reduction in network upgrade and line extension CapEx (of about $3.2bn vs. 2023) and the share count falling by 31% vs. 2022 year-end. There is too much uncertainty to update near-term forecasts, but we believe there is a reasonable chance that long-term forecasts do not have to be revised.

With shares at $422.32, these forecasts indicate a total return of 57% (14.5% annualized) by 2026 year-end:

Illustrative Charter Return Forecasts

Source: Librarian Capital estimates.

We have assumed a 10% FCF Yield at 2026 year-end; this reflects a conservative view on an industry that is relatively mature overall (albeit with Charter growing with share gains), commoditized and has price-based competition.

With Charter shares having gained 24% year-to-date, they are less attractive than before. While we believe Charter will achieve a favourable outcome from the dispute, there are significant risks to near-term financials (due to operational leverage as described), and upside in Charter shares may take longer to materialize if the dispute becomes protracted, and even longer if Charter were to end up transitioning to a post-Disney model in its Video business.

Overall, we believe Charter shares are still attractive, and reiterate our Buy rating.

Ends

Stocks mentioned: CHTR 0.00%↑ DIS 0.00%↑. We are long Charter.

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