To The Moon

Summary

• Charter rose after Q2 earnings despite massively escalating Video losses over the past few quarters, as Video has long been seen as irrelevant.
• Charter's own disclosures provide evidence that Video may have never stopped really contributing to profit, with as much as 21% of 2023 profit indirectly attributable to Video.
• CEO Chris Winfrey's new Video strategy is a major piece of Charter's future. The idea is to bundle streaming services with the core linear service.
• This strategy's viability depends on making those subscriptions upgradeable and flexible. The first eight months of the Disney deal fell well short of this, hence Charter's massive video losses.
• Charter is now course correcting, and a viable Video strategy may well boost profits to counterbalance rising broadband competitive intensity. However, investors should wait for results before buying in.

Nanci Santos

Charter (NASDAQ:CHTR) has had a wild ride the past ten days. While its own Q2 earnings report would have been news enough, it has also been, like most of the market, caught up in the broader market turmoil as the possible end of the yen-dollar carry trade and a softening labor market play tug of war with the Federal Reserve rate cut expectations.

Charter has already been the subject of several good pieces of analysis from Seeking Alpha authors in recent days. I commend those articles to you, and I don’t want to belabor the points they have already made.

I am writing this article because, while I agree that Charter’s broadband and wireless operations continue to be very important to the company’s future, I also think another division of the company, which I had long since lost any real interest in, is becoming increasingly important once again - although whether for better or worse is a separate question.

Charter's Interesting Disclosure

I started to first develop this new take on Charter towards the end of last year, when Charter announced its Q3 earnings a few weeks after finally resolving its 13-day carriage dispute with Disney (DIS) and restoring (most of) its channels to the 14 million customers of what was then the largest video provider in the US - Comcast (CMCSA) and Charter likes to swap that crown back and forth every quarter or so.

As was customary, Charter’s Q3 report included a summary of how many mobile, broadband and - this is the part I’m actually interested in for the first time in years -video subscribers. Those numbers were not pretty - Charter lost 327,000 video subscribers in a single quarter.

Pretty much every pay-TV operator who isn’t YouTube TV (GOOG) (GOOGL) reports ugly numbers like that now. But usually, all you get is the final summary of the quarterly losses. Charter, however, went further and actually broke down how much of these would be considered “Disney-related.” According to management, 100,000 of Charter’s video losses could be ascribed to the Disney dispute as could 15,000 of its Internet losses.

Surprisingly Lucrative

Two things jump out at me about those numbers. First, considering that the blackout dispute went on for over a week in the heart of the NFL season, that is not very many losses at all. At that rate, Charter was probably on pace to lose no more than a million video subscribers, and probably more like only half a million, even if the dispute had gone on all the way through the NFL regular season.

With Charter beginning the dispute around 15 million subscribers, I would have expected the losses for just the first week to be more like half a million - and by the way, at that loss rate, I still thought Charter was right to refuse Disney’s opening offer and walk away. So the Charter-Disney dispute definitely proved that distributors are getting their leverage over content providers back, and probably altered the balance of power between them a bit.

The other thing about that number, though, which is more relevant to our immediate purpose, is the disclosure - for the first time in the industry, as far as I’m aware - of how video losses correlate with Internet losses. That is, just how many extra Internet subscribers do you get for maintaining a video service, instead of simply transitioning your customers to YouTube TV or fuboTV (FUBO) as more and more smaller providers are doing? Apparently, Charter gets 15% of its subscribers to its video service to sign up for Charter Internet, which they otherwise would not have taken.

If you had asked me the day before the earnings call, I would have put that number at no more than 5%, probably more like 3%. This was that rare beast, information that was actually operational and useful to come out of an earnings call.

Couple Million Here, Couple Billion There...

This is only a single data point, of course; we cannot be sure that broadband losses in a carriage dispute behave the same way as more normal churn. But since it is all we have to go on, if we assume that this number is generally indicative, it means that Charter’s nearly 14 million video subscribers are bringing with them some 2 million broadband subscriptions that Charter would otherwise not have.

Charter’s residential broadband count stands at 28 million, so this is a relatively small slice of the total, but the fixed-cost nature of broadband deployment means that those 2 million represent a considerably larger share of profit than they do of revenue. Although there are some cable broadband costs that scale with usage, most of the costs are large capital outlays to build and maintain the network. If suddenly Charter lost 2 million broadband subscribers, those costs wouldn’t really decline in any meaningful way.

So at the margin, an additional broadband subscriber is almost pure profit. And if in fact video service is one way to get more broadband subscribers than you would otherwise get, the broadband profits of those customers can in some sense be considered video profits, indirectly. This might help explain why so many operators have been retaining video service past the point when many of us outside analysts expected them to simply give up the ghost - we’ve all been underestimating just how much broadband money they would lose if they did.

Profit Calculation

I will get into the financials of that in a minute, but first I need to note that Charter does not provide a breakdown of its operating profit by sub-sector. However, we do know that Charter has, as of the most recent Q2 earnings report, 28.318 million residential broadband customers, generating a little over $5.8 billion in quarterly revenue for a monthly ARPU of $68.34.

If we assume that the gross margin on that is $60 even, that means that the 2 million extra broadband subscriptions Video is bringing in are worth some $1.44 billion a year in profit. In 2023, Charter reported that its EBT (Earnings Before Taxes) was $6.854 billion.

Do the math, and you will find that this means that Charter’s ‘Video-affiliated Broadband Boost’ is almost exactly 21% of its total profit.

Wireless Pressure On Broadband Continues

We also need to put that disclosure together with another piece of information: Charter continues to see its broadband business, the heart of its cable empire, struggle to compete with the FWA (fixed-wireless access) offerings of wireless competitors such as Verizon (VZ) and T-Mobile (TMUS) effectively.

Charter management’s evolution on FWA has been a long, winding road to admitting that it is becoming not just a competitor, but on the verge of being a veritable disruptor. It took them long enough. In 2022, FWA was all but openly mocked, as management insisted that people didn’t want to pool their Internet connections with their neighbors - cable broadband has a dedicated pipe for each house, while wireless subscribers all use the capacity of the same tower and can potentially run into congestion issues. As recently as Q1 2023, management was saying that its goal was to increase its broadband customer base by more than the 344,000 of 2022.

Since then, however, management has, quite grudgingly, come to admit FWA is not such a mouse, even if it’s not quite a lion yet. Nine months ago, in the same Q3 earnings call, CEO Chris Winfrey finally admitted that “some” of the core broadband weakness at Charter “could” tie in to “low-end” consumers shifting over to FWA. By Q4, he was ready to admit that the “admittedly more persistent” FWA was definitely playing a role in Charter’s Q4 loss of 61,000 Internet subscriptions, a bleeding which not only left them well short of their “top ’22” target but has continued in 2024 and which cannot be blamed entirely on the end of the government’s Affordable Connectivity Program.

Even now, management’s concession is less than complete. Winfrey still insists that Charter “continue to believe that…the impact is temporary.” In particular, he cites Charter’s experience that higher-usage data customers are more likely to return to Charter after they’ve tried FWA.

That last corresponds with my own expectations pretty much ever since 5G FWA launched in 2022 - although as I’ve explained before, that won’t necessarily be the roadblock to further FWA growth that Winfrey expects that it will. It’s also consistent with the behavior of the wireless operators themselves - T-Mobile now throttles all FWA users over 1.2 TB per month when a tower is congested, so not surprisingly lower-data users are finding FWA more hospitable than higher-data users.

Video's Evolving Role As FWA Expands

The key point here is that even if data usage on FWA stops growing at some point, account growth may not, since wireless carriers are basically nudging one high-usage customer off to make room for two or three lower-usage ones. But since Charter and wireless companies charge each account the same price, regardless of exact data usage, that won’t help Charter much.

This brings me back to Video. Remember, part of what’s keeping Charter and others in the video business so long after its profit margin basically disappeared is that it generates enough broadband profit to make it worthwhile to continue. As FWA continues to expand, some might expect the ‘broadband boost’ of video to decline, either because Charter cuts prices on broadband to maintain subscriptions, reducing profit margins, or because the propensity of Charter video subs to buy Charter Internet declines as more of them shift to wireless.

I fully expect that Charter will probably cut prices, but I am not sure whether that makes Video less important. Remember, the key point about Charter’s network in comparison to a wireless one is that Charter has one fixed cost to run a wire to a home - or, more accurately, charges one fixed fee to a customer for taking advantage of that line by activating service.

That means that as FWA continues to pressure the Internet business, one of the ways to convince a customer to stay on the network could be to convince them to take Video service from Charter as well. Once they decide they like Charter’s video service and want to keep it, they might as well keep the Internet as well, since they are presumably already paying the fixed costs fee embedded in the price of the first service they’re already buying. In other words, Charter could even resurrect the old playbook of selling a bundle of Video and Broadband for less than it costs to buy both separately.

Nine Months On, Grading New Strategy

Doing this, of course, means convincing a customer to take Video service. And that in turn depends on the customer seeing good value for money in the Video bundle that Charter is selling. Anyone who has watched the trajectory of the business over the last decade knows that hasn’t been the trend for a long time.

This is what Charter’s showdown with Disney last year was all about; Winfrey is trying to make Charter’s bundle something customers actually want again. Nine months on, it’s no longer too early to ask how he’s doing.

The early indications are, frankly, not great. In fact, Charter’s video losses have actually accelerated since the Disney showdown, not returning to baseline even after Disney’s nets returned to Spectrum TV. This is exactly the opposite of what Winfrey’s high stakes showdown with Disney was meant to accomplish.

So, has the new strategy already failed? And what, exactly, has gone wrong?

The Vitality Of Versatility

In a word, “waste.” Charter’s big win in the Disney showdown was securing free access to the ad-supported tier of Disney+ for all Charter TV subscribers. As I noted at the time, the viability of that offering and its consumer value would depend greatly on whether it could also be used as a credit against the cost of a Disney+ ad-free subscription; ie., could a subscriber buy up to ad-free and pay only the difference between the two prices, or did an ad-free upgrade essentially forfeit the discount? How versatile was the $8 that Spectrum supposedly got for its customers?

As it turned out, when Spectrum launched the new offering in January, the answer was the latter - it was ad-supported or nothing. So it was far less surprising to me than it was to some when a report emerged last month that only 10% of Spectrum’s customers were even bothering to take advantage of the offer.

It’s never a good sign when 90% of your customers don’t want something you’re offering to them for free, and frankly, it rather puts paid to this notion that ad-supported streaming is taking over the streaming-verse. I’ve long argued that the seeming momentum of ad streaming is more a result of sequential bias than consumer taste shifts, but I won’t rehash that debate today. What matters is that, if the deal is ads only, Charter’s wasting a little less programming money on this new TV deal than it was on its old one.

This is true because of structural interactions as well as consumer tastes. When buying Disney+ retail, Disney offers the option to buy a bundle of Disney+ and Hulu ad-supported for only $2 more - $6 less than it costs to buy the two $8 services separately. The ad-free services can be bundled for $20, marked down from $32. This means that any Disney+ subscriber who wants to buy Hulu as well - even one who is willing to tolerate ads - also has little reason to indulge in the offer, since most of the free money Charter is offering is squandered when they go to buy Hulu.

Course Corrections In Progress

The final dance is not played out yet, though. On the most recent earnings call Charter management announced that it would begin offering the upgrade option after all before the end of September. They also announced that Hulu would be made available for a $2 upcharge to all TV subscribers in the fourth quarter as well. This means that Charter’s money is about to become much more versatile, capable of being used to buy whatever form of Disney’s streaming services customers like best.

This should significantly enhance the appeal of Charter’s TV service. It’s not to say the bleeding will stop entirely, but now anyone who wants to can get basically $8 off of the $10 ad-supported bundle Disney offers all its customers or $8 off of an ad-free Disney+ subscription with paired with a Hulu with ads subscription for $8 total. Put another way, Spectrum TV subscribers can pay no more than anyone else for Hulu and get ad-free Disney+ thrown in for free, or pay the regular Disney+ with ads price and get an ad-free upgrade and a free Hulu with ads thrown in.

This will likely greatly increase the appeal to customers. It still isn’t perfect; a true “good as cash” option would also give Spectrum TV subs $8 off the combined ad-free option, which Winfrey didn’t say anything about on the call, so I’m guessing that’s not coming. But with this significant upgrade, it is too soon to call Winfrey’s new strategy a failure yet.

There is also the other negotiations. Charter recently concluded - without any blackouts - a new extension of its content deal with Paramount (PARA) and it includes free access for TV subscribers to Paramount’s streaming services, Paramount+ and BET+ as well. Even better, this deal includes upgrade opportunities to the ad-free version right from the off, so there will be no interim ‘wasted money’ period as there was with Disney+. Charter is also offering complimentary access to ViX, the Spanish-language streamer.

Investment Summary

I can’t believe I’m saying this, but I’m almost starting to believe that Video is becoming relevant to Charter’s profit profile again. If you’ve followed my work over the years, you know that runs counter to what I’ve thought for a long time. But it needs to be emphasized that this doesn’t make Charter immune to the pressures on Video; Winfrey needs to prove that he understands the tastes and needs of the consumer and make sure that every programming dollar goes as far as possible.

He does this by making every dollar as versatile as possible; frankly, the fact that Disney managed to get eight months of basically free money out of him - Disney is paid for a Disney+ subscription for every Spectrum TV subscriber regardless of whether they take the offer or not - is ridiculous. That can’t happen again.

Winfrey’s done better in the next few deals, however, and I think it’s too soon to write the new strategy off. But because of the inexplicable eight-month delay in getting any real value out of the Disney+ concessions, it is also too soon to say that Winfrey’s strategy is working.

While I am starting to get very intrigued by Charter, I’m not ready to add it to my Buy pile yet. For now, I will give it a Hold rating.