AGB 2021.24 - Cable One (CABO)
Broadband First Strategy in Rural Markets
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“Since our early days, we've intentionally chosen to operate in small cities and large towns across rural America where we consistently provide measurably better products and services than alternative providers. Within our rural market demographics, only 25% of our competitors provide broadband service with download speeds of 100 megs or higher. Despite this advantage, we operate as if every market is highly competitive, setting ourselves apart from our competition by creating an exceptional local customer experience that includes reliable, high-speed, value-based broadband services.” - Chairman and Chief Executive Officer, Julie Laulis on Cable One’s Q3 2021 Earnings Call
Cable One is a leading provider of data, video and voice services in 24 states, mostly in the rural regions of the Western, Midwest and Southern U.S. Over 70% of the company’s customers are located in Arizona, Idaho, Mississippi, Missouri, Oklahoma, South Carolina and Texas. Cable One has 1.46M residential and business customers out of 2.7M homes passed (homes were service is available), which are comprised of 1.03M data customers, 279k video customers and 151k voice customers.
Cable One was formed inside of The Washington Post Company in 1986 when it acquired 53 cable TV systems with over 350k subscribers in 15 states. The Washington Post then made a series of acquisitions and divestitures (30 through 2015) to concentrate into the cable assets that serviced non-metropolitan markets. Cable One was spun out of Graham Holdings (Washington Post holding company changed its name in 2013) in the middle of 2015.
Up until 2012, Cable One had a similar operating model to many others in cable industry. The company focused on retaining double and triple play residential customers (ones that were subscribed to 2 or 3 of the data, video and voice services), because the belief was that customers that subscribe to more services are less likely to churn. As we’ve seen with our analysis of other subscription businesses (see Veeva Systems, Atlassian, Spotify, Workday), increased churn dramatically reduces the lifetime value of a customer.
This is a similar approach to companies in other industries trying to reduce customer churn. Insurance carriers offer discounts to plan premiums when subscribing to multiple plans like home and auto. Another example would be family plans for cell phone services (or even streaming services like Spotify) that are heavily discounted (on a per user basis) because these customers are believed to be less likely to churn.
However, the company realized that that even customers with double and triple play subscriptions were in aggregate canceling their video services as streaming on Netflix, Prime Video, Hulu, YouTube, etc. became more popular. These services provided a superior and oftentimes cheaper alternative for video content consumption.
For cable operators, video services already had low margins because of the programming and retransmission fees. On average, these costs add up to more than 40% of revenues for most operators and the margins are even worse for smaller operators due to less negotiating power and contract minimums. Add on the discounting and promotional offers to retain many of these customers and profit margins for video were almost non-existent. Cable One estimates that the free cash flow from its video services is close to zero.
Cable One pivoted its strategy to focus on high speed data (HSD) plans while deemphasizing video and voice services. This meant that the company would invest heavily into upgrading its network to bring the starting broadband offering to 100mbps download speeds by 2015. Even today that’s still a very competitive speed in the markets that Cable One operates in.
The company also started to focus more on selling plans and services to businesses. SMB customers typically get HSD through hybrid fiber-coaxial (HFC) connections like residential data customers and larger Enterprise customers get a fiber connection. Cable One launched Piranha Fiber in 2017, which is a 2gbps symmetrical service (download and upload speeds are consistent) and the company believes that this can scale up to 10gbps. The average ARPU for this business is $280/month, which is much higher than the ARPU for residential data at $78/month. Cable One estimates that its EBITDA margins for business services is 9x that of video services.
At the time of the strategy shift, HSD and business services were 30% and 8% of revenues while video and voice were 47% and 9% of revenues. Over the next 7 years, the company lost more than 40% of its residential video and voice subscribers, but increased its HSD customers by 48% and its business services customers by 105%. Given that the margins are substantially higher for HSD and business services vs. video, the margin profile of the company increased from 35% EBITDA margin in 2013 to 56% in 2020.
Cable One also focused on becoming more efficient on the cost side, getting rid of direct sales since internal analysis showed that direct sales only accounted for 9% of customer starts. Through natural attrition, the legacy Cable One business saw it’s headcount drop from ~2.4k in 2011 to ~1.8k by 2017. The company also implemented a lifetime value score for each customer so that service reps can focus on retaining the high valued customers while letting the low valued customers go.
Currently Cable One leads its with its residential data offering, starting with speed of 100mbps and going up to 1gbps (called GigaOne Plus), which is available for 97% of the company’s passed homes. Customers have responded well to this strategy. Over 70% of new customers starts are data only. Data services has 8x the EBITDA margins of video services.
As for video, the company offers the service but doesn’t emphasize it due to its low margin profile. There is no discount for subscribing to multiple services. Cable One increases the rates on video when programming costs go up (usually once per year) in the range of mid single digit dollars. The company doesn’t offer VOD and doesn’t have certain networks like ones owned by Viacom, but the customer understands that.
In 2019, the company rebranded its residential customer facing services to Sparklight. The rebranding for the legacy Cable One business is almost complete as of 2020 and cost between $9M-$11M.
Why is it a good business?
For the most part, cable businesses in the U.S. are a regional monopoly or part of an oligopoly due to the regulatory environment. Many studies have shown that U.S. consumers have little choice when it comes to broadband Internet or video access. Data from the FCC’s report called Fixed Broadband Deployment Report from 2021 suggest that only 32% of households in the U.S. have access to 3 or more providers of broadband Internet access. The data also suggest that competition is even more sparse in rural regions of the country with only 16% of households having access to 3 or more providers.
Typically, a home in the U.S. will have two choices for data, video and voice connectivity, one from a fixed line telecom provider like AT&T or Lumen Technologies and one from the local cable provider like Charter or Comcast. And in regions where telecom providers haven’t built fiber access, the cable company is usually the best bet for broadband Internet access. Telecom providers that haven’t built out fiber usually offer DSL internet, which is much slower than a cable connection so that it’s just uncompetitive.
Before a cable or telecom company can provide service to customers in a local region, these companies have to acquire a franchise license to use public rights-of-way, allowing these companies to place their wires and cables above and below public and private property. These companies also have to negotiate pole attachment contracts with local utilities to gain access to certain homes. While it depends on the region and what the competitive bargaining power is of the cable company, these licenses and fees can add up to be a large part of the overall cost of network expansion, making it cost prohibitive for many cable operators to expand to new regions. This is a big reason why many regions have just one cable operator.
Another reason for there being a lack of competition among cable companies is that the larger cable companies consider M&A to be one of their key growth vectors. Even as a midsized operator, Cable One has grown this way as well, acquiring 6 companies and making minority investments in 3 others since becoming a public company in 2015. During the regulatory review of an M&A transaction, the justice department will likely analyze changes in competitive dynamics. This would be less of a concern if a larger cable company in one region is acquiring a smaller cable company in a completely separate region, meaning the existing competitive dynamics of the region wouldn’t change.
In addition to benefits from regulation, cable companies also benefit from scale economies. On the video side, larger companies generally have better negotiating leverage with content providers, being able to bring down programming costs/subscriber. Larger cable companies also benefit from better economics when making purchases of equipment (cable box, modem, phone, etc.). And lastly, these companies also likely have better economics when dealing with interconnection fees paid to the tier 1 networks in the U.S. and in a similar vein are likely able to charge interconnection fees to smaller tier 3 network operators as well.
Specific to Cable One, many of the competitive dynamics are more in the company’s favor due to its focus on secondary and tertiary markets in the U.S. In over 75% of Cable One’s territories, there is no competitor that offers residential broadband download speeds of 100mpbs or higher. Higher download speeds are becoming more necessary due to the increasing data usage from streaming, mobile devices, etc. And while fiber competition is ramping up in certain regions, just 12% of Cable One’s passed homes have access to fiber-to-the-home from a competitor.
Cable One’s customers are also behind the curve when it comes to technology trends and this is well represented in the lower penetration rates vs. competitors that service metropolitan regions. The benefit to this is that Cable One can adopt a fast follower approach when it comes to new technology adoption. As an example, the company is still undergoing the upgrade to DOCSIS 3.1 from DOCSIS 3.0, a transition that didn’t start until 2019.
Returns on incremental capital?
Over the past 8 years, Cable One has spent half its capital on capex and the other half on acquisitions. Capex spend is generally for network improvements (including deploying DOCSIS 3.1), line extensions into new customers, purchases of customers premise equipment (modems, set top boxes, etc.), converting back office functions like billing and accounting, and building out the company’s fiber networks. Since 2017, more than half of capex was spent on infrastructure improvements to grow capacity for data and video services.
Prior to the spin out in 2015, Cable One spent a lot of its capex to improve the core infrastructure of the company. This included increasing channel capacity for HSD bonding up to 32 channels (increasing throughput speeds), doubling the number of service nodes so that fewer customers are sharing a single node, and replacing all the cable modem termination systems (CMTS) at the company’s head ends.
On the acquisition front, the company has been active since becoming a public company, acquiring other cable operators in rural regions of the U.S. NewWave was acquired in 2017 for $740M. NewWave has a presence in Arkansas, Illinois, Indiana, Louisiana, Missouri and Texas. After $152M in tax synergies and $24M in opex savings (reduction in programming costs, system operations and corporate overhead), Cable One effectively paid a 6.6x EBITDA multiple or 15% return on capital. Post acquisition, the company continues to improve NewWave’s core margins and cash flows.
Industry multiples have moved higher in recent years but on average, the multiples for cable assets have ranged between 8x-12x prior to synergies. Cable One’s acquisition of NewWave was considered to be 11.5x EV/EBITDA prior to the synergy calculations.
Unfortunately, there weren’t more disclosures on the multiples paid for the remaining Cable One acquisitions but here are the highlights for the 5 other acquisitions and 3 minority investments:
ClearWave was acquired in 2019 for $358M. A fiber only network with coverage in Southern IL.
Fidelity was acquired in 2019 for $531M. A rural cable operator in Arkansas, Illinois, Louisiana, Missouri, Oklahoma and Texas. Fidelity had 2.4k customers.
ValueNet was acquired in 2020 for $39M. An all fiber network provider in Kansas.
10% of Nextlink in 2020 for $27M. A fixed wireless internet provider.
40% of Wisper ISP in 2020 for $25M. A fixed wireless internet provider in Arkansas, Missouri, Oklahoma, Kansas, Indiana, and Illinois.
45% of Mega Broadband Investments (MBI) in 2020 for $575M. MBI was formed through a combination of Vyve Broadband, Northland Communications and Eagle Communication. MBI services 630k passed homes in Alabama, Arkansas, California, Colorado, Georgia, Idaho, Kansas, Louisiana, Nebraska, North Carolina, Oklahoma, South Carolina, Tennessee, Texas, Washington, and Wyoming.
Cable One has a call option to purchase the remainder of MBI between January 2023 and June 2024.
MBI has a put option to sell the remainder of MBI between July 2025 and September 2025.
Hargray was acquired in a two step process. First in 2020, Cable One traded its cable operations in Anniston, AL 15% of Hargray. Then in 2021, Cable One paid $2.2B for 85% not already owned.
CableAmerica’s Missouri operations for $113M in 2021. CableAmerica had 14k customers.
We estimate that Cable One has generated returns on incremental capital between 13%-17% over the past 4 years. While the returns haven’t been as large as other businesses we’ve analyzed, controlling for the high capital intensity of the business (both capex and acquisitions), the returns are in the upper bound. By comparison, American Tower, which also exhibits high capital intensity, had 9%-12% returns on incremental capital over the past 5 years.
Cable One doesn’t talk about its TAM but rather gives penetration rates for the company. Penetration rates for residential data customers have increased from 30% in 2015 to 37% in 2020. As of Q3 2021, penetration rates have increased to almost 39%. For residential video, the penetration rates have gone the opposite way from 22% in 2015 to just 11% in 2020 and voice has experienced a similar trajectory.
Compared to the large cable companies, Cable One’s penetration rate is still meaningfully lower. Charter has a broadband data penetration rate of almost 52% and a video penetration rate of almost 29%. Altice has 47% of broadband data penetration rate. It’s natural for Cable One to have a lower penetration rates than cable companies that have meaningful exposure to metropolitan areas of the U.S., because the customers base can more easily afford broadband services. But it’s unclear just yet what that delta should be between the cable industry and what Cable One can achieve long-term.
As an industry, Cable is just over 50% penetrated in broadband and that’s growing at almost 2% per year. That could imply that there is more upside to penetration over the long-term, but if you add in telco broadband penetration of almost 22%, the “greenfield” opportunity seems a bit smaller.
On the business services side, the TAM for Cable One could be in the $1B-$2B range, implying that Cable One is already commanding 12%-24% market share. The company did give a penetration rate for business services of 24% at its 2015 Analyst Day. If we assume that the business opportunity set remained the same (likely not the case, since Cable One has made acquisitions and entered the Enterprise market), that would imply that the penetration rate in 2020 was almost 43%. For the reasons above, it would be safe to assume that the penetration rate is much lower than the calculated 43%.
In terms of M&A opportunities, Cable One is one of the largest mid-sized cable operators along with Mediacom, RCN and WideOpenWest. Further down the list there are still many regional cable operators, some of which participate in rural areas. Cable One also has the call option on the remaining 55% ownership of Mega Broadband Investments that can be exercised between January 2023 and June 2024.
With a reinvestment rate between 65%-120% and a return on incremental capital between 13%-17%, we estimate that Cable One has increased its intrinsic value between 11%-16% over the past 5 years. The reinvestment rate does fluctuate much higher after large acquisitions are made. Cable One has had a lower leverage ratio historically but that flexed up above 3x net debt/EBITDA after the ClearWave and Fidelity acquisitions in 2019. So far, all of the company’s acquisitions have been purchased with cash or a trading of assets for equity, so the share count has remained relatively steady since the spin out in 2015.
What else is important?
Similar to other cable companies, with the lockdown measures related to Covid-19, there was a spike in demand for broadband Internet services. Cable One incented new customers to sign on and existing customers to not disconnect service. The company waived late charges, suspended all collection activities and stopped charging data overage fees. Cable One also partnered with local school districts to provide internet services for families with students that were not able to afford broadband Internet otherwise.
Because of the high growth in new customers (the company added more organic net subscriptions in 2020 than it did in the 4.5 years since the spin out) and the artificially low churn rate (due to the company’s actions discussed above), the net customer adds and the organic growth rate of the HSD segment were materially higher than average.
Data usage also spiked higher with average monthly data usage increasing from 260gb-270gb in 2018 to 500gb by 1Q 2021. That was a 28% increase from 1Q 2020. Even with the increased usage, because the company had invested to upgrade the network while deemphasizing video, peak utilization rates only reached 20% in downstream and 18% in upstream during this period.
One of the market concerns with Cable One and the rest of the cable industry is that these companies may have over-earned during the 1.5 years since Covid-19 hit. Because offices and schools were closed, most families needed broadband Internet services at home. And when things eventually return back to normal there is the worry that broadband sub growth rates will slow down or turn negative.
There’s also the impact from the Emergency Broadband Benefit (EBB) program implemented as part of the CARES Act. This $3.2B program helped to subsidize many low income households to gain access to broadband Internet. Over 5.5M households in the U.S. took advantage of this program according to the FCC. As the subsidy runs out, there is also a risk (with out other future subsidies) that some of these customers will cancel or downgrade their broadband Internet services.
Specific to Cable One, the company stated that most customers that took advantage of the EBB program were existing customers (just 10% were new) and most were using that subsidy to upgrade download speeds. There is a risk that some of these customers will opt for lower tier HSD packages once the benefit runs out.
Future competition from fiber
The cable vs. fiber debate is interesting because fiber is considered to be a superior technology in most respects. Fiber has better data speeds, symmetrical upload/download and fewer shared connections but are those features enough for customers to switch from cable? Plus, cable has successfully met the data needs for most consumers with advances in DOCSIS technology and channel bonding. So while cable has clearly won vs. DSL, could there be changes in the competitive landscape with future fiber rollouts?
Large telco companies like AT&T and Frontier have re-upped their plans to invest in fiber over the next 5 years. The question is can these companies build enough fiber to increase availability to make marketing spend, promotions and discounting economically feasible? Will the technological advantages of fiber convince potential customers to switch over from cable? And will there be fewer incremental advances in DOCSIS technology so that fiber can maintain a large enough technological advantage?
What cable has going for it is that collectively, these companies already have the majority share of the broadband Internet connections in the U.S. As the incumbent, “good enough” download and upload speeds should allow these companies to maintain market share unless there is aggressive pricing from fiber competitors. For consumers at least, having another viable choice for broadband Internet would be beneficial.
Specifically for Cable One, the current overlap with fiber available homes are only 13% of the company’s total passed homes. And specific to competition from AT&T, there is a 80k home overlap (out of 2.7M passed homes).
M&A is a biggest source of upside for Cable One. Because the company generates so much cash (43% operating cash flow margin), the company can easily afford to spend more cash than it has on the balance sheet at any given moment to make meaningful acquisitions. And given that Cable One is a best in class operator in rural markets, there is just a natural fit with many of the smaller operators that service these areas.
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Nice one! Any reason you picked Cable one to study instead of a more established player like Charter?