Charter Communications (CHTR 0.46%) has long been a value investing favorite. The company operates a large footprint of broadband and cable operations, which it consolidated after the 2016 acquisitions of Time Warner Cable and Bright House Networks. With legendary cable investor John Malone's Liberty Broadband Corporation (LBRDK 0.30%) owning more than 27% of shares and having a big input into Charter's strategy, the company seemed like a safe bet – until this year.
After reaping synergies and upgrading each network to modern broadband technologies, Charter posted steady broadband growth for years, generating market-beating gains between 2016 and 2021. However, as interest rates have rapidly risen and broadband growth has slowed, the script has flipped, with the stock now underperforming in a big way.
That could be due to Charter's somewhat risky capital allocation strategy that aims to juice equity returns over time. If Charter can maintain some growth and profitability, that strategy could pay off big for shareholders; however, if the business loses momentum and interest rates go higher, it could run into problems. With the stock now back at 2018 levels, Charter could be a huge winner -- but how big of a risk is it taking?
Charter's debt-fueled buybacks
The telecom industry isn't usually known for massive stock gains like those Charter experienced from 2016 to late 2021. Large telecoms usually grow, but not nearly as much as younger tech companies. They are usually viewed as steady dividend payers, because of the utility-like nature of broadband and cable subscriptions.
However, Charter aimed to juice equity returns through its aggressive buyback strategy. The strategy works like this: Charter keeps its overall net debt just under 4.5 times earnings before interest, taxes, depreciation and amortization (EBITDA). So as Charter's EBITDA grew over the years, it put on more and more debt. Management then repurchased as much stock as it could every quarter, using all of its free cash flow plus the extra cash from the debt issuance. So Charter would repurchase even more than it was making in free cash flow every quarter.
That strategy has enabled management to buy back a whopping 46.3% of its shares outstanding just since 2016, which is a huge amount in a such a short amount of time.
However, that strategy has also pushed Charter's debt to a whopping $97 billion dollars. That's causing a lot of nervousness as interest rates have risen.
Have 2022's headwinds changed the story?
Charter has faced a number of headwinds in 2022. Broadband, which has been the central profit center, has seen slowing growth. Net broadband additions actually went negative in the second quarter, although that was due to the ending of a federal rural broadband program. Net broadband additions were back in positive territory in the third quarter, but they grew by just 61,000, as opposed to 243,000 additions in the year-ago quarter.
Management attributes the slowdown to fewer people moving than pre-pandemic, which is causing less opportunity to add gross additions; however, some may fear competitive concerns, as both 5G wireless players and new fiberoptic players looking to grab broadband customers from Charter, which generally uses coaxial cable technologies.
Charter is also seeing longtime CEO Tom Rutledge step down from the role, as he is retiring, although staying on as executive chairman. Chief Operating Officer Chris Winfrey will be taking over, who has been with the company under Rutledge for a long time. So while Rutledge's retirement is causing some concern, one shouldn't expect much change.
In addition, Charter has mostly exhausted its deferred tax assets from years of prior losses, which means the company is now a full cash taxpayer. The near $400 million increase in cash taxes paid last quarter compared with last year, along with a $500 million increase in capital expenditures to expand its footprint in rural areas, has caused a decrease in Charter's free cash flow, from nearly $2.5 billion in last year's Q3 to just $1.5 billion in Q3 2022.
With lower free cash flow than last year and interest rates going up, it's no wonder Charter has sold off so much.
But the bull case may still be intact
Even with all these headwinds, there is a case to be made Charter could be a screaming buy. Apparently, one of its own directors believes that, too. On Nov. 1, director Eric Louis Zinterhofer bought a whopping $10.1 million worth of stock, at prices in the mid-$370 range.
What does Zinterhofer see? Well, Charter still has a lot going for it. Even in a recession, it seems unlikely that most will cut their broadband subscriptions. While people may cut their cable bundle subscriptions, traditional cable is a low-margin product and has already been in decline.
Moreover, Charter has begun offering bundled mobile plans in recent years, wholesaling Verizon's wireless network. With Charter's broadband being lower-priced than fiber internet, and with bundled discounts competing with even the lowest-cost wireless plans, Charter stands to survive a recession, if we have one. In fact, its cost-competitiveness could enable it to pick up new subscribers.
And even at this lower level of free cash flow, Charter has its debt well-covered until 2025, as it has staggered its debt maturities so that only a relatively small portion comes due every year. Even the $7 billion due in 2025 looks manageable. And by then, it's probably likely inflation and interest rates will be lower than today.
Meanwhile, the stock is quite cheap, with a market cap of just $60 billion, when factoring the conversion of special units granted to large shareholder Advance/Newhouse Partners. So even at the below-trend level of free cash flow of $6 billion, Charter's stock is only trading at 10 times free cash flow. As it continues its buyback strategy, Charter could retire more than 10% of its stock at these price levels. If Charter can get back to last year's $8.7 billion in free cash flow in time, that would yield a current price-to-free cash flow ratio of just 6.9.
Unless Charter's business deteriorates further or interest rates spike much higher on a sustained basis, I'd lean toward insiders' view that the stock is a bargain. The competitive threats of 5G wireless broadband and fiber are things to watch, but Charter's relatively low-cost, high-value offerings should enable it to get through this period.
