Altice: Catching the Falling Knife?

September 30, 2021

It has been a busy week for Altice (ATUS). Last Thursday its share price declined more than 10%, followed by another multi-percent decline on Friday, and then on Monday it gave up a further 6% owing to a couple of belated downgrades, and not until today (Wednesday the 29th of September) does it seem to have found its footing. The final score so far is a loss of a bit over 20% from the price a week ago, and actually 50% down from earlier this year.

I am of the opinion that this is falling too far, too fast, but there is a common expression among traders: Don’t catch a falling knife. In other words, don’t buy a stock when it’s in the process of collapsing. Of course, this adage presupposes that it is possible to identify the end of the collapse with any accuracy, or at least that when the collapse ends, your purchase price will be lower than it was when the stock showed up on your radar in the first place.

Now, the wise value cares more about whether the price is ultimately a good bargain than whether it could be higher or lower than another price. But on the other hand, even the most fundamentalist of fundamental investors cannot operate in complete ignorance of trading techniques. No market participant ever wants to leave any more money on the table than is feasible.

Altice is a cable and broadband company that operates mostly in New York City and the mid-South of the United States. Like many cable companies, it has been shedding cable subscribers at a few percent per year but making up the deficit with increased broadband subscribers and revenue. Presently, the company is working on mobile services and is working on expanding fiber to the home.

The impetus for the recent collapse price seems to be the CEO’s revelation at a conference last Thursday that it was anticipating the loss of 15-20 thousand broadband accounts in the third quarter, which amounts to less than half a percent of their total subscribers. Obviously, a 20% drop in price in response to a half-percent drop in subscribers is just the market being efficient again, even though to be fair the market has a reason to be disturbed since Altice’s broadband subscribers have been organically growing by one or two percent a year until this announcement. Also, Altice has rather a high debt level even by the standards of cable companies, so a change in subscriber trends would tend to be magnified. But anyway…

Following two days of carnage for the share price, analysts Doug Mitchelson of Credit Suisse and Frank Louthan of Raymond James, presumably not wanting to appear asleep at the switch, announced that they were downgrading Altice, resulting in a further 6% loss on Monday. Mitchelson downgraded Altice despite acknowledging that it was probably selling for below the value of its assets, and Louthan complained that the company is shifting its strategy from share buybacks to actually investing money into the company’s future. This is why sell-side analysts should not be encouraged.

So, by how much is Altice selling below its asset value, as Mitchelson the Mad Downgrader of Zurich has reluctantly admitted? First off, Altice has two share classes: approximately 270 million class A shares which are publicly traded, and 180 million class B shares that are not publicly traded and that have 25 votes for every vote the class A shares have. The class B shares can be converted into class A shares, and curiously, a few tens of millions of them have been converted over the years, presumably to take advantage of Altice’s repurchases. In theory, the fact that a noncontrolling interest cannot be bought publicly at any price would suggest that the control shares are worth more than their share of the profits would imply, and I shall address this later. I should also mention at this point that Altice also owns 43 million shares of Comcast, worth approximately $2.4 billion dollars, for reasons that are entirely unclear to me.

Turning to the company’s free cash flow, in 2020 sales were $9.895 billion; operating income was $2.115 billion; interest expense was $1.352 billion, leaving $763 million in operating income, or $573 million after taxes at a hypothetical 25% rate. The excess of depreciation and amortization over capital expenditures added another $1.01 billion, producing free cash flow of $1.773 billion.

In 2019 sales were $9.761 billion; operating income was $1.824 billion; interest expense was $1.536 billion, leaving $288 million in operating income, or $231 million after hypothetical taxes. Excess depreciation and amortization came to $908 million, producing free cash flow of $1.139 billion.

In 2018, sales were $9.567 billion; operating income $1.682 billion; interest expense $1.557 million, leaving $126 in operating income or $101 after estimated taxes, plus $1.228 in excess depreciation, producing $1.130 billion in free cash flow.

The first two quarters of 2021 have been largely a continuation of existing trends. Broadband revenues are up 9% and video revenue down 6%, while total residential customers were up 1% over last year’s total. Residential customers compose about 4/5 of total revenue, with the balance coming from business services (also up 1% over last year’s results), and a small amount from selling news and advertising.

Sales for the first half of the year are $4.994 billion as compared to $4.925 billion last year; operating income was $1.235 million; interest expense was $636 million, leaving $599 million or $449 million, plus $344 million excess depreciation, for a total free cash flow of $793 million, or $1.584 billion on an annualized basis.

As we see, operating income has increased compared to 2020’s results, although excess depreciation has come down. The most encouraging development, though, is the decline in interest expense, which resulted from Altice managing to refinance its debts at lower interest rates even though the total debt balance has not changed. Nonetheless, I would like to see the total debt balance decline, since it seems to be weighing on the company’s valuation to a notable degree

So, let us make a ballpark estimate of the value of Altice’s equity. If we apply a multiple of 10 times free cash flow of $1.584 on an annualized basis, we can round it off at $16 billion. This choice of multiple strikes a balance, it seems to me, between a company that is (at least for now) still growing its largest revenue source, broadband, which calls for a higher valuation, and its significant indebtedness of $27 billion, nearly 170% of its calculated equity value, which calls for a lower one. This debt figure strikes me as high, even though cable customers are a recurring source of revenue. However, this debt burden was not so high as to cause Altice’s creditors to prevent them from buying back $2.4 billion in stock over the last six quarters, and as I have stated, the company has managed to refinance its debt at lower interest rates despite the balance remaining high.

Given this figure of $16 billion for the entire company (plus $2.4 billion for its shares in Comcast), how shall we divide it between the publicly traded class A shares and the non-traded controlling class B shares? As I stated, there is customarily a premium given to the control bloc of shares that has traditionally ranged between 10 and 40%. (There is also normally a liquidity discount for the shares not being publicly traded, but as the class B shares are instantly convertible into class A shares, I don’t see the need to go into it). Given the wide range of potential premiums, one way of choosing between a low control premium and a high one is whether the control group is actually running the company as well as it would if they were at risk of the shareholders firing them. An entrenched and inferior management calls for a higher control premium, or essentially a higher discount for lack of control, than an adequate management, entrenched or not. To take a cliched and extreme example, Berkshire Hathaway does not suffer at all, valuation-wise from having Buffett and Munger in charge. If anything, Berkshire Hathaway would have a control discount.

How can we assess the competence of management? By comparing Altice to other cable companies, using something called Du Pont analysis. Du Pont analysis was invented in the 1920s (aren’t you glad you get the cutting edge of financial knowledge on this site), and was designed to decompose the concept of return on equity into three analytically useful components: operational efficiency, i.e. profits/sales; asset efficiency; i.e. sales/assets; and leverage, i.e. assets/equity. I have already said that the leverage aspect is a bit high for my taste, but the other two are the comparative tools that interest me today.

Altice’s operational efficiency, or free cash flow/sales, is 15.9%, and sales/assets is 29.8%, based on annualizing the first two quarters of 2021. Over at Comcast, free cash flow/sales over the same period was 14.2% and sales/assets was 40.3%. At Charter Communications, free cash flow/sales was 12.2% and sales/assets was 35.2%, and at Cable One, free cash flow/sales was 18.7% and sales/assets was 21.8%. Based on this simple comparison, Altice’s performance does not appear to be too far outside of the parameters of a normal cable company, being second in free cash flow/sales and third in sales/assets.

So if we allow for a 20% control premium, a somewhat arbitrary choice but one that recognizes that Altice is tolerably well run (despite the high leverage and apparent loss of broadband subscribers), the 180 million class B shares are worth 216 million out of the total 450 million shares, representing 48% of the total. This leaves 52% for the publicly traded class A shares. Also, the $2.4 billion in Comcast stock should be distributed evenly among all the shares, since control makes no difference in the performance of an entirely different company (although it would probably influence the decision to sell it or not). So, 52% of $16 billion plus 60% of $2.4 billion adds up to $9.76 billion, which, divided among 270 million shares, comes to about $36 a share.

That said, what should we do with our falling knife situation? $36 a share is certainly almost twice the current price, and is actually where Altice traded earlier this year. However, even if the fear of Altice’s deterioration in subscribers are overblown, it is quite possible that the rot will take longer than one quarter to be cured, and this fear can weight down the market quotation, particularly if as it appears Altice actually intends to make more capital investments than it has historically. So, although the price is attractive and based on the above calculations Mitchelson was correct to determine that the stock he downgraded was still underpriced, I cannot predict that there will be no more attractive entry points than today, or that when the quarterly report comes out at the end of next month, the market will react with further shock and horror. Or, even if the news this quarter and the next are actually in line with previous results, that the market will recognize it in a timely manner. Even so, as a value investor, I’ve never been in the business of picking ideal entry points, so the lack of my ability to call the bottom has never really hampered me. But given the dramatic overreaction we have seen to Altice’s disappointing announcement, it might be worth a look.

Disclosure: At the time of this writing, I have a long position in Altice. I also have a big scar on my foot that was caused by a falling knife. (No, really).

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