Charter Communications (CHTR) is one of the largest cable TV and broadband providers in the county. I have owned the stock for about a year, initially buying it because it seemed like a quality business that was out of favor and trading at a reasonable valuation multiple. The stock recovered a bit, until recently CHTR announced a decline in broadband subscribers which have caused a 9% selloff. Given the recent price moves and the fact I’ve held the stock for a while, I thought it would be a good idea to reevaluate its fair value.
Since I don’t believe Charter has a strong competitive advantage, where they can plow profits back into the company and sustain a high growth rate, I will value the company based on their current earnings power. The starting point for this is to estimate a reasonable amount of revenue. It looks like Charter’s revenue is poised to be about the same as last year, so I’ll use $53B as their revenue.
Next, I looked at the ranges of Charter’s operating margins over the years. Last year, CHTR had an operating margin around 25%, while a few years ago it was down around 15%. For this analysis, I’ll use an average figure of 20%. This operating margin produces $10.6B in operating income.
Following operating income is interest expense and taxes. Charter’s interest expense is about $4.5B. Typically Charter’s effective tax rate is around 20%. So subtracting the $4.5B from the operating income and applying the tax rate produces an estimated after tax income of $4.9B.
The last step is to apply a discount rate to the estimated income in order to get an earnings power value of Charter’s equity. This part is a bit tricky because interest rates are much higher now than they were a year or so ago. Short term Government bonds currently yield nearly 5%. When interest rates were low, a reasonable discount rate for Charter may have been 7-8%. Now that rates are higher, I think 8-9% is the type of return an institutional investor would demand for a stock like Charter. Dividing the $4.9B of after tax income by 8% provides an estimated equity value of $61B. CHTR has 152 million shares outstanding, which makes my fair value estimate of $410 a share.
Charter currently trades at $362 a share, which means it may be slightly undervalued but there is not a large margin of safety. Shortly before the recent selloff, Charter was trading around $410, so there might be some merit to my fair value estimate. Another aspect to consider is that Charter has historically done large share buybacks, at times spending $10B a year. If these large buybacks continue, then CHTR could provide high shareholder yield.
The last thing I would like to discuss regarding Charter is how many analysts use EBITDA when valuing the company. Using EBITDA as the earnings input in the valuation formula means that all of Charter’s depreciation charges are added back. For some context, Charter had about $9B in depreciation last year. Adding all of that back would practically double the company’s earnings power, and produce a much higher fair value (evidenced by many analyst ratings being much higher than my estimate).
The popularization of EBITDA came from John Malone, the godfather of the cable business. His rationale was that once you lay cable/fiber, there is a certain amount you charge in depreciation for accounting purposes to reflect the wear and tear. However the cables do not wear out much at all, so Malone would say that the depreciation charge overstates the cost of wear and tear. Therefore, analysts should ignore depreciation when looking at a cable/broadband company. On the surface, this argument sounds reasonable.
In order to get a better understanding of CHTRs capex and depreciation, I glanced at their latest investors presentation. In the slides, they breakout their capex spend into several categories. About 40% of Charter’s recent capital expenditures go towards “line extension”, which I assume is laying more fiber cables. The rest of the capex is for things like upgrades/rebuilds, support, TV boxes, and scalable infrastructure (these terms are vague, maybe in the 10K they explain in more detail). These items do not seem to be the kind of equipment that is slow to deteriorate like what Malone was talking about. So my view is that maybe some of Charter’s depreciation is overstated, meaning you can add a portion of it back to earnings. However it appears much of the capex is for things that justifiably should be depreciated, so I don’t think it makes sense to add back all the depreciation charge. There could be other arguments for valuing Charter using EBITDA, but my method is more conservative so I will stick with it.
In summary, I feel pretty neutral towards Charter at the moment. I may hold onto my current shares for a while, but if a better opportunity pops up then Charter may get the boot. The company may be slightly undervalued, but there are still much uncertainty regarding technological changes in cable TV, broadband, and wireless internet. For now, I think Verizon is similar to Charter except that it produces more cash and appears to be trading at a larger discount to its fair value.
what are you thoughts on chtr now? its at $280/share. It seems the capex is much higher than predicted? And the debt under higher for longer isn't helping either.