2023-06-27 12:52:38 ET
Summary
- Charter Communications' internet net adds have been under pressure due to fixed wireless access competition, but growth may pick up as fixed wireless growth slows and Charter's network evolution and rural build-out progress.
- Charter's mobile growth has gained traction, with record-high net adds last quarter, and while there may be churn once promotional periods end, some customers are likely to stick due to competitive pricing.
- The stock is rated as a BUY, with a conservative estimated fair value of $421 per share (25% upside), as the company's top-line growth rate is expected to improve.
- Investment risks include fixed wireless which could continue gaining traction in rural areas, and mobile-wise, MNOs are getting more aggressive in lower-tier plans.
Recap
Charter Communications Inc. ( CHTR ) shares trade at $337 per share at the time of writing. But they dropped almost 60% from the all-time high in less than two years. Why was the market so optimistic about the stock? And why did things change so quickly?
In 2020, Charter's internet revenue grew by double-digits thanks to strong subscriber growth: net adds were over two million a year. Further, its operating margin expanded to over 20%, as the company had "fewer selling opportunities" due to lower-than-usual move churn, which reduced sales and marketing expenses. This allowed the company to report strong FCF per share growth as well as beat consensus expectations by a wide margin.
Earnings surprise (Seeking Alpha)
However, things took a turn for the worse when fixed wireless access came in and took market share from cable companies. To compete with fixed wireless providers and fiber overbuilders, cable companies had no choice but to upgrade their network to DOCSIS 4.0, which requires a lot of money.
Charter expects to spend at least $5.5 billion ($100 per passing) to initiate the "network evolution initiative" that is expected to conclude in 2025, and another $4 billion per year for line extensions as the company is aggressively building its rural presence. Charter in 1Q23 reported $664 million of free cash flow, down from $1.8 billion a year ago.
That said, Charter trades at 10x its forward earnings, lower than its 5-year average of ~40x P/E, according to data by Morningstar. Hence, is Charter a BUY?
Will net adds pick up?
Charter's internet net adds remained under pressure, significantly below the numbers in pre-fixed wireless days. Wolfe Research found that 42% of the respondents who subscribed to fixed wireless services were from cable, as cited in Light Reading. Last quarter, Verizon (NYSE: VZ ) and T-Mobile (NASDAQ: TMUS ) reported 393,000 and 523,000 net adds, respectively. On the other hand, Charter only added 76,000 internet customers.
But while fixed wireless is still gaining traction, its net adds numbers were flat in the last several quarters. At the current pace, these numbers will be higher than Verizon and T-Mobile 's near-term target of 4-5 million and 7-8 million subscribers by the end of 2025, respectively. This suggests that the fixed wireless growth is running above expectations.
Internet net adds (thousand) (Companies) Charter internet net adds (thousand) (Company)
Additionally, while fixed wireless providers have excess capacity to begin with, they are "modeling out growth" in areas where there is less mobile traffic. This makes sense because fixed wireless takes a lot of capacity. Hence, our view is that while fixed wireless is here to stay, its future will be in less densely populated areas. Net adds might be flat, or even slowing down as we move forward, in our view.
Just as T-Mobile's Peter Osvaldik said :
But the way it's approached is in the areas where no amount of mobile traffic. And this is done on a sector-by-sector basis, modeling out growth, our anticipated growth of subscriber additions being a share taker as well as the anticipated growth in mobile usage growth and where all that modeling given how much bandwidth we're creating in the network, create still fallow capacity, that's where we go sell fixed wireless.
CEO Mike Sievert also added :
And in fact, this last quarter, 40% of our fixed wireless net additions or gross additions I should say, came from smaller markets and rural areas.
Further, through its research on fixed broadband, Opensignal found that almost half of the respondents who used Spectrum as their internet provider considered switching due to costs. Only 27% of respondents were dealing with speed or performance issues. Spectrum won or tied against fixed wireless providers in all categories, including speed, consistent quality, and video experience.
On the flip side, the survey suggests that when a third of T-Mobile's FWA subscribers and 30% of Verizon's FWA subscribers did consider switching, it was due to speed and performance. Indeed, both Verizon and T-Mobile's management said that as the fixed wireless customer base was getting more mature, the churn rate would be going down as well.
According to Verizon's Matt Ellis:
Customer satisfaction remains high as evidenced by NPS scores, as well as encouraging churn trends around the more tenured cohorts of customers.
Peter Osvaldik said:
Remember, this is an early base that started just a couple of years ago in reality. And so as the base matures, you tend to see early cohort churn.
But despite decreasing fixed wireless churn rate, our take is that customers increasingly look for higher speed and lower latency in the long run. According to Charter's management :
"Generally speaking, however, these customers typically exhibit higher levels of churn regardless of competition. And given the issues with fixed wireless product feeds, as confirmed by third-parties and questions surrounding that product's reliability and scalability, we expect fixed wireless customers to find their way back to us over time."
What about the competition with fiber overbuilders? While seeing "a little bit of softness" in gross adds and churn amid an intensely competitive environment from fiber overbuilders and fixed wireless providers, Charter still saw "small growth in areas with more overbuild".
This is where Charter's so-called network evolution comes in. As things stand, Charter has completed the first step of its network evolution, increasing the network capacity to 1.2 GHz, and is looking to initiate the second step that will cover 50% of its footprint. Indeed, DOCSIS 4.0 will improve upstream and downstream capabilities, but it is more like "marketing claims in the marketplace."
Additionally, Charter is expanding its presence in rural areas, although it incurs higher-than-anticipated RDOF build out costs. In total, 44,000 subsidized rural passings were activated during the quarter, with 20,000 of which being activated in March. The company initially looked at 300,000 passings this year, had the build out started at 15,000 to 20,000 passings per month-pace.
44,000 passings per three months are slightly behind the target (just under 15,000 passings per month, on average). But if we conservatively assume 20,000 passings per month, total build out this year should be around 224,000 passings, which should translate to almost 90,000 net adds (40% penetration rate).
Moreover, allocations for the $42.5 billion BEAD program were finally revealed on Monday. ACA Connects and Cartesian estimate about 12 million locations in the US will be classified as unserved and underserved, as reported by Fierce Telecom. This should expand Charter's presence in those areas.
In short, we believe Charter's internet net adds should pick up from the current levels thanks to slowing fixed wireless growth, network evolution, and accelerating rural build-out.
Mobile growth continued gaining traction, but is it sustainable?
Charter reported a record-high 686,000 mobile net adds last quarter thanks to a free second line offer for existing customers and a $50 Spectrum One plan, which includes internet and one mobile line. But are the record net adds sustainable?
Mobile net adds (thousand) (Companies, Vektor Research)
T-Mobile said that "new adds being printed" (the uptick) "did not appear to be coming from any of the incumbent players." Meanwhile, Charter's management insisted paying lines comprised the majority of the company's gross adds and those adds were "great adds." But both can be true at the same time. These adds might come from prepaid customers or younger customers getting phones.
While Charter continued to post strong net adds from paying lines, promotional offers did help. The below figure shows that MNOs' churn rate remained flat last quarter.
MNO's postpaid phone churn rate (%) (Companies)
But the question is whether there will be a lot of churns once the promotional periods end. Our take is that there will be churns, but some likely stick, especially as by the time the promotions are up, customers are still getting the competitive $30 per month rate. The company was already taking in more than 300,000 customers before launching the discounted rate. Charter said:
And when - I've said it before, but when the promotional period rolls off, they are going to have not only the fastest connectivity product, but they are going to have the best price in the marketplace as well at $29.99. That includes taxes and fees, contracts."
They are normal lines, and they are not going to be able to replicate the service or pricing that they are getting from us at retailers or promotions anywhere else in the marketplace.
Spectrum mobile net adds (thousand) (Company)
Valuation
Shares trade at 10x forward earnings. And free cash flow yield is around 9%. The last time the stock traded at ~$300 per share, revenue was $44 billion, and free cash flow was $2.2 billion in 2018. In 2022, revenue stood at $54 billion, and free cash flow was $6 billion.
Indeed, annualizing the 1Q23 free cash flow will bring the figure to just above $2.6 billion, which was dragged down by higher capital spending. But Capex should be down once Charter completes its network upgrade and rural build-out.
The market is expecting a ~2% top-line annual growth until 2025, lower than the 5-year historical average of ~5%. This is roughly consistent with our 10-year reverse DCF model (WACC: 8%, terminal growth: 2%).
10-year DCF model (Vektor Research)
However, we think slowing fixed wireless growth, network evolution, and accelerating rural build-out will help drive Charter's net adds. In addition, the mobile business helps drive top-line growth and margins as it scales up. Despite possible higher churn once the promotional period ends, some likely stick thanks to the competitive $30 per month rate.
Thus, if we conservatively estimate a 3% top-line growth rate, the estimated fair value will be $421 per share (25% upside). We rate the stock as BUY. What could go wrong? Fixed wireless continues to gain traction in rural areas, intensifying competition with cable in those areas despite huge investment. Mobile-wise, MNOs are getting more aggressive, further lowering the price for low-tier plans. If you have any thoughts, please do not hesitate to comment below.
For further details see:
Charter Communications: Net Adds Should Pick Up, Valuation Is Attractive