Why Charter’s Proposed Buyout of Time Warner Cable is all About the Future of OTT

BY ANDREW SHEEHY, CHIEF ANALYST - 18 Mar 2014 Comments

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Charter Communications first proposed buying Time Warner Cable (TWC) on 24 June 2013. Since then, the two companies have communicated on 11 separate occasions,  each time with TWC rejecting Charter’s advances.

Most recently, in a press release issued on 13 January 2014, Time Warner Cable dismissed Charter’s latest cash and stock offer as “grossly inadequate” and claimed that the offer “substantially undervalues TWC and would represent an EBITDA multiple of approximately 7X, well below past transactions in the cable sector.”

News reports on Wednesday 15 January 2014 indicated that Charter has approached Comcast in an effort to raise more money for the deal (Charter’s lastest bid of $132.50 a share was countered by TWC which proposed $160).

US cable industry veteran and billionaire, John Malone, acquired a 27% stake in Charter in May 2013 via his media company, Liberty Media. Having recently completed the purchase of the UK’s only cable network operator, Virgin Media, in June 2013 it is clear that Mr. Malone thinks that bigger is better in the cable business, and to a larger extent we think he is right.

It is certainly interesting to ask whether Mr Malone’s latest overture will materialise, and we think we know the answer to that, but there is a more important question at stake - which is what will be the source of long-term value in a future merged company, which is what we will look at here.

Rationale for the Proposed Acquisition

Based on documents released by Charter, the rationale for the proposed acquisition of TWC is mainly based on benefits that will come from:

  • TWC gaining access to a more competitive, all-digital product: Having been planning a migration to an all-digital network for some time Charter has said it plans to roll-out a new digital cable TV and broadband service called ‘Charter Spectrum’ in 1Q14. This is partly a competitive response to gains made by non-cable rivals such as DIRECTTV and Netflix, whose nationwide network footprint allows them to target all of Charter’s customers, and partly a response to similar all-digital products that have been introduced by other US cable operators such as Comcast (Xfinity) and Cablevision (Optimum). Charter Spectrum will offer more channels (200 up from 100), higher broadband speeds (up to 45Mbits/s) and a greater number of HD channels;
     
  • Market scale: In an industry where the market leader, Comcast, boasted 22 million video customers at the end of 2012 (compared with  4.0 million for Charter and 12.2 million for Time Warner Cable) a larger company should mean improved bargaining power when it comes to acquiring content or negotiating with suppliers;
     
  • Operational cost savings: The merged structure would will provide the usual opportunities for cost savings such as, for example, elimination of duplicate administrative functions and expenses, rationalization of cable  network operations, avoiding duplicated R&D and reduced capital expenditures.

Charter Communications vs. Time Warner Cable

It is interesting to compare the two companies using some key operating metrics:

Total Revenues

For the year ending 31 December 2012, TWC’s total revenues were USD 21,386 million, a factor of 2.9x higher than Charter which recorded USD 7,503 million.

However, if the quarterly revenues of the two companies are plotted on a relative basis over a 5-year period from  1Q09 to 3Q13, then the two companies have managed to increase their revenues by almost the same percentage (26.4% for TWC and 27.4% for Charter). The only real difference is that over 2013 Charter’s quarterly revenues have been growing at a faster rate than TWC’s.

Result: Charter wins!

Residential Video Customers

Over the period 4Q12 to 3Q13, the total number of residential video customers at Charter has increased from about 5.0 million to 5.5 million. In comparison, if we look at the same metric for TWC then the total number of residential video customers has been decreasing steadily, from 14.7 million to 14.5 million.

If we look at total customer relationships (including both business and residential customers) over the period 1Q09 to 3Q13 then Charter has achieved an increase in total customer relationships of 16.8% whereas TWC has managed only 3%, with significant losses of prior gains having occurred over the recent quarters.

Result: Charter wins!

High-speed Internet Customers

As the only clear growth market for both companies this important metric reveals another difference between Charter and TWC.

If we look at quarterly data over the period 1Q09 to 3Q13 we see that the total number of high-speed interent customers at Charter has increased from 2.947 million to 4.290 million, an increase of 45.6%.

If we look how TWC has performed over the same period then we see that the total number of high--speed internet customers has increased from 8.952 million to 11.550 million, an increase of just 29%.

So while TWC had 2.7x as many high-speed internet customers as Charter at the end of 3Q13, Charter has been growing its high-speed user base faster than TWC.

Result: Charter wins!

Average Revenue per User (ARPU)

One metric where we think TWC has done a better job than Charter is in ARPU, which we have measured as total revenues divided by total customer relationships: Once again, if we look at the quarterly data from 1Q09 to 3Q13 we see that Charter’s ARPU has increased from USD 331 to USD 362 per quarter (an increase of 9%)  whereas TWC has managed to increase total ARPU from USD 298 to USD 366 (an increase of 23%)  – and the trend over the whole 5-year period is clearly one where TWC’s rate of improvement in ARPU is better than Charter.

Even we look at the last year, then the TWC’s ARPU has been increasing here Charter’s ARPU has dropped.

Result: TWC wins!

Share Price

If we compare how the share prices of the two companies have performed over the 3-year period from January 2011 to January 2014 then Charter is clearly the runaway winner with a total gain of 357%, compared with TWC who has managed 200%, which should be compared with the S&P 500 which has increased by 145% over the same period.

Result: Charter wins!

Title:Comparison of Performance of Stock Prices Sub Title:Charter Communications, Time Warner Cable and S&P500 Companies:Charter Communications, Time Warner Cable Markets:Television, Pay-TV, Cable TV Years:2011, 2012, 2013, 2014 Countries:United States


Analysis: Rationale for Merger

Based on the foregoing we think that it will be a matter of time before TWC succumbs to the advances of its smaller competitor, Charter Communications or maybe another US cable TV player. Specifically, Charter has generally better record of execution over the last 4 years (in spite of a product offer that has been historically inferior to the competition).

One exception relates to ARPU where TWC has achieved more growth than Charter. However, while ARPU is an important metric both companies are involved in a scale business where the performance of the whole business is ultimately more important than the precise level of performance when viewed on a per-user basis. So while higher ARPU’s can be a good thing, they should not in our view be over-interpreted and so the balance still swings in favour of Charter.

It is also interesting to compare TWC and Charter with Netflix and DIRECTV who are two non-cable competitors:

Title:Comparison of Major Indicators
Sub Title:Charter Communications, Time Warner Cable, Netflix and DIRECTV
Companies:Charter Communications,Time Warner Cable,Netflix,DIRECTV
Markets:Television, Internet, OTT Internet TV, Pay-TV, Cable TV
Years:2012, 2013, 2014
Countries:United States

Three observations can be made from this table:

Either Netflix is severely underpriced or TWC and Charter are overpriced. At less than USD 10 per month, Netflix’s ARPU is less than 10% of what Charter and TWC are achieving. Admittedly, Netflix does not offer broadband or phone service but these services would only add another USD 40 or so to the Netflix ARPU which indicates that Netflix, when viewed as a video service, is underpriced.

Implication: While Netflix is a growing threat in terms of rising market share, the price difference between Netflix and Charter/TWC will likely drop, thereby some alleviating the competitive threat. However, Netflix will remain far cheaper than Charter/TWC.

Netflix is already the biggest video service provider in the world, dwarfing Charter: The core rationale for Charter’s proposed acquisition of  TWC is that the merged structure would have the scale to compete more effectively than at present. But with over 35 million video customers, Netflix is already 10x larger than Charter, 3x larger than TWC and 1.6x larger than Comcast, which is itself the world’s largest cable network operator. Moreover, Netflix’s customer base is still growing steadily whereas the challenge for Charter and TWC is to retain the customers then already have;

Implication: When it comes to content acquisition, Netflix's modest revenues means that the company is still a relative lightweight but it will have to increase price at some point and this will mean that it will be increasingly able to compete with Charter/TWVC in content deals.

Netflix’s market cap indicates that internet-based distribution is a better model:  In spite of an ARPU that it is at least 50% less than Charter, in spite of being less than half the size (in terms o f revenue)  and in spite of having no high-speed internet or voice products, Netflix’s market capitalisation is USD 19,6 billion, Netflix’s ARPU is 38% higher than Charter (16 January 2014).

While the market might have unrealistic expectations of Netflix in the short term, the company’s internet-only model is very popular with users and all the trends indicate that the internet-based distribution of television content is going to increase strongly.

Therefore, while the proposed Charter-TWC deal is in our view likely to proceed at some point (for the reasons we outlined above) we think that the real question relates to the source of long-term value in a future Charter-TWC cable company?

There are only four potential sources of value in a cable network operator:

  1. The network  (i.e. the physical infrastructure used to distribute the content from the network operations centre to the customer’s premises);
     
  2. The content (i.e. programming that the cable network operator owns and can therefore license to other distributors);
     
  3. Ancillary services that can be delivered using the cable network (e.g. high-speed internet and phone service);
     
  4. Value-added services that span multiple connected devices and allow the user to enjoy their services and content on an ‘anytime, anywhere’ basis.

 Let’s look at these points in some more detail:

Network

It is clear that there is lasting value in the network assets that TWC and Charter have assembled – but in the long term this value will mainly come from their use to provide broadband internet service, not a video programming service which mainly comprises content that have been produced by others and, increasingly, will be available elsewhere on the web.

For instance, one source of long term value could be where a leading cable company partnered with leading internet TV and online movie companies – such as Apple, Google, Microsoft, Netflix and Hulu etc. to ensure that their customers received a high quality service experience (e.g. no pixilation, HD-only, pauseless rewind and fast forward etc.) that was based on a very high-quality, high-speed internet service. The only other option these users would have in gaining access to such services would be to use a xDSL-based broadband service which, probably, would not offer the same quality (hybrid fibre-coax network technology being fundamentally capable of a higher-speed service than any xDSL technology).

Content

When Time Warner Cable was spun out of Time Warner in 2009 the decision made at that point was that the business of creating, marketing and licensing TV content was a fundamentally different business to that of running a cable network. The thinking at the time was that the strategic trajectory of both businesses were headed in different directions.

Interestingly, when the world’s biggest cable network operator, Comcast, acquired NBC Universal in 2011, the decision made at that point was the complete opposite.

Regardless, there is no chance that TWC or Charter are currently thinking in terms of vertically integrating and getting back into the content business.  These two companies are, for better or worse, now committed to executing their network businesses.

Ancillary network services

Without services like high-speed internet and voice the cable network operators would be in real trouble: for the nine months ended 30 September 2013, TWC derived 41.9% of total revenues from high-speed internet and voice. The equivalent figure for Charter was  34.7%.

While these low  numbers might suggest that there is still plenty of growth left, in reality both companies are approaching a saturation point: the addressable market for both companies is defined by the extent of their network coverage (i.e. total homes and businesses passed) and their sales and marketing teams have been working around the clock to upsell as many video customers with bundled deals (so-called double and triple-play services) as well as to sign up what few new customers remain.

At the end of 3Q13, 76% of TWC’s residential customer base had adopted the company’s broadband service. For business customers the figure was 82.5%: clearly, these figures demonstrate that the growth story for these services must come to an end sometime soon.

Therefore, the sale of ancillary network services cannot be a source of long-term value as there is little room for growth left in the market.

Value-added Services

 The services  we are referring to here constitute a kind of ‘glue’ that  spans the cloud, network hardware and software, multiple devices (smartphones, PCs, connected TV sets and tablets) and device software (including the operating system as well as apps). This is the domain and companies like Apple, Google, Microsoft, Amazon and a very short list of others.

To us it is inconceivable that cable network operators will ever be able to assemble true ‘anytime, anywhere’ services that can compete with what companies like Google and Apple will be able to deliver.

In summary, we think that the question of whether the Charter-TWC merger will occur is the wrong one: our analysis is that TWC will, eventually, succumb to Charter’s advances at which point the long-term value will come from the combined network and how the new management develops and monetizes that network in the future. The sale of video services will in our view become less and less important.

A watershed will occur when the merged structure does a deal with an existing OTT internet TV player, such as Netflix, which will allow that company to deliver a higher-quality service than would be possible if the cable network’s users accessed it over the www. At this point, cable network operators like Charter and TWC will see that they are really just network operators, which is what telcos and mobile operators eventually figured out, and that the content will be mostly delivered using OTT models.


Andrew Sheehy
Chief Analyst

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