Cable: Concentrated With Conviction - What The Narrative Misses

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Includes: BGAOF, BT, CHTR, CMCSA, CTL, FTR, GOOG, GOOGL, KKPNF, LBRDA, LBRDK, LBTYA, LBTYK, LILA, LILAK, T, VZ
by: Michael Rivers
Summary

My clients and I are heavily invested in cable assets.

This may seem unwise given the current narrative that cable is in decline and can't handle the competition.

I think cable has better technology and economics than are widely recognized.

Introduction

My clients and I have a lot invested in the cable industry. This includes four investments: Comcast (CMCSA), Liberty Global (LBTYA, LBTYK), Liberty Broadband (LBRDA, LBRDK) and Liberty Latin America (LILA, LILAK). From 2/28/17 to 3/31/19, the S&P 500 has increased 29.9% versus -3.8% on average for my cable holdings. Ouch. In other words, a nontrivial part of my under-performance over the last 2+ years - aside from value and international - has been due to cable. What happens in cable-land matters for me.

Which begs the question: why on earth would anyone want to invest in cable? Isn't it going the way of the dodo? I think those two questions sum up the popular narrative and a key reason why I've under-performed.

Here's the storyline:

  1. Wireline phones are being replaced by mobile phones
  2. Cable video is being replaced by Netflix and other over-the-top options
  3. Cable internet, a.k.a. broadband, will soon be replaced by fiber, 5G, satellite internet, etc.

Meaning: cable is uncompetitive and therefore a poor investment.

What The Narrative Gets Right

Like all narratives, there are elements of truth: the impact to phone, video, and advertising must be acknowledged upfront.

For instance, cable phone is clearly in permanent decline. To cable companies, phone was always a cash cow add-on and never part of the long term story. It made sense to provide phone service for those who wanted it because it's profitable even if fading. As an analyst, phone was never a significant reason to own cable and I've always modeled it as a cash cow in permanent decline.

Cable video, too, is declining, but perhaps not as quickly or completely as the common storyline would suggest. Supporting the narrative, the top two U.S. cable providers are seeing 1.5% to 2.5% declines in subscribers per year. That's not a good trend, but it's not precipitous and can be easily accounted for in valuing cable businesses. Also, there are plenty of people sticking with traditional cable bundles, and many will continue to do so. That's due partly to subscribers uninterested in change, and partly to the economics of the bundle.

Over-the-top options, you see, aren't as great a deal as commentators would have you believe. Dozens of articles highlight how the cable bundle is usually cheaper than selecting multiple over-the-top options. For those happy with a narrow video selection (like me), over-the-top is the way to go. But for families or individuals wanting channels covering many interests (sports, kids, scripted, unscripted, nature, drama, horror, history, science, etc.), the bundle is and will continue to be the cheapest option. Less acknowledged by many: over-the-top providers have experienced rapid customer turnover and raised prices to cover programming costs, putting into question how great a deal it will be in the future.

Another thing missed in the narrative is that video has become much less profitable for cable companies over the last decade (content costs have risen faster than video pricing), and thus of decreasing importance to the profit story (what matters for stock prices). For investors, video declines cause the top line to fall much more than the bottom line, making it manageable and not a big concern to the investment thesis.

Another element the narrative misses is that those who quit cable video still need broadband internet access, and the price of stand-alone internet is much higher outside a package, thus offsetting profitability declines and in many cases actually increasing them. This means that when video customers "cut the cord," cable companies almost always maintain or increase profits.

Advertising, a historic revenue source for cable, is declining along with video as subscribers go over-the-top. The revenue decrease is, like video, easy to model and not as rapid or inevitable as described in the narrative.

So, yes, cable phone is dwindling, cable video is in decline, and cable advertising reflects video's decay. But, the overall impact on profit growth is less than feared and easy to model. The narrative, you see, gets parts of the story right, but overstates others.

What The Narrative Gets Wrong

Now, on to what the narrative gets wrong and misses: cable broadband and business.

Cable broadband has been dominating other wireline providers for well over a decade. Cable internet is faster than wireless or DSL (digital subscriber lines - legacy twisted copper), more reliable than wireless, and more economical than wireless or fiber. Over the last decade, it's been growing subscribers at 4.5% to 5.5% per year versus flat to declining for legacy telecom companies. As cable speeds increase each year, so has price, making broadband internet a 7-10% annual revenue grower. It's also much higher profit margin than phone, video or advertising, and those margins expand as cable penetration increases (most costs are fixed or declining even as revenues climb).

20% of households still don't have broadband, and cable is only 40-70% penetrated relative to legacy telecom (depending on geographic market), so there's still room to grow market share. As mentioned above, profitability is maintained or increased when subscribers cut video because broadband rates increase without packaging and margins are significantly higher. The popular storyline misses or discounts these important points.

Cable for business customers is an important story, but almost completely ignored in the oft-heard narrative. Just like broadband, cable for business has been taking market share from legacy wireline for years at an inexorable rate. It started with small businesses, then moved up to medium-sized companies, and is now gaining enterprise customers. Much in new capabilities must be developed - no easy task - but cable is getting there over time and taking market share quarter after quarter.

Cable for business has been growing 9-10% recently after a more rapid 20% phase early on. Market share is currently less than 15%, implying years if not decades of future, high margin growth. Business cable includes broadband data, phone and video, and many additional services and products can be added: security, information technology support, Wi-Fi access points, etc. The accepted storyline about cable misses or ignores this huge and growing profit center.

What's more, broadband is becoming a vital and growing platform of services for both residential and business customers. Wi-Fi in homes and offices accounts for 80% of internet traffic, so the vast majority of internet usage is over Wi-Fi and wireline instead of wireless cell towers. There are almost endless capabilities that can be layered on top of connectivity, too: smart homes, security, Virtual Reality/Augmented Reality, Internet of Things, the list goes on.

The average home has over 10 devices using Wi-Fi, an amount that rises each and every year. The average high-end user - a peek into the future - has over 20 devices connected. And, that number keeps increasing as people buy new thermostats, tablets, phones, smart watches, smart TVs, wireless scales, smart speakers, you name it. This increasing usage makes customers even more dependent on broadband and its speed, cost, and reliability. Again, the popular narrative tends to ignore these burgeoning opportunities.

The Competition

Although video dominates the story-line (many still associate cable exclusively with video), cable has become a connectivity story, and its dominance in broadband and business is currently unrivaled. Less fully grasped, competing options to cable seem unlikely to unseat its dominance any time soon.

There's been a lot of ink spilled over the years about the challengers to cable. First, it was DSL from legacy telecoms. Then fiber optic lines: FiOS from Verizon (VZ) and U-verse from AT&T (T). Then: Google (GOOG, GOOGL) Fiber. Now, the threat is 5G. In the future: satellite internet. Each time, the narrative misses the underlying technological and economic advantages of cable: the unmatched density of deep wireline networks between trunk lines (with almost unlimited capacity) and homes/offices. The economics, too, of cable relative to alternatives are superior and not widely acknowledged.

To understand why, you have to go back 40 years to when cable companies built dense, deep networks (almost entirely fiber now) to provide a growing number of video channels to customers. As cable channels grew and phone and broadband internet were added to the mix, this required higher capacity networks built closer to homes and offices each year. Legacy telecoms, initially satisfied with twisted copper for low bandwidth phone calls, didn't densify as early or effectively, and have been behind the power curve ever since. DSL was never a real competitor in speed or economics; it was simply a rear-guard action to keep legacy telecoms from falling too far behind.

Fiber to the home has long been a viable technological option, but the cost of deployment is prohibitively high. The reality is that for legacy telecoms, fiber is often ten times the price to deploy relative to cable for roughly the same speed. To compete successfully, competitors can't spend 10x cable while receiving the same revenue per customer. It's not about technology - fiber to the home is clearly faster - it's about economics: building deep, dense networks are expensive, and returns on capital, investor interests, competitive pricing, and relative network speeds all matter.

That's why legacy telecoms (AT&T, Verizon, CenturyLink (CTL), Frontier (FTR), British Telecom (BT), Proximus (OTCPK:BGAOF), KPN (OTCPK:KKPNF), etc.) have been slow in deploying fiber. Verizon learned this the hard way with FiOS, where it's never generated economic returns on investment. AT&T absorbed Verizon's painful experience and has thus been reluctant to expand fiber significantly. Google thought it could do better, but gave up expansion in 2016 - sometimes even failing to complete the cities it promised. Why? Terrible economics. That and I think Google just wanted to compel wireline providers to boost capacity to support its real business: advertising, which wireline providers did regardless of Google's folly.

After fiber, the threat most frequently cited is wireless: both terrestrial (cellular towers, fixed wireless), and satellite.

Specifically, 5G or 5th generation wireless is perceived by some as a threat to wireline cable. 5G fixed wireless is millimeter wave (short wavelength), high speed (lots of data) and low latency (quick response time). It shouldn't be confused with 5G mobile, however (more on this below). 5G fixed wireless requires direct line of sight, special equipment, and can have problems with inclement weather. It also involves essentially equivalent infrastructure and economics as cable and fiber in terms of backhaul to high capacity trunk lines. In other words, 5G fixed wireless faces the same economic problems as fiber in terms of lack of deep, dense networks and cost of deployment.

There are some use cases, like high-density urban areas, where it might turn out to be economical, but even if it is, cable can often respond with the same speeds at one-tenth the deployment cost, or 10x the speed at the same or lower cost (cable recently announced 10 Gigabits per second capability, with 25 Gbps soon to follow). 5G fixed wireless could be a real threat if:

  1. It can somehow dramatically reduce the cost of deployment - not currently viable, requiring both technological and economic breakthroughs that haven't occurred
  2. Consumers' speed requirements and number of devices level off - not in the cards with 30%+ annual data rate increases and accelerating device use cases and up-take.

5G mobile, in contrast to 5G fixed wireless, will become widely deployed but isn't comparable in speed, reliability or economics to wireline cable. It requires equipment deployed close to homes and offices, relying again on someone with deep, dense, local networks. Sound familiar? Wireless providers already buy gobs of capacity from cable companies to provide the backhaul capacity they haven't built. I could be wrong, but I don't think 5G mobile will be a significant competitor with cable broadband in the short to intermediate term because it lacks high capacity and low unit pricing. In fact, I believe 5G mobile might become one of cable's biggest customers.

Another possibility the narrative misses is that if 5G does become a viable competitor to wireline cable, whether fixed or mobile, cable companies, with their dense, deeply penetrated networks, are best positioned to exploit 5G's capabilities. That's why I believe Verizon unsuccessfully offered to buy Charter in 2017, and Japanese wireless giant, Softbank, indicated similar interest. It's also a good reason cable companies recently started offering wireless phone service.

After 5G, satellite internet is the next most frequently touted competitor to wireline cable. As an old satellite guy, I love this idea. But, it's not new (remember Iridium?), it's highly speculative, technologically unproven, and economically suspect. There are good reasons to believe it will suffer the same issues as all wireless alternatives: atmospheric interference, signal to noise problems, and the inverse power law (as distance doubles, signal strength must quadruple). Wireless is disadvantaged to wireline due both to physics and economics, which is why almost all wireless systems try to get signals to wires in the shortest distance possible. Satellite broadband seems a great way to provide low bandwidth internet to remote areas but a lousy case for competing with high-speed, dense, local, wireline networks. In time, it could become competitive, but no time soon.

Why I Like Cable

I don't want to leave you with the impression I think the narrative is pure poppycock; it isn't. It just overemphasizes some parts of underlying reality while dismissing or ignoring other important parts. Make no mistake, the popular view about cable is pervasive, and why cable has fared poorly as an investment recently. And, stock prices won't change until perceptions do.

I like cable, though, for the reasons highlighted above. Cable dominates what matters both now and into the short to intermediate term future: fast, reliable, economic broadband connectivity - the lifeblood of the digital economy. Cable has a long runway of new services, customers and use cases ahead of it. Competitors don't stack up, and that's clear in cable's subscriber increases, reported profits, high cash flow returns, and technological superiority in speed and reliability.

Comcast is the #1 provider in the U.S., and Charter (CHTR) is #2 (Liberty Broadband, our investment, consists almost entirely of a 24% ownership in Charter at a discount to market price). Comcast also owns NBCUniversal and Sky, which are mostly content creation companies in the U.S. and Europe. Charter, in contrast, is pure cable.

Liberty Global is the #1 cable company in Europe. It's growing strongly in the U.K. and challenging legacy telecom in Belgium, the Netherlands, Poland, and Slovakia. We've seen this story play out in the U.S., which is 5-10 years ahead of Europe in terms of video and broadband penetration. The biggest difference between the historic U.S. experience and Europe's is the role mobile phones are playing, which has created competitive intensity that's badly hurt recent growth and profits for all European telecoms. The economic and technological case is the same, though: cable is higher capacity at the local level and more economic to deploy with higher speed and reliability than alternatives. Over time, those superior characteristics are likely to win out just as they have in the U.S.

Liberty Latin America is the #1 cable business in parts of the Caribbean, Puerto Rico, Chile, and Costa Rica. It's a leading provider in Panama and Jamaica and holds significant positions in Barbados, the Bahamas, and Trinidad and Tobago. It's also a dominant provider of undersea cable in the region, and business customers account for one-third of company sales. It's the same economic proposition as Comcast, Charter and Liberty Global with superior connectivity and economics. Consolidation in the region is a key strategy, just as it was in the U.S. and Europe because geographic concentration matters in the economics of telecom businesses. Liberty Latin America is taking advantage of that.

I love dominant businesses with recurring revenues and years of future growth and profitability expansion. Cable is that business. These facts account for our concentration in the sector despite recent stock price pullbacks. The economic and technological advantages are too compelling to ignore. I remain confident these investments will pay off over time.

My love of cable, however, doesn't blind me. I read several articles a week seeking to tear cable down. The anti-cable narrative is strong, so I have plenty to read. To invest intelligently, I must be ever aware of the economics and technology of challengers, including fiber, 5G wireless and satellite. Capacity, usage, device penetration all need to be monitored. If these trends shift, I'll know early. That doesn't make me omniscient, but it does mean I take each and every threat seriously and am downright paranoid about potential challengers. Nothing I've read or learned seems a short to intermediate term danger, and why I'm comfortable and even elated with our concentration in the industry.

Conclusion

The narrative about cable highlights undisputed facts like phone, video and advertising declines, but tends to ignore or under-analyze the technological and economic advantages of wireline cable for broadband and business. What many miss is that cable is more about connectivity than video, and economics trump technology. I like cable because it looks set to dominate for some time. Connectivity has become essential to people (a recent poll showed roughly one-third of consumers would rather go without water for two days than without an internet connection), and cable is at the center of this vital trend. Additional demands on connectivity seem to indicate a very bright future that investors haven't fully grasped, yet. When or as they do, I think we'll see stock prices adjust and investing results improve.

Disclosure: I am/we are long CMCSA, LBRDK, LBTYK, LILAK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: © Copyright 2019 Athena Capital Management Corp. All rights reserved. Permission is hereby granted to electronically link, forward, or store this document in its entirety or to quote passages as long as source is attributed to "Michael Rivers, CFA, Athena Capital Management." Nothing in this letter should be considered investment, financial, tax, or legal advice. The opinions, estimates, and projections contained herein are subject to change without notice. Information throughout this letter has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.