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Charter: Solid Progress in Q1 After Shares Collapsed in 2022
Company Update (CHTR US) (Buy)
Q1 results show Charter’s business is on the mend
Residential Internet revenues grew 4.9% year-on-year
EBITDA should accelerate in H2 as we lap cost increases
Excluding rural CapEx and one-offs, FCF Yield exceeds 10%
We see 85% upside (25.8% p.a.) by 2025 year-end. Buy
We review Charter after Q1 2023 results were released last Friday (April 28).
Charter shares have rebounded 20% from their October 2022 low, though their path has been volatile and they remain 46% lower than at 2020 year-end:
Charter Share Price (Last 1 Year)
Source: Google Finance (03-May-23).
Q1 2023 results showed that Charter’s growth has reaccelerated. Residential Internet revenues grew 4.9% year-on-year and 1.4% from Q4; excluding low-margin Video, total Residential revenues grew 5.7% year-on-year and 1.7% from Q4. Charter’s Internet subscriber count grew by 0.2% (76k) in Q1, while its Mobile lines grew by 13% (686k). Adjusted EBITDA grew just 2.6% year-on-year, but should accelerate in H2 as we lap investments made last year. Management maintained that growth is temporarily reduced by low market activity. Network expansion and upgrade plans, including the subsidised Rural Constructive Initiative, remain on track. Buybacks have reduced the share count by another 2.4% in Q1. Because of one-off CapEx programs and elevated working capital in Q4, total Free Cash Flow (“FCF”) fell by 72% year-on-year; excluding subsidised rural CapEx and part of working capital outflow, FCF/Share was an annualized $36.52, equivalent to a 10.2% FCF Yield. We believe Charter can generate around $76 of FCF/Share in 2026. With shares at $357.23, our forecasts indicate a total return of 85% (25.8% annualized) by 2025 year-end. Buy.
As this is our first Charter article on Substack, we start with a longer recap of its investment case. Readers familiar with our research can jump one section ahead to “Charter Q1 2023 Results Headlines”.
Charter Investment Case Recap
Our Charter investment case contains the following components:
Broadband connectivity demand will continue to grow as technology advances and new use cases appear
Incumbent Cable networks are superior in cost and at least competitive in speed against new entrants
Mobile is a further opportunity as Cable operators will have lower costs from cross-selling and WiFi offload
Total connectivity revenues will grow faster than GDP from both the number of users and value per user
Operator profits will grow faster than revenues due to natural operational leverage and increasing efficiency
Keeping a flat leverage and putting surplus cashflows into buybacks help Charte grow FCF/Share by double-digits
During 2017-21, Charter achieved a CAGR of 31.7% in its FCF/Share (our definition), with a 5.8% CAGR in the number of Internet subscribers having driven a 10.6% CAGR in Internet revenues and in turn a 7.8% CAGR in EBITDA. Internet subscriber growth was around 5% in 2017-19 but accelerated to 8.3% in 2020 during the pandemic:
Charter Internet Subscribers & Key Financials (2017-21)
NB. SBC = Share-Based Compensation; average basic share numbers used for comparability; FCF/Share figures are calculated differently in the rest of the article. Charter completed the acquisition of TimeWarner Cable in May-16. Source: Charter company filings.
CapEx was lower in 2021 than in 2017, and buybacks had reduced the average number of shares at an 8% CAGR.
However, Internet subscriber net adds started to normalize in Q4 2020 and dropped precipitously in Q2 2022. This deceleration slowed EBITDA growth (to 4.8% in 2022) and contributed to a collapse in Charter’s share price:
Charter Customer Net Adds by Category (Since Q4 2019)
Source: Charter company filings.
Charter and other U.S. Cable operators attributed the net add deceleration primarily to a slower market, with fewer gross adds across the sector (in part due to reversal of COVID-19 benefits) and their own churn remaining at historical lows.
However, 2022 also saw a significant increase in connectivity offerings, including Fixed Wireless products from T-Mobile (with more spectrum from their Sprint acquisition) and Verizon (who bought new C-band spectrum released by broadcasters), as well as accelerated fiber overbuild by AT&T (following their Warner Media disposal).
Fixed Wireless has contributed most of industry net adds since Q2 2022 and, while AT&T and Verizon broadband net adds remain marginal, fiber may have helped them retain customers who would otherwise have moved to Cable:
Wireline & Fixed Wireless Broadband Net Adds - Key Players (Since 2019)
NB. Comcast Q1 2022 figure includes one-third benefit from end of COVID free programs. Source: Company filings.
We believe Fixed Wireless represents a small headwind within the lower end of Charter’s subscriber base. While Charter’s broadband offers a superior speed (1 Gbps+ download, vs. Fixed Wireless’s typically less than 200 Mbps), some customers are happy with the lower speed that Fixed Wireless provides. (At Comcast, a third of their subscribers were still on speeds of less than 300 Mbps as of May 2022.). We believe Charter has likely retained such price-sensitive customers with free speed upgrades or lower prices, which explains both its broadly stable subscriber count and relatively weak Average Revenue Per User growth in recent quarters. Retaining subscribers is the right strategy, given Charter’s stated focus on increasing its share of overall communications spend per subscriber household.
We believe fiber overbuild can be effective in helping telcos defending their existing markets and open new markets, but will not help them take share in markets where Cable already operates.
The Fixed Wireless headwind should recede over time as connectivity demand continues to grow, because subscribers will start demanding speeds that Fixed Wireless cannot provide, and because Fixed Wireless operators have only limited spectrum will face increasing bandwidth demand from both mobile and Fixed Wireless customers.
Charter is also raising its CapEx to increase its speed advantage, pre-empt further fiber construction and open up new markets in rural areas. Significant CapEx increases in 2023-25 were announced at the December investor day:
“Line Extensions” CapEx, which add new passings, to be $4bn in 2023, $1bn higher than in 2022. This includes the Rural Constructive Initiative, partly subsidized by government programs such as RDOF and BEAD, and the actual amounts will vary depending on how many Charter’s success in bidding for subsidies
Charter Current Rural Constructive Initiative
Source: Charter investor day presentation (Dec-22).
“Network Evolution” CapEx, which will use DOCSIS 4.0 technology to upgrade the upload speed to 1 Gbps and the download speed to 2-10 Gbps (on different parts of the network), to be $5.5bn, with most to be in 2024-25
CapEx is expected to fall back to below 2022 levels (measured in CapEx as percentage of revenues) from late 2025 or early 2026. In our forecasts, we further assume that Cable EBITDA will resume growing at 4.5% annually from 2024 and Mobile EBITDA will grow to $750m by 2026, which give a $8.31bn FCF total in 2026 (compared to $8.25bn in 2021, the relatively low growth largely due to an additional $3bn of cash taxes after tax losses were exhausted in 2022):
Illustrative Charter Cashflow Forecasts (2022-26)
Source: Librarian Capital estimates.
We have followed U.S. Cable stocks for nearly a decade, and first released our research on Charter publicly with a Buy rating in January 2020. After an initial period success when Charter gained nearly 60% in less than two years, the share price collapsed from October 2021, and remain 30% below the level at our initiation.
We did not anticipate the size of the broadband net add acceleration in 2022 and its impact on the share price, but we believe things are now again moving in the right direction. Q1 2023 results show that Charter’s growth is reaccelerating and management’s plans are on track.
Charter Q1 2023 Results Headlines
Q1 2023 results showed that Charter’s growth has reaccelerated, with Residential Internet revenues growing 4.9% year-on-year and 1.4% sequentially (compared to 3.9% and 1.2% respectively in Q4 2022):
Charter Revenues & EBITDA (Q1 2023 vs. Prior Periods)
Source: Charter results releases.
Excluding low-margin Video revenues, total Residential revenues grew 5.7% year-on-year and 1.7% from Q4. Year-on-year growth was achieved with a 2.0% growth in Internet subscribers and an 87.8% growth in Mobile lines:
Charter Customer Numbers (Q1 2023 vs. Prior Periods)
Source: Charter results schedule (Q1 2023).
During Q1 2023, Charter’s Internet subscriber count grew by 0.2% (76k), while its Mobile lines grew by 13% (686k). The bulk of Internet net adds were existing markets, with only 17k from subsidized rural build-outs.
Adjusted EBITDA growth was just 2.6% year-on-year, due to investments made in 2022 which meant total expenses grew by 3.9% and faster than revenues. These investments include improvements in employee job structure and pay (reflected in the 6.9% increase in Cost to Service Customers) and higher staffing levels across sales channels (reflected in the 7.5% increase in Sales & Marketing expenses). Management expects to progressively lap these cost increases from mid-year onwards, which should help EBITDA growth accelerate in H2.
The 19.9% increase in Other Costs of Revenues was “primarily driven by higher mobile device sales and other Mobile direct costs”. The 6.8% increase in Other Operating Costs was driven by higher labor costs.
Temporarily Low Broadband Market Activity
As in previous quarters, management maintained that Charter’s broadband subscriber growth is temporarily reduced by low market activity. As CEO Chris Winfrey stated on the call:
“On the overall broadband market, I do think that there continues to be the headwind of all the COVID volume that was pulled forward in the broadband market and in combination of just a lower transaction, lower moving environment. And so I think the entire market is still suffering from that as a little bit as well as a small swing back into wireless substitution … Housing starts also been down, so that clearly contributes into this as well, and all of which I think is temporary in nature … There is no reason to think that we don’t get back into the normalized market environment. It’s just become very difficult to predict exactly when that happens”.
If the broadband normalizes as management predicts, then Charter’s EBITDA growth should accelerate meaningfully.
Network Expansion & Upgrades on Track
Plans to expand Charter’s footprint, including with the subsidised Rural Constructive Initiative, remain on track.
During Q1 2023, Charter added 312k household passings (including 44k subsidized rural passings); year-on-year, total passings grew 2.1% to 55.9m (including 169k subsidized rural passings). Among subsidized rural passings, Charter has achieved a penetration of 30.2% and average residential ARPU of $104.72, healthy at this stage of the roll-out.
CEO Chris Winfrey confirmed that efforts are proceeding as expected, or even ahead of schedule on the RDOF program:
“Subsidized rural passings growth is accelerating with 20,000 subsidized rural passings activated in March. Costs are coming in as planned and we have the labor, the equipment and the supply necessary to execute our build. If we get the pull permit support we need, we can complete our RDOF commitments 2 years ahead of the RDOF deadline. The pace of penetration gains in subsidized rural passings continues to exceed our expectations, with 6-month penetrations at approximately 40%.”
Plans to upgrade the network are similarly on track, with the physical work for high-split completed in two mid-sized markets and set to be launched in 6 others; these represent about 15% of Charter’s footprint. Management reaffirmed expectations that network evolution efforts will cost on average $100 per passing and be “essentially complete” by 2025 year-end.
Adjusted FCF Yield Exceeds 10%
Because of one-off CapEx programs and elevated working capital in Q4, total FCF (as defined by management) fell by 63% year-on-year to $664m; if we also deduct share-based compensation costs, then FCF fell by 72% to $456m:
Charter EBITDA & Cashflows (Q1 2023 vs. Prior Periods)
Source: Charter company filings.
However, Q1 cashflows tend to be seasonally weak, and this year it was also affected by significantly worse working capital. Working capital flows included payments for rural construction equipment inventory stockpiled in Q4 to mitigate supply chain issues as well as for mobile devices, with the latter more than doubling year-on-year to $251m due to growth. Management expects full-year working capital to be “roughly neutral” excluding the impact of mobile devices.
If we excluding the Rural Constructive Initiative CapEx and part of working capital not related to mobile devices, then Charter generated $1,578m of FCF in Q1 2023, or $36.52 of FCF/Share:
Charter Adjusted FCF & FCF/Share (Q1 2023 vs. Prior Periods)
Source: Charter company filings.
With shares at $357.223, the adjusted FCF/Share figure of $36.52 implies a 10.2% FCF Yield, while the unadjusted figure of $10.55 implies a 3.0% FCF Yield. Buybacks have reduced the share count by 13.1% year-on-year and 2.4% from Q4 as Charter continues to repurchase shares, albeit at a lower rate than last year.
The difference in FCF from the prior-year quarter was largely due to CapEx rising with new CapEx plans; the difference in FCF from Q4 2022 was largely due to seasonally lower CapEx and the absence of a cash tax payment in Q1.
Charter Return Forecasts & Conclusion
We keep our assumptions unchanged and show our forecasts below. These are illustrative only, but reflects the fundamental assumptions outlined in our investment case above.
The most important points in our forecasts are that they show total FCF in 2026 to be 36% higher than in 2021 on a pre-tax basis (but roughly the same after new cash taxes) and the share count to fall by another 26% during 2022-25. These give a 2026 FCF/Share of nearly $76:
Illustrative Charter Return Forecasts
Source: Librarian Capital estimates.
As part of our standardized methodology, we look at a 2025 year-end exit. We assume a 4.5% FCF Yield to reflect expectations that FCF will recover substantially in 2026 with the end of current CapEx programs. Relative to 2026 FCF, our exit assumption implies a 9.8% FCF Yield.
With shares at $357.33, our forecasts indicate a total return of 85% (25.8% annualized) by 2025 year-end.
We reiterate our Buy rating on Charter stock.