Charter Communications has a debt problem (NASDAQ:CHTR)

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Charter Communications (NASDAQ: CHTR) is an American telecommunications and mass media company with a market capitalization of $100 billion. Buying your home bandwidth, you may know the company as Spectrum. The company has an impressive portfolio of assets; however, as we will see throughout this article, growing competition and high debt pose a significant threat.

Finance Communications Charter

Communication Charter Investor Presentation

Finance Communications Charter (Charter Communications Investor Presentation)

Charter Communications managed to maintain relatively high revenues (>$50 billion in FY21) as well as strong EBITDA conversion ($20.6 billion). The company managed to achieve net income of $4.7 billion for the full year, demonstrating a continued ability to grow both its top line and its bottom line for shareholders.

However, there are also several potential downsides. Part of the company’s revenue growth is due to impacts related to COVID-19 in 2020. Another important aspect of the company’s financial condition is the conversion of its adjusted EBITDA to net income. This conversion rate for the company was around 22%.

Among the company’s expenses are annual interest expenses of more than $4 billion. This represents one of the company’s largest expenses due to its 4.4x leverage to Adjusted EBITDA. For perspective, the company’s annual FCF is around $8.5 billion. Two of its biggest expenses here are interest expense and capital expense.

Communication debt charter

Charter Communications has a huge amount of debt which the company has used to grow and expand its portfolio of assets.

Communication Charter Investor Presentation

Communication debt charter (Charter Communications Investor Presentation)

Charter Communications has long-term debt of approximately $93 billion. The company has a weighted average debt life of 13.8 years and a weighted average interest rate of 4.5%. Unfortunately for the company, however, interest rates are expected to rise significantly through 2021, potentially with a single 0.5% increasee.

Suppose that over the next 2 years, interest rates increase by 1.5%. Over a similar period, if the company wishes to maintain a similar interest rate, it could have to refinance about $10 billion in debt, which could result in nearly $200 million in annual interest expense. This would consume about 5% of the company’s net income.

Over the next decade, the corporate debt problem becomes more prominent. Historically, 0% interest rates have not been common. Being forced to refinance about $50 billion in debt over a decade at 1.5% more would add $750 million in annual interest expense, or about 20% of the company’s net income. These are significant potential expenses.

Charter Communications Capital / Competition

At the same time, Charter Communications has significant capital expenditure and growing competition.

Communication Charter Investor Presentation

Charter Communications Capital Expenditures (Charter Communications Investor Presentation)

Charter Communications saw a slight increase in capital spending from $6.9 billion in fiscal year 2020 to $7.1 billion in fiscal year 2021. This represents approximately 4% year-on-year capital expenditure growth. However, the company faces increasing competition. AT&T (NYSE:T) has announced great interest in expand its potential fiber locations to over 30 million by 2025.

This doubling is significant because AT&T is a much larger capital investor (about 3 times more than Charter Communications per year). Where the company offers fiber internet, it is almost certainly a much better value opportunity than traditional cable internet. At a minimum, spending more on enterprise fiber deployment is expensive.

In addition, the company has already encountered capital expenditure problems. New York threatened to dissolve the Time Warner Cable Company merger in 2018, based on the company’s non-compliance with its investment obligations. Regardless of how we reduce it, we expect the capital expenditure needs of the business to need to increase.

Charter communication problem

In our view, Charter Communications’ problem is simple.

The company is not trading at a low valuation. It has a P/E of ~23 (~4.5% earnings yield). It also has a substantial debt of around $90 billion on top of its market capitalization. The company’s multiple means that it is very sensitive to any change in its earnings situation. Part of the higher multiple appears to be attributable to future growth potential.

The company has a history of not meeting its capital expenditure requirements (and getting into trouble). Its capital expenditures have increased over the past few years, and we don’t see that trend reversing. Strong investments and pushes from AT&T and Comcast (NASDAQ: CMCSA) in fiber mean the company’s years of simply servicing its cable could be over.

On top of all this, historically low interest rates are expected to rise significantly. For 2022, interest rates are likely to increase by 1%. Given the company’s heavy indebtedness, the possibility of a significant increase in interest rates could lead to a significant drop in the company’s net income.

This combination of risks means that the company is currently overvalued and we expect it to decline in the months and years to come.

Thesis risk

The risk to our thesis is that, by many parameters, in a substantial part of the firm’s service area, the firm holds a monopoly. This means that the business, from these customers, will continue to have strong margins and strong revenues. This could be enough for the company to pay off some of its debt and potentially generate higher revenue.

Although we expect this to take many years, the market loves turnaround stories and tends to be forward looking.

Conclusion

Charter Communications, as one of the largest broadband companies, has an impressive portfolio of assets. The company has tens of millions of customers and in many of its service markets it has an effective monopoly. The company has demonstrated a consistent ability to grow revenue and we expect this growth to support earnings.

However, on the other hand, the company has huge relatively short-term debt at an interest rate of 4.5%. In a rising interest rate environment, this could lead to higher interest expense. Given new competition in fiber from companies like AT&T, which could increase capital expenditures, we view the company’s expenditures as having significant growth potential.

This risk deserves special attention and given the ratio of enterprise value to net profit of almost 40 times, we recommend that you pay particular attention to it. The value of the company’s debt prevents us from investing in it at this time.

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