After A Remarkable Run, A Rural Cable Company Looks Fully Valued

| About: Cable One, (CABO)


From its February 2016 Lows, Cable One shares are up 30% to trade at historically rich valuation multiples for its sector.

Investors are understandably enamored with management’s solid navigation of an unconventional business model, CABO’s margin expansion, free cash flow generation and return of capital to shareholders.

But with no revenue growth, margin for error is slim. At 10x adjusted EBITDA and 22x after tax FCF, CABO shares look fully valued.

Spun off from Graham Holdings (NYSE:GHC), the former Washington Post Company, in mid-2015, Cable One (NYSE:CABO) is a small market cable company serving mostly rural communities in 19 states with video, broadband and voice service. CABO shares have performed exceptionally well in its 12-month tenure as a public company, up 30% from both its early days of stock market independence and February 2016 market depths.

Investors have overlooked flat revenue performance and accelerating revenue and video subscriber erosion impacting half of Cable One's revenue base to instead favor rising margins, increased free cash flow and $51 million of share repurchases in the nine months to 3/3/16. Recent stock price gains have pushed the company's core valuation metrics (at 10x EBITDA and 22x ATFCF, using a $345 million projection for 2016 adjusted EBITDA, +9% over 2015) to historically unsustainable levels (absent an M&A takeout), above even larger industry peers with superior financial performance and much greater operating leverage. Given the risks inherent in Cable One's increasingly one dimensional business model and the likelihood that easy cost-side benefits have already been achieved, Cable One's current valuation looks unjustifiable. Indeed, 2016 could well be peak year for cash flow growth and margin expansion, an outcome in which the market appears to be assigning very low likelihood.

Cable One has taken a very unconventional approach to its business by intentionally de-emphasizing increasingly low-margin video and voice businesses in favor of a growing, high-margin broadband segment. The strategy has resulted in flat overall revenue performance at the company over the past two years as broadband revenue growth of about 20% in recent quarters has been entirely offset by the managed declines of a similar percentage for video and voice. The company's video strategy - no triple play discounting to subsidize pay TV, a willingness to do without expensive channels with low perceived value like Viacom networks and certain regional sports, rate increases to recover broadcast retransmission fees and aggressive management of the expense line - has been decidedly against industry convention and not without risk. In effect, management has chosen to dramatically accelerate the secular decline of pay TV, a noteworthy approach given video's historical prominence to cable operators.

To put the magnitude of the erosion of its video business erosion in perspective, consider that Cable One's subscriber count has declined by a stunning 50% just since mid-2014, from about 700,000 pay TV subscribers to just 350,000 at March 31, 2016. And that figure seems likely to go even lower in the near term as customers react to a $5 per month customer surcharge that was implemented just last month to recover the soaring cost of carrying local broadcast channels. Cable One's 50% decline in video subscribers compares to single digit subscriber declines at its much-larger cable peers over the similar period and further contrasts with recent evidence of video customer stabilization, even modest net additions at the largest cable companies.

The reason behind Cable One's strategy of video neglect, of course, is the segment's increasingly slim profit margin as industry economics have come to heavily favor programmers over distributors in the past decade. Small operators like Cable One are increasingly on the losing end of license fee negotiations, if they can even be considered negotiations at all. Bulked-up program suppliers like Disney, Comcast's NBCUniversal , 21st Century Fox and Time Warner name their increased price and demand universal carriage of entire channel portfolios at every contract renewal. Even with the benefit of an industry purchasing coop, small distributors like Cable One often pay wholesale carriage rates some 25% higher than do large operators for the same programming. Consumer trends toward cord cutting and a lower rate of pay TV subscription by young people has magnified the unattractiveness of the video business. Said Cable One CEO Thomas Might on the company's Q1 2016 earnings call in May, according to the transcript: "What we don't like for many reasons about residential linear video and phone [is that] they produce very modest operating cash flow today and no free cash flow to speak of. Add cord cutting trends to that and we think we can do better elsewhere."

That's a rational approach to an increasingly unattractive business segment, though it does raise questions why, with legacy video infrastructure in place and consuming maintenance capital, the company can't find clever packaging and feature enhancements to make money with video. (It's also worth pondering why Cable One and its former parent inexplicably missed opportunities to sell the company to a larger player despite multiple waves of industry consolidation over the past 30 years, but that's another story.)

The daunting challenge for Cable One is that video comprised about 44% of total revenues in Q1. Include residential voice - a segment that declined by a startling 22% in Q1 - and a full 50% of Cable One's revenues are exposed to dramatic decline. Video penetration dropped to 21% of homes passed in Q1, lowest in the industry and about half of its larger peers. High-margin revenue from local ad sales and ancillary video-related dollars such as set top box rental and PPV - though small at about 4% of company sales in Q1 - seems likely to substantially disappear.

The good news for Cable One is that broadband and commercial account revenues and have, to date, almost completely offset the brutal declines in video and voice. Cable One has become a more profitable company, with EPS up 23% and adjusted EBITDA up 14% in Q1 . The data segment delivered 21% revenue growth in Q1 though with only 2.2% customer growth as ARPU rose sharply to $60 in Q1, up 18% over the year earlier period. And the company would seem to have growth left in the segment as broadband penetration was only about one in three homes passed in Q1, though management acknowledged on the May call that the increasingly poor demographic profile of rural America - less affluent, older, in decline - is a considerable factor. A service footprint that is 25% overbuilt by phone companies, according to management, and a policy of no discounting further accounts for the low penetration.

Assuming the recent pace of decline at video and voice continues over the next few years before bottoming at around 10% video penetration, broadband penetration will need to rise well into the 40s to maintain overall revenue flat. That seems plausible, if not likely, and perhaps not on a pace to completely offset the video and voice declines. Broadband rate increases over time will help too, of course, but there is no remedy for a service territory with poor demographics that is slowly becoming even more sparsely populated.

Cable One has done an admirable job in an increasingly challenging business but its pioneering, one dimensional business shouldn't be valued at a premium to larger industry peers. At 8x EBITDA - in line with the cable group - CABO shares would trade back around $400, near where a newly independent Cable One traded in summer 2015.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.