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Charter Communications (NASDAQ:CHTR)

Q4 2013 Earnings Call

February 21, 2014 10:00 am ET

Executives

Stefan Anninger - Vice President of Investor Relations

Thomas M. Rutledge - Chief Executive Officer, President and Director

Christopher L. Winfrey - Chief Financial Officer and Executive Vice President

Analysts

Philip Cusick - JP Morgan Chase & Co, Research Division

Vijay A. Jayant - ISI Group Inc., Research Division

Jason B. Bazinet - Citigroup Inc, Research Division

John C. Hodulik - UBS Investment Bank, Research Division

Kannan Venkateshwar - Barclays Capital, Research Division

Craig Moffett - MoffettNathanson LLC

Bryan D. Kraft - Evercore Partners Inc., Research Division

Benjamin Swinburne - Morgan Stanley, Research Division

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

James M. Ratcliffe - The Buckingham Research Group Incorporated

Amy Yong - Macquarie Research

Matthew J. Harrigan - Wunderlich Securities Inc., Research Division

Operator

Good morning. My name is Regina, and I will be your conference operator today. At this time, I would like to welcome everyone to the Charter Communications Fourth Quarter 2013 Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to Mr. Stefan Anninger. Sir, you may begin.

Stefan Anninger

Thanks, operator. Good morning, everyone, and welcome to Charter's 2013 Fourth Quarter Earnings Call. This morning, we issued a press release over PR Newswire at 8 a.m. Eastern Time detailing our results. The presentation that accompanies this call can be found on our website, charter.com, under the Financial Information section of our Investor & News Center. The press release and trending schedules can be found at the same location.

Before we proceed, I would like to remind you that there are a number of risks factors and other cautionary statements contained in our 10-K filed this morning. We will not review those risk factors and other cautionary statements on this call. However, we encourage you to read them carefully. Various remarks that we make on this call concerning expectations, predictions, plans and prospects constitute forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ from historical or anticipated results. Any forward-looking statements reflect management's current view only, and Charter undertakes no obligation to revise or update such statements or to make additional forward-looking statements in the future.

During the course of today's call, we will be referring to non-GAAP measures, as defined and reconciled in this morning's earnings release. These non-GAAP measures, as defined by Charter, may not be comparable to measures with similar titles used by other companies.

Please also note that on July 1, Charter completed its acquisition of Cablevision's Bresnan Broadband Holdings, LLC, and its subsidiaries, also known as Bresnan. Unless otherwise specified, all customer and financial data referred to on this call are pro forma for the Bresnan transaction as if it had occurred on July -- excuse me, on January 1, 2011. Please also note that all growth rates noted on this call and in the presentation are calculated on a year-over-year basis unless otherwise specified.

Joining me on today's call are Tom Rutledge, President and CEO; and Christopher Winfrey, our CFO. And with that, I'll turn the call over to Tom.

Thomas M. Rutledge

Thank you, Stefan. After reorganizing the company in 2012 and making our products and service offerings fully competitive, in 2013, we improved execution on fundamentals in our service operation and created significant momentum heading into this year, 2014.

In the fourth quarter, total residential customer relationship growth more than doubled year-over-year to 63,000 or a 3.2% gain for the full year, and we're growing market share across all products. Total residential PSU net adds grew by 147,000 in fourth quarter '13 versus 57,000 in quarter -- in fourth quarter '12.

We've stabilized our video customer base, improving our video results by 34,000 year-over-year, and we increased our multichannel market share with the expanded basic customers growing over the last 12 months. We're now well positioned from a product and service perspective to grow video customers.

We grew total revenue by 5% inside the quarter, and excluding advertising, revenue grew by 6.2%. Residential revenue grew by 4.9%, more than double last year's fourth quarter rate. And so far in this year, 2014, residential revenue is growing at approximately 6%. Commercial revenue grew by over 19% and, excluding video, grew by 23%.

EBITDA grew by 2.6% year-over-year, or 4.8% excluding the political advertising margin in the fourth quarter of '12. In full year, 2013 capital expenditures were in line with our expectations.

Sales are improving. From a customer perspective, we continue to see strong new demand for our products. Connect activity improved year-over-year by 14%, as we're improving our sales and marketing execution and providing a high-value, fully competitive product. And that improvement is occurring across all sales channels. Triple Play sell-in of video sales were at 57% in the fourth quarter, improving both year-over-year and sequentially. Involuntary churn is declining due to a better product and service offering.

The migration of our legacy customer base continues successfully with minimal disruption to existing customer relationship ARPU. 68% of our legacy customers are now on new pricing and packaging. 92% of our customers have our digital product, using 2-way HD boxes increasingly on all outlets in the home as we go all-digital. And 75% of our Internet customer base now receives data speeds of 30 megabits or more. We don't market or sell anything lower.

From a customer satisfaction perspective, as you can see on Slide 3, Charter's customer satisfaction levels are improving substantially. The improvement is being driven by the product and service operation investments we've made over the last 18 months, combined with our improving execution on a fully centralized operating strategy. And those investments are beginning to drive an overall reduction in service transactions and churn, together with increased dollars of margin on a quickly growing revenue base.

And while we're investing more in service quality to reduce total transactions, we've been able to reduce unit cost on higher-quality CPE by roughly 50% over the last 2 years, given our FCC waiver on cable cards, downloadable security strategy and volume buys. Ultimately, our investments are leading to higher revenue per relationship, lower transaction costs, higher customer satisfaction and greater customer and revenue retention at promotional roll-off, all positioning us well for significant free cash flow growth and greater cash flow growth per home passed.

In 2014 -- before I turn the call over to Chris, there are a few objectives for 2014 to highlight. First, we want to continue to improve service operations to drive our growth and financial objectives, the fundamental blocking and tackling of a high-volume transaction business. Second, to accelerate our product development in 2014, we continue to develop a cloud-based user interface for television displays, which, if all goes according to plan, will be available on every single set-top box in every one of our video customer homes. Our Charter TV app for tablets and smartphones launched in early November and allows for streaming of live cable channels inside the home. It also acts as a touch-screen guide, remote for set-top boxes and has the same look and feel as our new cloud-based user interface for set-tops. Our goal is to offer a richer user interface with a consistent look and feel. We anticipate adding more features to the TV app, including VOD both inside and outside the home.

Finally, the most important objective in 2014 is to transition the balance of our network to all-digital. At the end of 2013, we've completed approximately 15% of our all-digital initiative, and we plan to be all digital by the end of this year. This initiative allows us to unleash the full capacity and -- or full capability of our plant by unburdening our network from analog signals, giving us more network capacity to differentiate our products from those offered by satellite and telco competitors. By the end of this year, we'll be offering a superior product across the vast majority of our footprint, including, as you can see on Slide 4: more than 200 channels of HD, more than satellite, with digital pictures, an interactive programming guide and full Video On Demand on every single TV outlet; minimum Internet speeds of 60 megabits for newly migrated Internet customers and, in some areas, minimum Internet speeds of 100 megabits; fully featured voice at a competitive price, all giving us the ability to offer the best products in the market at a superior price point, whether at promotional rate or full price.

At the same time we take areas all-digital and deliver a superior product and service, we'll reestablish Charter in its new competitive light under the Charter Spectrum brand. So we've fundamentally transformed this company in 2 years. We're pleased with how we finished 2013, and we're very optimistic about 2014 and the strong start we've had so far. And with that, I'll turn it over to Chris.

Christopher L. Winfrey

Thanks, Tom. As a reminder, unless otherwise stated, the results we're discussing and showing in today's slides are presented on a pro forma basis as if we had acquired Bresnan on January 1, 2011.

Turning to Slide 5 of today's presentation, total customer and PSU trends improved across our residential and commercial businesses during the fourth quarter compared to the prior year, with PSU net add growth of 158% and 50% [ph], respectively. We are gaining market share across all products with high-value, fully competitive products, which are designed to stick. We lost 2,000 residential video customers during the quarter versus 36,000 last year, a 34,000 improvement.

Q4 video results include about 5,000 in bulk digital upgrades, but our residential video customer base was effectively flat during the fourth quarter. Looking over the last 12 months, which removes the impact of Q4 seasonal downgrades to limited basic, we grew residential expanded basic customers, indicating that we are starting to take back share in multichannel video.

Expanded customers now make up 93% of our video base. We also added 93,000 residential Internet customers during the quarter versus 59,000 during the fourth quarter last year. And we added 56,000 residential phone customers in fourth quarter versus 34,000 a year ago.

Residential customer relationship growth accelerated sequentially to 3.2%, as Tom mentioned, while residential revenue per customer relationship grew by 2.1%. The net result is that we grew residential revenue by 4.9%. And excluding Bresnan, which we're quickly returning to growth, Charter grew residential revenue by 5.0%.

I'd like to make a quick point regarding the lower ARPU growth we saw this quarter. The continued migration of legacy customers to our new pricing and packaging at a faster rate than planned has put some near-term pressure on customer relationship ARPU. 68% of our legacy customers are now in our new pricing and packaging. And as the final waves of this migration take place, there's a higher mix of price-sensitive customers that are migrating, some of which are migrating from higher legacy price points into lower current pricing with more video and Internet product, which ultimately leads to step-ups with lower churn and results in far better ROIs. We continue to see higher average dollar step-ups and better retention at promotional roll-off for customers that we acquired approximately 10 -- 12 months ago. So our plan to maintain customer rates is fully on track.

Turning to commercial, we added 18,000 PSUs versus 12,000 last year. And as Slide 6 shows, commercial revenue grew by 19.4% and by 23.3% if you exclude the lower growth video base in commercial. We expect continued success in the $9.5 million B2B communications market in our footprint, where we offer more value to business customers.

Looking at adjusted EBITDA and expenses on Slide 8. Programming expense grew by $38 million and accounted for over 45% of the increase in total operating expense growth year-over-year. On a per expanded [ph] customer basis, programming cost grew by 7.2% in the fourth quarter and 6.1% for the full year, consistent with our expectations. As our video base has now stabilized and expanded customers as a percentage of our video customer base grows, programming expense dollar growth will reflect both rate and volume growth, which means that 2014 programming expense growth may look more like our competitors and peers, albeit for slightly different reasons.

Cost to service customers, which includes field operations, network operations and customer care costs, declined modestly on an absolute basis year-over-year. Ongoing service quality investments are now being offset by lowering transaction costs per dollar of revenue.

Marketing spend was higher by $21 million or up 20% year-over-year, given the higher sales activities and channel development, which we see as a positive. Other costs grew by $28 million or 15% year-over-year, primarily driven by higher labor cost to support commercial revenue, higher collection cost related to sales growth and overhead related to our insourcing activities, and in that order.

So in total, adjusted EBITDA grew by $19 million or 2.6% year-over-year. Excluding the impact of $16 million of political advertising margin in the fourth quarter of 2012, our EBITDA growth would've been 4.8%, and that includes higher expenses for higher customer growth, which we saw in our PSUs and customer adds inside the fourth quarter.

Looking at Slide 9, capital expenditures totaled $566 million during the quarter or $1.83 billion in 2013, including Bresnan for the period we've owned it, and that's in line with the estimate we provided. On a pro forma basis, full year capital expenditures totaled $1.85 billion. Just over 45% of our 2013 CapEx was driven by CPE to support new customer acquisition, upgrades and digital box migration of existing customers. Looking at full year 2014, we expect to spend approximately $2.2 billion in capital expenditures. Of that total, approximately $400 million will be driven by our all-digital initiative, primarily digital set-tops and installation costs exclusively related to the migration dates by market and being onetime in nature. Also in the $2.2 billion is $100 million to support our insourcing activities for field operations, customer care and ITE [ph], which includes real estate, trucks, tools, test equipment and standing up our own platforms instead of relying on third-party vendors, also, in essence, onetime in nature.

Keep in mind that our full year capital expenditure estimate reflects an aggressive plan for customer growth, seeking additional 2-way boxes with each add, and our digital -- and our all-digital initiative as well. So our capital spend could be lower than $2.2 billion, although that's not our goal.

Free cash flow for the fourth quarter was $84 million compared to $33 million on an actual basis during the same period last year. The increase was primarily due to higher adjusted EBITDA and contribution from trade working capital, offset by higher capital expenditures.

During the fourth quarter, Charter liquidated one of its tax partnerships, which resulted in a step-up in tax basis of approximately $400 million and provided a onetime benefit to GAAP tax expense of $36 million. This onetime benefit was a key driver of the positive net income that we had in the fourth quarter.

Looking forward, based on the updated tax assets shown on Slide 12, we do not expect to be a significant cash taxpayer until at least after 2018.

We ended the quarter with $14 billion -- $14.2 billion of net debt and a leverage ratio of 4.8x on an LTM basis. Our weighted average borrowing cost remains 5.6%. And Slide 11 shows the weighted average life of our debt is 7.4 years, with over 95% of our debt maturing beyond 2016.

So we finished the year with $1.1 billion of total liquidity, and we have a balance sheet which is comprised of low-cost debt, long-dated maturities and significant flexibility. And the balance sheet is well designed to support our Triple Play growth strategy and benefit significantly from our significant tax assets.

As we complete our all-digital initiative at the end of this year, Charter is poised to substantially grow free cash flow in 2015 and beyond.

Now I'll pass it back to Tom for some final comments.

Thomas M. Rutledge

Thanks, Chris. Before I pass it back to the operator for questions, a few words on the recent events surrounding M&A. Last week, we nominated a slate of directors for Time Warner Cable. Notwithstanding everything that's happened, we are still interested in wisely acquiring subscribers through M&A where that opportunity arises.

Operator, we're now ready for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from the line of Phil Cusick with JPMorgan.

Philip Cusick - JP Morgan Chase & Co, Research Division

I guess the big question today is about the CapEx, $2.2 billion this year, and I understand the extra spending. Can you help us think about the '15 levels? You -- we've talked before and talked about normalizing back toward the industry in '15. And as we think about -- assuming you get the $2.2 billion spent this year, as we think about normalizing back, should we think about that as back to sort of a '13 level? Or could it -- that be back to be a more something closer to the industry percent of revenue?

Thomas M. Rutledge

All right. Why don't you take that, Chris?

Christopher L. Winfrey

Sure. So the CapEx for this year is $2.2 billion. And what we wanted to make sure people understood is there's $400 million of all-digital that's onetime in nature, as well as $100 million of insourcing activities. So we're not going to give guidance for 2015 or beyond. The biggest reason is it's highly contingent on growth. I mean, even if you look in 2013, when we were making a fair amount of transformation, 45% of our expenditure in CapEx was tied to CPE, and that all has revenue attached to it. So in some sense, it's our view, and we think it should be the view of shareholders as well, that to the extent we're spending on CPE and growing the business and it has revenue attached to it, people really should be cheering us on to go spend that capital. So if you take the $2.2 billion and you back off the $500 million of onetime, you get to $1.7 billion. And if you start to consider some of the things that Tom mentioned about what we're already seeing in the residential revenue growth rates inside this quarter and put those pieces together, I'd say you have a highly fast-growing cable business that is spending capital to generate that growth. And when the $500 million is no longer there in 2015, you get a significant increase in free cash flow, and we're highly confident of that. But the forward CapEx is going to be a driver of growth. And absent that growth, which we think is outsized relative to industry, there's nothing unique or structurally different about Charter that would cause it to spend more on a percentage of revenue relative to others.

Thomas M. Rutledge

Yes, I'd just add that capital, from an efficiency perspective, on an incremental dollar of revenue and on an incremental box basis for CPE, continues to go down. So assuming that we grow our revenues and assuming that we create good customer relationships, which we expect to do, the actual cost of capital per customer is declining, relatively speaking, because boxes are getting less expensive. And that's due to Moore's Law, but it's also due to the fact that we're buying them from different vendors now. We have the ability to download security and pick different -- and get out of the historic buying patterns that we were in. And as a result of that, and along with cloud-based infrastructure, our capital costs are actually declining on a per unit basis.

Philip Cusick - JP Morgan Chase & Co, Research Division

And as we think about the $400 million, does that essentially get the all-digital transition done? You've gone back to, essentially, every home and inserted the number of boxes that need to be in front of every TV?

Thomas M. Rutledge

Yes.

Operator

Our next question will come from the line of Vijay Jayant with ISI Group.

Vijay A. Jayant - ISI Group Inc., Research Division

Just -- you've done all-digital in 15% of the market. Can you give us any early indication on what, in those markets, you're seeing on subscriber trends, margins and just return on investment? And I have a follow-up.

Thomas M. Rutledge

Okay. So we are growing where we've gone all-digital. And Chris, do you want to...

Christopher L. Winfrey

Yes. Look, we're growing video. In the markets where we've gone all-digital, we're growing video. And it's not just improving on video; we're performing better across all products in those markets where we've gone all-digital relative to those where we have yet to go all-digital, so...

Thomas M. Rutledge

And you can see that the performance of the company, from an RGU perspective, is already accelerating. And only 15% of it through the fourth quarter was all-digital. So it's a combination of the all-digital impact but, even more significantly, just the cleaning-up of the operation and the creation of a better product set and value proposition for consumers, which is driving accelerating RGU growth. But interestingly, in the 15% footprint, it's even greater proportionally.

Vijay A. Jayant - ISI Group Inc., Research Division

Chris, just on the cost side, other expenses up 15% for the quarter. Is that the run rates when we start thinking about 2014?

Christopher L. Winfrey

Look, I don't want to provide, particularly, guidance on a line-by-line basis. But if you think about what's inside that number, the biggest drivers there are growth in commercial, and that's to be able to onboard a higher level of growth that's taking place inside commercial; as well as increased collection cost, given the fact that we've increased sales by 14% year-over-year. And some of that, just by nature of bringing in higher sales, drives some of that. We also changed some of our methodologies in there, which should be onetime in nature, meaning a plateau at a higher level. So I wouldn't expect that to continue to accelerate. And then the third area is, not to get into the mundane, but as you insource labor, then things like property tax and insurance and all that kind of good stuff flows in there. So that's going to be very much tied to the insource. But the biggest driver there is really growth. When you think about the other operating expense the same way as the marketing expense -- I mean, look, marketing expense was up $21 million year-over-year, but that's tied to that higher sales growth. That's commissions. When you look at EBITDA for the quarter, you may have to get your head around a couple of things. One is, there was $16 million of political advertising margin that wasn't there. And second is the market expense that's driving growth, so you can decide for yourself how you want to look at that $21 million. And the third one is, as you highlighted, the other expense, the majority of which is driven by growth as well. And those all factor in to the 2.6% growth; or if you want to exclude margin, political margin, 4.8%; or if you want to do a growth-adjusted, it ends up being something higher than that. So I think those are the right ways to think about those cost elements.

Operator

Your next question will come from the line of Jason Bazinet with Citi.

Jason B. Bazinet - Citigroup Inc, Research Division

Yes, I just had a question on CapEx. You said something on the call that sort of piqued my interest. You said that there's nothing structural about Charter that suggests its capital intensity should be different than peers'. And I was just going back to my model. I don't know, it goes back to like the Jerry Kent days through the Neil Smit days. And I've never seen Charter sort of generate a CapEx-to-rev number that's sort of in line with peers. So can you -- I assume that's because it's a revenue question, but what is the right parameter we should be using to sort of think about when you could glide into a peer level of CapEx-to-revs?

Thomas M. Rutledge

Well, I think that what Chris meant was that, if we were not growing, our capital expenditures on the same infrastructure would be very similar to anyone else's. There's nothing inherently different about the physical infrastructure and the need for capital at Charter relative to any other operator. We do think that we will grow faster than the rest of the industry, but we think we have that opportunity because of the way Charter was managed in the past and because of the kinds of penetration that it currently has. And so adjusted for growth, we think we're very similar, and growth capital will be a function of how fast we grow.

Jason B. Bazinet - Citigroup Inc, Research Division

But when you're all done -- let's say that you're successful with your plan. Do you think, when it all settles out, that you will have higher CapEx-to-revs versus peers?

Christopher L. Winfrey

Yes. And we hope we do because it will be driven by growth.

Operator

Your next question will come from the line of John Hodulik with UBS.

John C. Hodulik - UBS Investment Bank, Research Division

Two things. First, you guys said that you saw 6% residential revenue growth thus far in 2014. Should we expect that to continue to accelerate as we move through the year? And then there's been lots of commentary on the call here about -- on the cost side, different cost items. Is there another incremental cost that comes with all of the installation of the new boxes and the move to all-digital? And then, I guess, summarizing that side, can we expect margins to be up year-over-year or flattish?

Thomas M. Rutledge

Yes, I think our revenue growth will accelerate. And the reason I think that is because our sales were accelerating and our Triple Play sell-in was accelerating. And the numbers that we're generating today can translate into future higher growth rates. In terms of cost for capital associated with all-digital, it's all in there in our estimate. And it's onetime in nature and goes away at the end of the project, which ends at the end of this year. And from -- I don't know if there was anything else...

Christopher L. Winfrey

Margin -- look, we don't want to provide margin guidance, but if you look at the categories, we've given some color on programming, where we expect to -- we've stabilized, and we expect to be growing our expanded video customer base and return that category to growth, which means that you're going to add pressure on programming not only through rate, which everybody faces, but also in volume. On the marketing side, it's tied to growth. And we look at marketing and sales expenses somewhat of a different category because it's tied to the growth. And -- but the key one, and I think people will pick up on it as they start to look through the numbers, is the cost to serve, some of the onetime investments that we had made to bring the service cost to a higher quality level. It has stabilized, and I think that puts you in a position where, growth adjusted, you're in a good position from a margin perspective.

Thomas M. Rutledge

The way I would describe margin -- I do expect margins to grow, and I expect them to grow adjusted for sales activity and other things of that nature. But fundamentally, you have cost structures associated with programming, which are growing rapidly. And that's an issue, a negative issue in the business. But the creation of high-quality customers that have -- that are satisfied with our customer service creates longer-lived customers and creates customers that have less service calls and transactions per dollar of revenue. And so the margin that comes from operating the business is improving, and we expect it to continue to improve as we get more and more customers into more valuable, less transaction-intensive packages. And that is rapidly occurring. We've gotten 68% of our customer base already into the packaging and pricing scenario. And as a result of that, service calls are dropping, satisfaction is going up, and customer life is expanding, all of which reduce cost and improve margins.

Operator

Your next question will come from the line of Kannan Venkateshwar with Barclays.

Kannan Venkateshwar - Barclays Capital, Research Division

Just a couple of questions. So just following up on cost a little bit, as you are accelerating the rollout of these all-digital boxes over the course of next year, could you give us some idea about the amount that you expect to spend on OpEx, which is the truck rolls or when you put in a new box within a house and so on, how those statistics change? And secondly, just on a consolidation question, I mean, you obviously mentioned you are still open to these transactions. But just given the Comcast-Time Warner Cable deal, how do you look at the landscape right now? And purely in terms of size, is there a threshold for you that you need to get up to in terms of scale for a consolidation to make sense?

Thomas M. Rutledge

Right. Well, first of all, the cost of putting the boxes in is fully capitalized, including the placement of the boxes. So when the project is complete, there's no significant OpEx cost to operating the business. I mean, you could argue having more boxes per home means you could have more box failure per home, therefore higher service calls, but that's actually offset by the higher quality of the service overall and the total number of transactions associated with it. So it's actually a cost reducer to have a better product. But there is no OpEx cost, essentially, associated with the all-digital project. With regard to consolidation and the scale and landscape, I don't want to talk about specific opportunities, but we've always thought that the biggest opportunity Charter has is to grow penetration against the 7 million passings that we have a fully deployed plant in front of today and no subscriber relationship. That's where the biggest ROI is. And if Charter does that successfully, we'll create enormous value for our shareholders. So any -- and I don't think the landscape changing precludes us of realizing that opportunity. That said, if the landscape changes in such a way that we see an opportunity, we'll be opportunistic and take advantage of it.

Operator

Your next question will come from the line of Craig Moffett with MoffettNathanson.

Craig Moffett - MoffettNathanson LLC

Chris and/or Tom, one of the motivations in looking at Time Warner Cable was to try to reset your programming costs. Can you talk about -- it seemed like nothing else out there would have the same impact on programming costs that something of the scale of TWC would have. Can you talk about how you think about programming costs going forward, and are there alternative mechanisms that you've got to be able to manage that cost item in the absence of a significant change of scale?

Thomas M. Rutledge

Craig, this is Tom. I'm not sure that even all of Time Warner and Charter together would meaningfully change our scale from a programming cost perspective. We'd be the size of DISH and smaller than DIRECT and smaller than Comcast. And so it did have a marginal improvement immediately through synergy and the structure of the deal that we had proposed, but from an overall change-of-landscape scale perspective, that wasn't our main motivation.

Christopher L. Winfrey

Or the value creation.

Thomas M. Rutledge

Or how the value got created or will get created. The opportunity for us is to grow the cash flow per home passed in front of a plant that is essentially underpenetrated. And we brought tax assets and onetime synergies to the program, but the big driver is selling more cable to people who aren't buying it today. But when you look at the competitive landscape, I think that, while our costs are going up with programming, so are our competitors'. And when I look at our overall product mix and how that stacks up relative to our competitors, I think we have a superior infrastructure, a superior product and a superior customer service organization, potentially, and that all of that, combined, gives us the big opportunity. But as I said earlier in my comments, programming is an issue, and it's not unique to us, and I don't think we could solve it through an M&A the size of Time Warner. And if Time Warner is not available, think about the whole landscape out there. It's very hard to put together a scale that would really meaningfully change it.

Craig Moffett - MoffettNathanson LLC

Tom, if I could ask a follow-up, then. Have you taken a position yet on the Comcast-Time Warner Cable deal from a regulatory perspective? I would think that, that actually is large enough to bend the curve. And would you see bending the curve for one player beneficial to Charter or detrimental to Charter?

Thomas M. Rutledge

I'm not going to comment on that. I haven't taken a position.

Operator

Your next question will come from the line of Bryan Kraft with Evercore.

Bryan D. Kraft - Evercore Partners Inc., Research Division

I just had a few questions. First, on CapEx. Chris, can you tell us how much CapEx there was in '13 for all-digital? And then I just wanted to clarify, on the all-digital conversions, are you turning off all of the analog, or are you keeping, say, the limited basic channels on analog? And then the other question I had is on the rebrandings. How are you going about the timing of the rebranding? Is that all at once? Is it market-by-market? And are there going to be any significant OpEx to execute the rebranding?

Christopher L. Winfrey

I'll answer the first question, which is just a simple answer. The all-digital cost was -- it was south of $100 million inside of 2013, so it was under $100 million.

Thomas M. Rutledge

And yes, we'd turn off all analog signals, including limited basic. So the plant is fully digital, fully 2-way interactive on every outlet we deploy.

Christopher L. Winfrey

The rebranding...

Thomas M. Rutledge

Yes, the -- well, the rebranding is working in a way that, as we go all-digital, we get the set-top boxes placed out in specific geographies. We then launch a suite of 200 new HD channels on -- in total on top of the 100-plus that we currently have. And then we take the speeds up on our data service, and we begin to describe all of that as Charter Spectrum. And it's not really a significant change in marketing cost because we're already branding and marketing the company as Charter. But as we transform the product set and make it superior to anything that our competitors provide or anything that Charter has ever provided in the past, our thought is that we can begin to create a new sub-brand like Optimum at Cablevision or XFINITY at Comcast and use that to associate a brand notion with the high-quality products that are being presented in the marketplace. But from a cost of marketing perspective, the same mail pieces, the same broadcast advertising, the same radio advertising and on-channel promotions are done at the same rate, regardless of whether we call ourselves Charter or Spectrum or anything in between.

Operator

Your next question will come from the line of Ben Swinburne with Morgan Stanley.

Benjamin Swinburne - Morgan Stanley, Research Division

I have 2 questions. My first is on ARPU. Chris, you made some comments in your prepared remarks about the step-down from Q3 to Q4. I was just wondering if you could revisit that and flesh it out for us a bit. I know there was an expectation that, as the promotional roll-offs continued from last year, you would see that sort of build. So maybe if you could just add some color there. And I have a follow-up.

Christopher L. Winfrey

Sure. The simplest way to think about ARPU is that everybody wants to be really simplistic and just take a look at gross adds and to take a look at the roll-off of rate. But the reality is that these businesses have a tremendous amount of transactions that are taking place in the meantime. That includes migration of legacy to new pricing and packaging. And in the early days of that migration, it was giving us significantly lifts. And today, it's neutral or slightly negative. But those customers are getting a much higher-value product, and they're getting more video, more Internet product, and they're getting fully featured phone. So we're still happy to do it. So there is a short-term temporary drag that's taking place as we continue to migrate legacy package customers were a little bit more price-sensitive into the new pricing and packaging, if for no other reason they have no other rate place to go to, to be able to get that better value. The -- I want to be really clear. The customers that we acquired inside of the back end of 2012, they are rolling off, and we are getting the rate that we intended to get, and we are retaining a much higher percentage of those customers. So the model is entirely intact. But when you're looking at the amount of customers of your overall base that could have come in inside of Q4 2012 relative to the total number of transactions that are taking place in the systems, it's relatively small. And once we get through the migration, then you will see the lift that we see on a daily basis as those customers are rolling off to a higher rate and being, over time, retained at a better rate with a better product and producing lower churn.

Benjamin Swinburne - Morgan Stanley, Research Division

Got it. That makes sense. And just going back to CapEx, and I ask the question sort of in the context of thinking about longer-term capital intensity and sort of the relationship between this all-digital project and underlying growth. I'm a little bit shocked that the all-digital project is a $500 million project. So I'm just curious how you think about just normal digital set-top additions, because it would seem you could, in theory, characterize all of those as benefiting all-digital. And so as we think about this project wrapping up, aren't there additional benefits to capital intensity from the fact that you've sort of placed so many set-tops in the field that will not -- you won't have to acquire as many. Even if you keep adding more subscribers, the sort of boxes per sub growth will decline. So it's a bit trying to parse how you've defined all-digital versus not all-digital on your spending.

Christopher L. Winfrey

I think that's a -- it's an important point. I mean, outside of the -- there's the $400 million. About half of that is tied to actual boxes. The rest of it is tied to the actual placement fee. But if you take a look at the question -- previous question that came from Bryan about all-digital cost, it was just south of $100 million this year for 15% of the footprint, and now we're going to do $400 million -- it's not $500 million, by the way. It's $400 million for all-digital inside 2014. You already see the efficiency that's taking place because we have more saturation of boxes being placed, we're buying boxes for much cheaper cost. Your point is that once you get beyond that, you're going to have an entire base of placed boxes that you're not going to have to acquire on the increment when you're growing. And you're absolutely right, we become more efficient over time. We have to buy less, and when we buy, we buy them at a cheaper price.

Thomas M. Rutledge

Yes, all you're buying is incremental customer relationship boxes and lost boxes replacements.

Christopher L. Winfrey

And the other thing to keep in mind is we're not placing cheap 1-way DTAs. We're replacing 2-way Video On Demand boxes that are going to have a long life and will be placed with the cloud-based user interface over time. But they're embedded the boxes' modem, they have the 2-way interactive guide, and they have Video On Demand on every outlet. And we think that, that's a -- we think that's a pretty strong product to put in front of customers.

Operator

Your next question will come from the line of Frank Louthan with Raymond James.

Frank G. Louthan - Raymond James & Associates, Inc., Research Division

So talk to us a little bit about the $100 million investment in customer care. How much have you spent on sort of improving customer care? What exactly are you doing going forward? What sort of things is this going to go to and improve?

Christopher L. Winfrey

Frank, this is really just about insourcing labor across care, IT and field operations, and there's nothing horribly attractive about it other than you've got to have real estate to help those people, you've got to have trucks and tools and test equipment. And in some cases, as it relates to IT, we are putting in place hardware and software to do for ourselves what vendors have historically done for Charter in the past. And all that ties into the insourcing of $100 million.

Thomas M. Rutledge

But the reason Charter needs to do it and doesn't want to outsource is because, as Charter went through the bankruptcy process and was restructured, Charter didn't spend money on normal capital because they were trying to make debt covenants. And they didn't buy tools, test equipment, trucks. They outsourced the contractors' normal work that would be done internally. As a result of that, they had very poor customer service numbers. And so in order to fix that, Charter is running a more capital-intensive program relative to the rest of the industry to get back to a sort of normal state of affairs where we have our own service technicians who are able to do installations and service calls and we have our own call centers so that we can take phone calls and take care of customers. All of that capital has been spent over this year, over '13 and some more in '14, to get to, really, a normalized state.

Operator

Your next question will come from the line of James Ratcliffe with Buckingham Research.

James M. Ratcliffe - The Buckingham Research Group Incorporated

First of all, to follow up on the insourcing discussion. Should we expect this to lower OpEx going forward -- once you've brought these folks in, that the cost will be lower, or is it purely the service quality improvement and, presumably, revenue associated with that? Secondly, on the decision to put full-fledged boxes on TVs rather than DTAs, can you give us an idea of what the incremental cost associated with that is on a capital side and also, if there are any incremental programming costs associated with having, for example, OnDemand and the like available to more sets in homes, beyond more customers?

Thomas M. Rutledge

I'll answer the insourcing question. Yes, it actually reduced operating costs. And this is one of those situations where you can think you're saving money as an operator and actually cost yourself money. If you bring a higher quality of customer service to your customers, your customers buy more products from you, they're happier, they have less service calls. If you take care of the calls that you get efficiently, and if you fix problems the first time, the right time -- the right way, you actually end up with less activity in the business, which is the where the real cost of the business is. So insourcing, while it requires some capital, improves the quality -- assuming you manage the insourced people properly, it improves the quality of the business, which reduces the cost of the business by reducing transaction volume and increasing the life of the average customer. So 2 cable systems with the same amount of customers and the same amount of revenue per customer can have a different cost structure if one cable system has longer-life subscribers and less transactions, therefore, per dollar of revenue. And that's where the big upside in OpEx is by insourcing. Chris?

Christopher L. Winfrey

The second question -- look, I want to be careful not to give out sensitive pricing information about where we're buying boxes, but again, I just wanted to take a rule of thumb and say that the DTAs were about $50 cheaper than a fully functioning set-top box. In some sense, what you've really done is you've saved yourself, call it, just for the purpose of this example, $50, but you're going to have to come back -- if you want to have a competitive product in the household, you're going to have to come back and spend the same amount of capital anyway to put a fully functioning box on there and to put something that can have an interactive guide, that can have a modern sort of interface and that, ideally, could have Video On Demand that could allow you to compete better with satellite. So if you place a DTA, you're -- it's just throwaway spend, in our view. And so we'd rather spend capital upfront to actually get a credit from the customer for the value that you're bringing by having a better product in front of them and not to cause them a service interruption 2 times. So we'd rather spend that money upfront and actually get a better result from the customer when you've gone in and placed that box. So related to the operating cost, yes, it drives more Video On Demand. But from an operating cost standpoint, from a -- for pay Video On Demand, maybe you have margin on that, so it increases your opportunity to get Video On Demand, and you -- or you're able to charge an actual rate for the box because the box has value. So don't forget that each one of these boxes that you're placing, they have revenue directly attached to them, and it's not something that you're just giving away for life.

Operator

Your next question will come from the line of Amy Yong with Macquarie.

Amy Yong - Macquarie Research

Just a really quick question on balance sheet capacity. Can you just lay out what the priorities are at this point between leverage, capital returns and then, I guess, M&A?

Christopher L. Winfrey

Amy, our targets haven't changed, which is our target leverage range is 4x to 4.5x. And we're about 4.8x, which is where we were last year when we acquired Bresnan. And so despite having acquired Bresnan, we're back at the 4.8x. Our target leverage is to be 4x, 4.5x. We're going to be very opportunistic and disciplined about how we use our free cash flow. In the past, we've shown an ability and willingness to buy back stock; to do M&A when it's accretive; and as of late, really, to invest in the business because we felt like that was the best ROI. We do not put out a formulaic return to capital scenario because we think it gives us the ability to do things that create the most value, and so far, that's worked very well for Charter. And there will continue to be discipline around that, both from a target leverage range as well as how we deploy capital in the future.

Operator

Your next question will come from the line of Matthew Harrigan with Wunderlich Securities.

Matthew J. Harrigan - Wunderlich Securities Inc., Research Division

Could you comment on Netflix and some of the peering issues on the traffic asymmetry? And also, on Comcast-Time Warner Cable, are there any issues with some of the practices or conditions that could be imposed on the data side? They might not be binding on you but still might constitute industry practice and, more or less, consumer expectation. And then secondly, any thoughts -- more thoughts on out-of-the-home WiFi and how that could be a CapEx bucket in future years, even if it's not a priority right now?

Thomas M. Rutledge

Matthew, yes, with regard to Netflix, from what I can gather from the controversies, Netflix is putting themselves in a position to throttle their own network to try to gain sympathy in various operators, and it's an interesting approach. With regard to the Comcast-TWC data conditions, should that deal go forward and be approved, obviously, any conditions that would be accepted could have an impact on the business. And so, yes, that's an issue. And with regard to WiFi, we've spoken before about the opportunity that WiFi presents. We're putting out significant WiFi in our residential customer base. We're beginning to put it out in our commercial base. We have not gone out yet and put it in a public space, and really, that's just been a question of priority. In past operations I've managed, I've been a big proponent of WiFi. I still am, but Charter's priorities are more basic still, and we need to get our product set significantly superior to our competitors and grow our penetration. And we're focused on the day-to-day task of doing that.

Operator

Ladies and gentlemen, this does conclude today's conference call. Thank you, all, for attending, and you may now disconnect.

Christopher L. Winfrey

Thank you.

Thomas M. Rutledge

Thank you.

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Source: Charter Communications Management Discusses Q4 2013 Results - Earnings Call Transcript
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