Taking advantage of the switch to streaming

Pengana Capital

Pengana Capital Group

Charter Communications is the USA’s second largest cable company, providing subscription-TV, internet connectivity (‘Connectivity’) and fixed voice services to 27m households and 2m small businesses. Cable companies are often described as payTV businesses; however, the truth is that they generate far more profit from Connectivity. It is more appropriate to think of Charter as a Connectivity business than a subscription-TV business.

It is no secret that households are dropping their incumbent TV subscriptions in preference for internet-delivered services like Netflix. With their history rooted in subscription-TV and roughly 40% of their current revenue coming from that market, it is easy to automatically jump to the conclusion that the outlook for cable companies is bleak (at best). However, we have a different perspective.

The decay of traditional subscription-TV is closely entwined with the growth of broadband connectivity as a household cannot consume internet-delivered video without Connectivity. As households become less dependent on subscription-TV, they are becoming more dependent on Connectivity. This is exceedingly positive for cable companies.

Connectivity is a meaningfully better business than subscription-TV. It offers vastly superior profit margins, is far less capital intensive and the sustainability of the improved economics is more dependable.

In the subscription-TV business, cable companies have to buy expensive content from dominant media companies, resulting in gross margins of <50%. This market is also highly competitive with the cable companies’ competitors including two satellite providers, one local incumbent telco and a slew of new internet-delivered video services. Further, subscription-TV is a highly capital intensive business as the cable companies have to fund the set top boxes and their installation. Cable companies actually make very little profit and low returns on capital from subscription-TV.

In Connectivity, the cable companies don’t have to buy content from anyone, meaning they generate >90% gross margins. Capital expenditure is low as Connectivity requires cheap modems that can be installed by the customer rather than the cable company. Further, the Connectivity market is not overly competitive as the cable companies’ only competitor is the local telco, which generally has an inferior product (DSL) to the cable company. The upshot is that cable companies are either monopolies or duopolies.

We have long held the views expressed above and they were a cornerstone of a prior meaningful position in Comcast. So this begs the question, why invest in Charter now?

Charter has been in the midst of a major restructuring program following its acquisition of a large peer (Time Warner Cable). We chose to sit on the sidelines during this restructure as it was fraught with risk. Charter’s 4Q18 result demonstrated that the bulk of the transition was behind the company, which gave us the green light to invest.

We expect to do handsomely from the investment, provided Charter continues to grow its Connectivity subscribers, its margins expand and capital intensity declines (owing to the shift away from subscription-TV and towards Connectivity).

Pengana Capital
Pengana Capital
Deputy Portfolio Manager, Pengana International Equities (ASX: PIA)
Pengana Capital Group
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