“When it comes to the data side, we haven’t had a rate adjustment. Well actually, we’ve had one in five and a half years now.” – Julia Laulis, CableOne CEO
The Madera Technology Master Fund returned -1.1% in June. The Fund has returned +14.0% year to date.
This month we feature Episode II in our education series on the secular shift in entertainment infrastructure. This is extremely disruptive. We want to cut through the misinformation from the rest of Wall Street and make sure you are well informed from a technologist’s perspective.
As the world moves increasingly to over-the-top (OTT) video, the consensus belief is that cable operators have a natural hedge in broadband internet. We believe broadband is only a hedge against disintermediation, not against shrinking future cash flows. Since most investors buy equities for future cash flows, we believe the shift to broadband-only presents a very attractive risk/reward opportunity for shorts within this space. After all, would you rather have 100% of $10 or 65% of $30?
THE CORE PROBLEM IS THE $150 MONTHLY AVERAGE REVENUE PER CUSTOMER (ARPU)
The $150 arpu consists of three services: video at $80, internet at $50, and voice at $20. Video is the only product with variable costs as programming rights are ~$50 per subscriber per month. This implies the average customer is paying $150 per month and generating $100 of gross profit ($150 less $50 programming) resulting in 67% gross margin.
DROPPING VIDEO AND VOICE MEANS (50)% REDUCTION IN GROSS PROFIT DOLLARS
If our average customer decides $150 per month (triple play) is untenable and moves to internet-only (single play), revenue goes to $50, as $80 of video and $20 of voice are both lost. This customer is now paying $50 per month and generating $50 of gross profit resulting in 100% gross margin. While gross margin percentage is much higher in this scenario, gross profit dollars are 50% lower.
To give you context for the bull case view on the cable industry, the prevailing belief is that internet is currently priced at $80 per month and will jump to between $100-$300 per month as cable companies extract price increases from consumers. The bull case is that internet pricing will be increased by 100%.
BUT BROADBAND-ONLY IS $80 PER MONTH, SO THAT $50 MATH IS WRONG (RIGHT?)
We use our proprietary JSTARS platform to monitor broadband pricing, and we believe $50 is a pretty good estimate for what a typical broadband customer pays. For normal folks, Comcast, Verizon Fios, and Spectrum all offer broadband internet service for $39.99 per month. We included two screen captures of pricing for Comcast’s 100 Mbps (very fast) service for twelve (12) month commitment and without a commitment. These cost $39.99 and $59.99 per month respectively. At the super high end, RCN offers 1 Gbps (that’s 1,000 Mbps) speed for $49.99 per month. All of these plans are well below the $80+ pricing cited by cable investors. In fact, through all of our big data analysis, we have been unable to find pricing that would indicate an average of $80 per month.
Figure 1
| 100 Mbps with contract is $40 | $60 without contract |
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IF WE USE $80 FOR BROADBAND, GROSS PROFIT DOLLARS ARE STILL DOWN (20)%
In this case, we have $80 of revenue and $80 of gross profit (assumes broadband is 100% gross margin) versus $150 of revenue and $100 of gross profit in our original case. Your margin percentage may have gone up, but your cash flow went down.
While the bull case may ignore prices that are clearly advertised by each provider, the more concerning point is that the bull case assumes cable internet is like is like insulin, with no substitute. That may have been true when cable companies were regional monopolies and technology was from circa 2001, but what has changed is that now there is in fact a substitute. Technology disintermediates and drives change. The future is wireless, not wired. In 2017, T-Mobile offers unlimited data + phone services for $40 per month. All of the wireless carriers are launching 5G services starting in 2018.
If we distill the bull case to its core, it assumes that consumers are frankly idiots with expenses, they never shop around, and they never seek to find alternatives. Our observation is that this belief is unfounded.
BUT BROADBAND-ONLY COSTS LESS TO SUPPORT THAN VIDEO
Based on SEC filed financials, customer service is ~$7 per customer per month and technical and product support is ~$18 per customer per month, or $25 per month combined. If we use $80 broadband-only pricing and assume a generous (80)% reduction in per customer monthly support costs, that gets back to parity of $100 of gross profit. Our experience is that WiFi/internet requires more support calls than television, but we will not argue that point today.
OKAY WHAT ABOUT CABLEONE?
For context, CableOne is often cited by cable investors as the exemplification of the bull case, how the cable thesis is supposed to play out. CableOne has been losing about 10% of video subscribers per year and has grown ebitda dollars over the same period, which supports the idea of broadband-only being a better business. The fatal flaw with this reasoning is that CableOne’s arpu is $94 as of March 2017. This is up only slightly over two years from $90 in March 2015. This means a CableOne customer would trade down from $94 total cost to $80 for internet-only, using the cable bull case, which is only a $14 reduction in revenue.
CABLEONE’S PRICES ARE BELOW $80 PER MONTH
CableOne’s middle tier internet plan is $50 per month for 150 Mbps of speed. The top tier is 200 Mbps for $75. CableOne has also not raised price in over five (5) years--a fact CEO Ms. Julia Laulis mentioned on a recent call, but maybe no one listened--so we are somewhat skeptical of the extent that pricing power exists.
Figure 2
A WORSE REALITY AND COMPLACENT INVESTORS MAKES FOR COMPELLING RISK/REWARD
Using our JSTARS big data tools, we observe the reality is actually worse than as we have presented it. We find the customers most likely to trade down are those with monthly bills over $200 per month, meaning the most profitable customers are fleeing first. That is a problem. As we have previously said, we believe base case downside is (50)% with potential for (100)% if we see pronounced acceleration in consumer behavior.
You can access the first article in our education series on this technology shift, “Is cable video a commodity business,” here.
Thank you and please reach out with any questions,
Kris
+1-212-229-0859
