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CHARTER COMMUNICATIONS, INC. /MO/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) General Charter Communications, Inc. ("Charter") is a holding company whose principal asset is a 100% common equity interest in Charter Communications Holding Company, LLC ("Charter Holdco"). Charter owns cable systems through its subsidiaries. We are a cable operator providing services in the United States with approximately 6.1 million residential and commercial customers at September 30, 2014. We offer our customers traditional cable video programming, Internet services, and voice services, as well as advanced video services such as OnDemandTM ("OnDemand"), high definition ("HD") television and digital video recorder ("DVR") service. We also sell local advertising on cable networks and provide fiber connectivity to cellular towers. Transactions with Comcast On April 25, 2014, we entered into a binding definitive agreement (the "Agreement") with Comcast Corporation ("Comcast"), which contemplates the following transactions: (1) an asset purchase, (2) an asset exchange and (3) a contribution and spin-off transaction (collectively, the "Transactions") as described in more detail below. The Transactions are expected to be consummated substantially contemporaneously with each other and will be consummated as promptly as practicable following the merger of a subsidiary of Comcast with Time Warner Cable Inc. ("TWC") as previously announced by Comcast and TWC. The completion of the Transactions will result in Charter acquiring approximately a net 1.4 million existing TWC residential and commercial video customers. Asset Purchase At closing, we will acquire from Comcast systems currently owned by TWC serving approximately 1.5 million video customers and all other assets and liabilities primarily related to such systems for cash consideration. We will pay to Comcast the tax benefit of the step-up it receives in the tax basis of the assets. Such tax benefit to Charter will be paid as realized by us over an eight-year period, and an additional payment will be made at the end of such eight-year period in the amount of any remaining tax benefit (on a present value basis) not previously realized by Charter. Asset Exchange At closing, we and Comcast will exchange certain systems serving approximately 1.5 million TWC video customers and approximately 1.6 million Charter video customers and all other assets and liabilities primarily related to such systems. Most tax gains associated with the asset exchange are expected to be offset by Charter's existing net operating losses. Financing The consideration for the assets acquired and transaction expenses will be financed with new indebtedness of Charter and is currently estimated at approximately $8.0 billion principal amount. Charter has received commitments from a number of leading Wall Street investment banks to provide incremental senior secured term loan facilities totaling up to $8.4 billion and a senior secured incremental revolving facility equal to $500 million under the Charter Communications Operating, LLC ("Charter Operating") credit facility. Pursuant to that commitment, Charter has fully drawn on $3.5 billion term loan G commitments and $1.0 billion has been committed, but not issued, in additional Charter Operating term loans. In October 2014, our subsidiary, CCOH Safari, LLC, announced an offering of $1.5 billion aggregate principal amount of 5.50% senior notes due 2022 and $2.0 billion aggregate principal amount of 5.75% senior notes due 2024 (collectively, the "Notes"). We expect to close that offering in November 2014 and the net proceeds will be used to fund a portion of the purchase of certain assets pursuant to the Transactions. We will reduce the commitments by the amount of the Notes at the closing of the offering. See "Item 2. Management's Discussion and Analysis - Liquidity and Capital Resources - Recent Events." Contribution and Spin-Off Transaction CCH I, LLC ("CCH I"), a current indirect subsidiary of Charter, will be reorganized to be a direct subsidiary of Charter. CCH I will then form a new subsidiary that will merge with Charter, through a tax-free reorganization and become the new holding company ("New Charter") that will own 100% of Charter and indirectly Charter Holdco. New Charter will then acquire an approximate 33% stake in a new publicly-traded cable provider to be spun-off by Comcast serving approximately 2.5 million existing Comcast video customers. The cable systems will be contributed to Midwest Cable, Inc., which upon consummation of the Transactions, is expected to change its name to GreatLand Connections Inc. ("GreatLand Connections"). New Charter will 25 -------------------------------------------------------------------------------- acquire its interest in GreatLand Connections by issuing New Charter stock to Comcast shareholders (including former TWC shareholders) as a result of a merger of a wholly owned subsidiary of New Charter with and into GreatLand Connections. Comcast shareholders, including the former TWC shareholders, are expected to own approximately 67% of GreatLand Connections, while New Charter is expected to directly own approximately 33% of GreatLand Connections. GreatLand Connections expects to incur leverage of approximately 5 times its estimated pro forma EBITDA (as such term is defined by GreatLand Connections' financing sources for purposes of the financing) to fund a distribution to Comcast and issue notes to Comcast prior to the spin-off. Additionally, we will provide services to GreatLand Connections, and we will be reimbursed the actual economic costs of such services, in addition to a fee of 4.25% of GreatLand Connections' gross revenues. The asset purchase, asset exchange and the acquisition of interests in GreatLand Connections will be valued at a 7.125 multiple of 2014 EBITDA (as defined by the parties), subject to certain post-closing adjustments. Acquisition of Bresnan In July 2013, Charter and Charter Operating acquired Bresnan Broadband Holdings, LLC and its subsidiaries (collectively, "Bresnan") from a wholly owned subsidiary of Cablevision Systems Corporation ("Cablevision"), for $1.625 billion in cash, as well as a working capital adjustment and a reduction for certain funded indebtedness of Bresnan (the "Bresnan Acquisition"). Bresnan managed cable operating systems in Colorado, Montana, Wyoming and Utah that pass approximately 670,000 homes and serve approximately 375,000 residential and commercial customer relationships. Overview Our business plans include goals for increasing customers and revenue. To reach our goals, we have actively invested in our network and operations, and have improved the quality and value of the products and packages that we offer. We have enhanced our video product by increasing digital and HD-DVR penetration, offering more HD channels, and moving to an all-digital platform. We simplified our offers and pricing and improved our packaging of products to bring more value to new and existing customers. As part of our effort to create more value for customers, we have focused on driving penetration of our triple play offering, which includes more than 100 HD channels (or 200 or more in all-digital markets), video on demand, Internet service, and fully-featured voice service. In addition, we have implemented a number of changes to our organizational structure, selling methods and operating tactics. We have fully insourced our direct sales workforce and are increasingly insourcing our field operations and call center workforces and modifying the way our sales workforce is compensated, which we believe positions us for better customer service and growth. We expect that our enhanced product set combined with improved customer service will lead to lower customer churn and longer customer lifetimes, allowing us to grow our customer base and revenue more quickly and economically. We expect our capital expenditures to remain elevated as we strive to increase digital and HD-DVR penetration, place higher levels of customer premise equipment per transaction and progressively move to an all-digital platform. Total revenue growth was 8% and 12% for the three and nine months ended September 30, 2014, respectively, compared to the corresponding periods in 2013, due to the Bresnan Acquisition described above and growth in our video, Internet and commercial businesses. Total revenue growth on a pro forma basis for the Bresnan Acquisition as if it had occurred on January 1, 2012 was 8% for the nine months ended September 30, 2014 compared to the corresponding period in 2013. For the three and nine months ended September 30, 2014, Adjusted EBITDA was $783 million and $2.3 billion, respectively, and for the three and nine months ended September 30, 2013, Adjusted EBITDA was $732 million and $2.1 billion, respectively. Adjusted EBITDA is defined as net loss plus net interest expense, income tax expense, depreciation and amortization, stock compensation expense, loss on extinguishment of debt, gain (loss) on derivative instruments, net, and other operating expenses, such as merger and acquisition costs, special charges and (gain) loss on sale or retirement of assets. See "-Use of Adjusted EBITDA and Free Cash Flow" for further information on Adjusted EBITDA and free cash flow. Adjusted EBITDA increased 7% and 12% for the three and nine months ended September 30, 2014 compared to the corresponding periods in 2013 as a result of the Bresnan Acquisition, which contributed $96 million during the nine months ended September 30, 2014 compared to the corresponding period in 2013, and an increase in residential and commercial revenues offset by increases in programming costs, costs to service customers and marketing costs. For the three and nine months ended September 30, 2014 and 2013, our income from operations was $218 million and $694 million, respectively, and for the three and nine months ended September 30, 2013, our income from operations was $209 million and $665 million, respectively. In addition to the factors discussed above, income from operations for the three and nine months ended September 30, 2014 was affected by increases in depreciation and amortization primarily due to the Bresnan Acquisition and current capital expenditures. We believe that continued competition and the prolonged recovery of economic conditions in the United States, including mixed recovery in the housing market and relatively high unemployment levels, have adversely affected consumer demand for our services, particularly video. Historically, our primary video competitors have often offered more HD channels and have typically 26 -------------------------------------------------------------------------------- only offered digital services which have a better picture quality compared to our legacy analog product. In response, we have promoted our digital product and initiated a transition from analog to digital transmission of all channels we distribute, which will result in substantially more HD channels and higher Internet speeds. In the current economic environment, customers have been more willing to consider our competitors' products, partially because of increased marketing highlighting perceived differences between competitive video products, especially when those competitors are often offering significant incentives to switch providers. We also believe some customers have chosen to receive video over the Internet rather than through our OnDemand and premium video services, thereby reducing our video revenues. We believe competition from wireless service operators and economic factors have contributed to an increase in the number of homes that replace their traditional telephone service with wireless service thereby impacting the growth of our telephone business. If the economic and competitive conditions discussed above do not improve, we believe our business and results of operations may be adversely affected, which may contribute to future impairments of our franchises and goodwill. We have a history of net losses. Our net losses are principally attributable to insufficient revenue to cover the combination of operating expenses, interest expenses that we incur because of our debt, depreciation expenses resulting from the capital investments we have made and continue to make in our cable properties, amortization expenses related to our customer relationship intangibles and non-cash taxes resulting from increases in our deferred tax liabilities. The following table summarizes our customer statistics for video, Internet and voice as of September 30, 2014 and 2013 (in thousands except revenue per customer relationship). Approximate as of September 30, 2014 (a) 2013 (a) Residential Video (b) 4,157 4,179 Internet (c) 4,662 4,290 Voice (d) 2,389 2,217 Residential PSUs (e) 11,208 10,686 Residential Customer Relationships (f) 5,768 5,498 Monthly Residential Revenue per Residential Customer (g) $ 110.81 $ 108.68 Commercial Video (b)(h) 139 166 Internet (c) 294 245 Voice (d) 172 138 Commercial PSUs (e) 605 549 Commercial Customer Relationships (f)(h) 380 359 (a) We calculate the aging of customer accounts based on the monthly billing cycle for each account. On that basis, at September 30, 2014 and 2013, customers include approximately 13,500 and 9,700 customers, respectively, whose accounts were over 60 days, approximately 1,200 and 1,000 customers, respectively, whose accounts were over 90 days, and approximately 800 and 900 customers, respectively, whose accounts were over 120 days. (b) "Video customers" represent those customers who subscribe to our video cable services. Our methodology for reporting residential video customers generally excludes units under bulk arrangements, unless those units have a digital set-top box, thus a direct billing relationship. As we complete our all-digital transition, bulk units are supplied with digital set-top boxes adding to our bulk digital upgrade customers. Third quarter 2014 and 2013 residential video net additions include 20,000 and 3,000, respectively, bulk video units as a result of adding digital set-top boxes to bulk units. (c) "Internet customers" represent those customers who subscribe to our Internet services. 27-------------------------------------------------------------------------------- (d) "Voice customers" represent those customers who subscribe to our voice services. (e) "Primary Service Units" or "PSUs" represent the total of video, Internet and voice customers. (f) "Customer Relationships" include the number of customers that receive one or more levels of service, encompassing video, Internet and voice services, without regard to which service(s) such customers receive. This statistic is computed in accordance with the guidelines of the National Cable & Telecommunications Association ("NCTA"). Commercial customer relationships include video customers in commercial structures, which are calculated on an EBU basis (see footnote (h)) and non-video commercial customer relationships. (g) "Monthly Residential Revenue per Residential Customer" is calculated as total residential video, Internet and voice quarterly revenue divided by three divided by average residential customer relationships during the respective quarter. (h) Included within commercial video customers are those in commercial structures, which are calculated on an equivalent bulk unit ("EBU") basis. We calculate EBUs by dividing the bulk price charged to accounts in an area by the published rate charged to non-bulk residential customers in that market for the comparable tier of service. This EBU method of estimating video customers is consistent with the methodology used in determining costs paid to programmers and is consistent with the methodology used by other multiple system operators. As we increase our published video rates to residential customers without a corresponding increase in the prices charged to commercial service customers, our EBU count will decline even if there is no real loss in commercial service customers. For example, commercial video customers decreased by 13,000 during the three months ended September 30, 2014 due to a higher applicable video rate applied. Critical Accounting Policies and Estimates For a discussion of our critical accounting policies and the means by which we develop estimates therefore, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" in our 2013 Annual Report on Form 10-K. 28--------------------------------------------------------------------------------Results of Operations The following table sets forth the percentages of revenues that items in the accompanying condensed consolidated statements of operations constituted for the periods presented (dollars in millions, except per share data): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Revenues $ 2,287 100 % $ 2,118 100 % $ 6,748 100 % $ 6,007 100 % Costs and Expenses: Operating (excluding depreciation and amortization) 1,518 66 % 1,397 66 % 4,444 66 % 3,950 66 % Depreciation and amortization 535 23 % 493 23 % 1,568 23 % 1,354 23 % Other operating expenses, net 16 1 % 19 1 % 42 1 % 38 1 % 2,069 90 % 1,909 90 % 6,054 90 % 5,342 89 % Income from operations 218 10 % 209 10 % 694 10 % 665 11 % Other Expenses: Interest expense, net (217 ) (214 ) (638 ) (635 ) Loss on extinguishment of debt - - - (123 ) Gain (loss) on derivative instruments, net 5 (8 ) (3 ) 9 (212 ) (222 ) (641 ) (749 ) Income (loss) before income taxes 6 (13 ) 53 (84 ) Income tax expense (59 ) (57 ) (188 ) (124 ) Net loss $ (53 ) $ (70 ) $ (135 ) $ (208 ) LOSS PER COMMON SHARE, BASIC AND DILUTED: $ (0.49 ) $ (0.68 ) $ (1.26 ) $ (2.05 ) Weighted average common shares outstanding, basic and diluted 108,792,605 102,924,443 107,744,534 101,293,696 Revenues. Total revenue grew $169 million or 8% for the three months ended September 30, 2014 as compared to the three months ended September 30, 2013. Total revenue grew $741 million or 12% for the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013. Revenue growth primarily reflects increases in the number of residential Internet and triple play customers and in commercial business customers, growth in expanded basic and digital penetration, promotional and annual rate increases, and higher advanced services penetration offset by a decrease in basic video customers. The Bresnan Acquisition increased revenues for the nine months ended September 30, 2014 as compared to the corresponding period in 2013 by approximately $276 million. 29--------------------------------------------------------------------------------Revenues by service offering were as follows (dollars in millions): Three Months Ended September 30, 2014 2013 2014 over 2013 Revenues % of Revenues Revenues % of Revenues Change % Change Video $ 1,109 48 % $ 1,047 49 % $ 62 6 % Internet 652 29 % 575 27 % 77 13 % Voice 141 6 % 161 8 % (20 ) (12 )% Commercial 253 11 % 215 10 % 38 18 % Advertising sales 87 4 % 75 4 % 12 16 % Other 45 2 % 45 2 % - - % $ 2,287 100 % $ 2,118 100 % $ 169 8 % Nine Months Ended September 30, 2014 2013 2014 over 2013 Revenues % of Revenues Revenues % of Revenues Change % Change Video $ 3,309 49 % $ 2,991 50 % $ 318 11 % Internet 1,906 28 % 1,596 27 % 310 19 % Voice 436 6 % 490 8 % (54 ) (11 )% Commercial 731 11 % 587 10 % 144 25 % Advertising sales 234 3 % 208 3 % 26 13 % Other 132 2 % 135 2 % (3 ) (2 )% $ 6,748 100 % $ 6,007 100 % $ 741 12 % Video revenues consist primarily of revenues from basic and digital video services provided to our non-commercial customers, as well as franchise fees, equipment rental and video installation revenue. Residential video customers decreased by 22,000 from September 30, 2013 to September 30, 2014. The increase in video revenues is attributable to the following (dollars in millions): Three months ended Nine months ended September 30, 2014 September 30, 2014 compared to compared to three months ended nine months ended September 30, 2013 September 30, 2013 Increase / (Decrease) Increase / (Decrease) Incremental video services, price adjustments and bundle revenue allocation $ 78 $ 231 Decrease in basic video customers (12 ) (37 ) Decrease in premium, OnDemand and pay-per-view (4 ) (14 ) Bresnan Acquisition - 138 $ 62 $ 318 30-------------------------------------------------------------------------------- Residential Internet customers grew by 372,000 customers from September 30, 2013 to September 30, 2014. The increase in Internet revenues from our residential customers is attributable to the following (dollars in millions): Three months ended Nine months ended September 30, 2014 September 30, 2014 compared to compared to three months ended nine months ended September 30, 2013 September 30, 2013 Increase / (Decrease) Increase / (Decrease) Increase in residential Internet customers $ 52 $ 146 Service level changes and price adjustments 25 90 Bresnan Acquisition - 74 $ 77 $ 310 Residential voice customers grew by 172,000 customers from September 30, 2013 to September 30, 2014. The decrease in voice revenues from our residential customers is attributable to the following (dollars in millions): Three months ended Nine months ended September 30, 2014 September 30, 2014 compared to compared to three months ended nine months ended September 30, 2013 September 30, 2013 Increase / (Decrease) Increase / (Decrease) Price adjustments and bundle revenue allocation $ (30 ) $ (110 ) Increase in residential voice customers 10 33 Bresnan Acquisition - 23 $ (20 ) $ (54 ) Commercial revenues consist primarily of revenues from services provided to our commercial customers. Commercial PSUs increased 56,000 from September 30, 2013 to September 30, 2014. The increase in commercial revenues is attributable to the following (dollars in millions): Three months ended Nine months ended September 30, 2014 September 30, 2014 compared to compared to three months ended nine months ended September 30, 2013 September 30, 2013 Increase / (Decrease) Increase / (Decrease) Sales to small-to-medium sized business customers $ 30 $ 85 Carrier site customers 4 13 Other 4 14 Bresnan Acquisition - 32 $ 38 $ 144 Advertising sales revenues consist primarily of revenues from commercial advertising customers, programmers and other vendors. Advertising sales revenues increased $12 million and $26 million, respectively, for the three and nine months ended September 30, 2014 compared to the corresponding periods in 2013 primarily driven by an increase of $7 million and $14 million in political 31 -------------------------------------------------------------------------------- advertising revenue, respectively. The Bresnan Acquisition increased advertising sales revenues for the nine months ended September 30, 2014 as compared to the corresponding period in 2013 by approximately $7 million. Other revenues consist of home shopping, late payment fees, wire maintenance fees and other miscellaneous revenues. Other revenues remained relatively constant during the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013. The Bresnan Acquisition increased other revenues for the nine months ended September 30, 2014 as compared to the corresponding period in 2013 by approximately $2 million. Operating costs and expenses. The increases in our operating costs and expenses are attributable to the following (dollars in millions): Three months ended Nine months ended September 30, 2014 September 30, 2014 compared to compared to three months ended nine months ended September 30, 2013 September 30, 2013 Increase / (Decrease) Increase / (Decrease) Programming $ 67 $ 170 Franchise, regulatory and connectivity 1 5 Costs to service customers 17 39 Marketing 5 31 Other 31 69 Bresnan Acquisition - 180 $ 121 $ 494 Programming costs were approximately $621 million and $554 million, representing 41% and 40% of total operating costs and expenses for the three months ended September 30, 2014 and 2013, respectively, and were $1.8 billion and $1.6 billion, representing 41% and 40% of total operating costs and expenses for the nine months ended September 30, 2014 and 2013, respectively. Programming costs consist primarily of costs paid to programmers for basic, digital, premium, OnDemand, and pay-per-view programming. The increase in programming costs is primarily a result of annual contractual rate adjustments, including increases in amounts paid for retransmission consents and for new programming, offset in part by video customer losses. We expect programming expenses to continue to increase due to a variety of factors, including annual increases imposed by programmers with additional selling power as a result of media consolidation, increased demands by owners of broadcast stations for payment for retransmission consent or linking carriage of other services to retransmission consent, and additional programming, particularly new sports services. We have been unable to fully pass these increases on to our customers nor do we expect to be able to do so in the future without a potential loss of customers. Costs to service customers include residential and commercial costs related to field operations, network operations and customer care including internal and third party labor for installations, service and repair, maintenance, billing and collection, occupancy and vehicle costs. The increase in costs to service customers was primarily the result of higher spending on labor to deliver improved products and service levels and higher collection costs. The increase in marketing costs for three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013 was the result of heavier sales activity and sales channel development. 32 -------------------------------------------------------------------------------- The increases in other expense are attributable to the following (dollars in millions): Three months ended Nine months ended September 30, 2014 September 30, 2014 compared to compared to three months ended nine months ended September 30, 2013 September 30, 2013 Increase / (Decrease) Increase / (Decrease) Administrative labor $ 15 $ 30 Commercial sales expense 7 21 Advertising sales expense 5 9 Bad debt expense 5 10 Other (1 ) (1 ) $ 31 $ 69 The increase in administrative labor during the three and nine months ended September 30, 2014 compared to the corresponding periods in 2013 relates primarily to increases in the number of employees. Commercial sales expenses increased during the three and nine months ended September 30, 2014 compared to the corresponding periods in 2013, primarily related to growth in the business. Depreciation and amortization. Depreciation and amortization expense increased by $42 million and $214 million for the three and nine months ended September 30, 2014 compared to the corresponding periods in 2013, respectively, primarily representing depreciation on more recent capital expenditures and the Bresnan Acquisition, offset by certain assets becoming fully depreciated. Other operating expenses, net. The changes in other operating expenses, net are attributable to the following (dollars in millions): Three months ended Nine months ended September 30, 2014 September 30, 2014 compared to compared to three months ended nine months ended September 30, 2013 September 30, 2013 Increase / (Decrease) Increase / (Decrease) Merger and acquisitions costs $ 1 $ 15 Special charges, net - (8 ) Loss on sale of assets, net (4 ) (3 ) $ (3 ) $ 4 For more information, see Note 10 to the accompanying condensed consolidated financial statements contained in "Item 1. Financial Statements." Interest expense, net. Net interest expense increased by $3 million for each of the three and nine months ended September 30, 2014 compared to the corresponding periods in 2013. The average interest on our long-term debt decreased from 5.6% and 5.9% for the three and nine months ended September 30, 2013 to 5.5% and 5.6% for the three and nine months ended September 30, 2014, respectively, while our weighted average debt outstanding increased from $14.3 billion and $13.4 billion for the three and nine months ended September 30, 2013 to $15.2 billion and $14.5 billion for the three and nine months ended September 30, 2014, respectively. Loss on extinguishment of debt. Loss on extinguishment of debt of $123 million for the nine months ended September 30, 2013 was recorded as a result of repaying and refinancing amounts outstanding under the Charter Operating credit facilities and from the repurchase of CCO Holdings, LLC ("CCO Holdings") notes. For more information, see Note 5 to the accompanying condensed consolidated financial statements contained in "Item 1. Financial Statements." 33 -------------------------------------------------------------------------------- Gain (loss) on derivative instruments, net. Interest rate derivative instruments are held to manage our interest costs and reduce our exposure to increases in floating interest rates. We recorded a gain of $5 million and a loss of $3 million during the three and nine months ended September 30, 2014, respectively, and a loss of $8 million and a gain of $9 million during the three and nine months ended 2013, respectively, which primarily represents the amortization of accumulated other comprehensive loss for interest rate derivative instruments no longer designated as hedges for accounting purposes offset by their change in fair value. For more information, see Note 7 to the accompanying condensed consolidated financial statements contained in "Item 1. Financial Statements." Income tax expense. Income tax expense was recognized for the three and nine months ended September 30, 2014 and 2013 primarily through increases in deferred tax liabilities related to our investment in Charter Holdco and certain of our indirect subsidiaries, in addition to $6 million and $11 million for the three and nine months ended September 30, 2014, respectively, and $1 million and $12 million for the three and nine months ended September 30, 2013, respectively, of current federal and state income tax expense. The nine months ended September 30, 2013 included a step-up in basis of indefinite-lived assets for tax, but not GAAP purposes, resulting from the effects of partnership gains related to financing transactions, which decreased our net deferred tax liability related to indefinite-lived assets resulting in a benefit of $67 million. Our tax provision in future periods will vary based on various factors including changes in our deferred tax liabilities attributable to indefinite-lived intangibles, as well as future operating results, however we do not anticipate having such a large reduction in income tax expense attributable to these items unless we enter into restructuring transactions or similar future financing. The ultimate impact on the tax provision of such future financing and restructuring activities, if any, will be dependent on the underlying facts and circumstances at the time. For more information, see Note 11 to the accompanying condensed consolidated financial statements contained in "Item 1. Financial Statements." Net loss. Net loss decreased from $70 million and $208 million for the three and nine months ended September 30, 2013 to $53 million and $135 million for the three and nine months ended September 30, 2014 primarily as a result of the factors described above. Loss per common share. During the three and nine months ended September 30, 2014 compared to the corresponding periods in 2013, net loss per common share decreased by $0.19 and $0.79, respectively, as a result of the factors described above. Use of Adjusted EBITDA and Free Cash Flow We use certain measures that are not defined by accounting principles generally accepted in the United States ("GAAP") to evaluate various aspects of our business. Adjusted EBITDA and free cash flow are non-GAAP financial measures and should be considered in addition to, not as a substitute for, net loss and net cash flows from operating activities reported in accordance with GAAP. These terms, as defined by us, may not be comparable to similarly titled measures used by other companies. Adjusted EBITDA and free cash flow are reconciled to net loss and net cash flows from operating activities, respectively, below. Adjusted EBITDA is defined as net loss plus net interest expense, income tax expense, depreciation and amortization, stock compensation expense, loss on extinguishment of debt, gain (loss) on derivative instruments, net, and other operating expenses, such as merger and acquisition costs, special charges and (gain) loss on sale or retirement of assets. As such, it eliminates the significant non-cash depreciation and amortization expense that results from the capital-intensive nature of our businesses as well as other non-cash or special items, and is unaffected by our capital structure or investment activities. However, this measure is limited in that it does not reflect the periodic costs of certain capitalized tangible and intangible assets used in generating revenues and our cash cost of financing. These costs are evaluated through other financial measures. Free cash flow is defined as net cash flows from operating activities, less capital expenditures and changes in accrued expenses related to capital expenditures. Management and Charter's board of directors use adjusted EBITDA and free cash flow to assess Charter's performance and its ability to service its debt, fund operations and make additional investments with internally generated funds. In addition, Adjusted EBITDA generally correlates to the leverage ratio calculation under our credit facilities or outstanding notes to determine compliance with the covenants contained in the facilities and notes (all such documents have been previously filed with the United States Securities and Exchange Commission, the "SEC"). For the purpose of calculating compliance with leverage covenants, we use Adjusted EBITDA, as presented, excluding certain expenses paid by our operating subsidiaries to other Charter entities. Our debt covenants refer to these expenses as management fees, which fees were in the amount of $62 million and $49 million for the three months ended September 30, 2014 and 2013, respectively, and $184 million and $147 million for the nine months ended September 30, 2014 and 2013, respectively. Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Net loss $ (53 ) $ (70 ) $ (135 ) $ (208 ) Plus: Interest expense, net 217 214 638 635 Income tax expense 59 57 188 124 Depreciation and amortization 535 493 1,568 1,354 Stock compensation expense 14 11 41 37 Loss on extinguishment of debt - - - 123 (Gain) loss on derivative instruments, net (5 ) 8 3 (9 ) Other, net 16 19 42 38 Adjusted EBITDA $ 783 $ 732 $ 2,345 $ 2,094 Net cash flows from operating activities $ 520 $ 538 $ 1,729 $ 1,563 Less: Purchases of property, plant and equipment (569 ) (425 ) (1,678 ) (1,259 ) Change in accrued expenses related to capital expenditures (13 ) 19 31 21 Free cash flow $ (62 ) $ 132 $ 82 $ 325 Liquidity and Capital Resources Introduction This section contains a discussion of our liquidity and capital resources, including a discussion of our cash position, sources and uses of cash, access to credit facilities and other financing sources, historical financing activities, cash needs, capital expenditures and outstanding debt. Recent Events In September 2014, Charter Operating entered into a new term loan G facility pursuant to the terms of the Charter Operating credit agreement providing for a $3.5 billion term loan maturing in 2021. Pricing on the term loan G was set at LIBOR plus 3.50% with a LIBOR floor of 0.75% and issued at a price of 99.50% of the aggregate principal amount. The term loan G forms a portion of the incremental facilities commitments as announced by Charter in July 2014 that will be used to fund the purchase of certain assets pursuant to the Transactions. Charter Operating assigned all of its obligations with respect to the term loan G and transferred all of the proceeds from the term loan G to a newly-created subsidiary, CCO Safari, LLC ("CCO Safari"), which is considered a Non-Recourse Subsidiary under Charter Operating's Amended and Restated Credit Agreement dated April 11, 2012, (the "Credit Agreement"), and CCO Safari placed the funds in escrow pending the closing of the Transactions, at which time, subject to certain conditions, Charter Operating will re-assume the obligations in respect of the term loan G under the Credit Agreement. In October 2014, our subsidiary, CCOH Safari, LLC, announced an offering of $1.5 billion aggregate principal amount of 5.50% senior notes due 2022 and $2.0 billion aggregate principal amount of 5.75% senior notes due 2024. We expect to close that offering in November 2014 and the net proceeds will be used to fund a portion of the purchase of certain assets pursuant to the Transactions. See "Item 2. Management's Discussion and Analysis - The Transactions." Overview of Our Contractual Obligations and Liquidity We have significant amounts of debt. The principal amount of our debt as of September 30, 2014 was $17.7 billion, consisting of $7.3 billion of credit facility debt and $10.4 billion of high-yield notes. Our business requires significant cash to fund principal and interest payments on our debt. As of September 30, 2014, $16 million of our debt matures in 2014, $91 million in 2015, $128 million in 2016, $1.1 billion in 2017, $1.0 billion in 2018 and $15.3 billion thereafter. As of December 31, 2013, as shown in our annual report on Form 10-K, we had other contractual obligations, including interest on our debt, totaling $7.5 billion. During 34--------------------------------------------------------------------------------2014, we currently expect capital expenditures to be approximately $2.2 billion, including approximately $400 million for completion of our 2014 all-digital plan. Our projected cash needs and projected sources of liquidity depend upon, among other things, our actual results, and the timing and amount of our expenditures. Negative free cash flow was $62 million for the three months ended September 30, 2014 and free cash flow was $132 million for the three months ended September 30, 2013, and $82 million and $325 million for the nine months ended September 30, 2014 and 2013, respectively. As of September 30, 2014, the amount available under our credit facilities was approximately $774 million. We expect to utilize free cash flow and availability under our credit facilities as well as future refinancing transactions to further extend the maturities of or reduce the principal on our obligations. The timing and terms of any refinancing transactions will be subject to market conditions. Additionally, we may, from time to time, depending on market conditions and other factors, use cash on hand and the proceeds from securities offerings or other borrowings, to retire our debt through open market purchases, privately negotiated purchases, tender offers, or redemption provisions. We believe we have sufficient liquidity from cash on hand, free cash flow and Charter Operating's revolving credit facility as well as access to the capital markets to fund our projected operating cash needs. We continue to evaluate the deployment of our anticipated future free cash flow including to reduce our leverage, and to invest in our business growth and other strategic opportunities, including mergers and acquisitions as well as stock repurchases and dividends. As possible acquisitions, swaps or dispositions arise in our industry, we actively review them against our objectives including, among other considerations, improving the operational efficiency, clustering or technology capabilities of our business and achieving appropriate return targets, and we may participate to the extent we believe these possibilities present attractive opportunities. However, there can be no assurance that we will actually complete any acquisition, disposition or system swap, including the transactions with Comcast, or that any such transactions will be material to our operations or results. Free Cash Flow Negative free cash flow was $62 million for the three months ended September 30, 2014 and free cash flow was $132 million for the three months ended September 30, 2013, and $82 million and $325 million for the nine months ended September 30, 2014 and 2013, respectively. The decrease in free cash flow for the three months ended September 30, 2014 compared to the corresponding period in 2013 is primarily due to an increase of $144 million in capital expenditures, changes in operating assets and liabilities, excluding the change in accrued interest, that used $84 million more cash, and an increase of $9 million in cash paid for interest offset by an increase of $51 million in Adjusted EBITDA. The decrease in free cash flow for the nine months ended September 30, 2014 compared to the corresponding period in 2013 is primarily due to an increase of $419 million in capital expenditures, $40 million in cash paid for interest and $15 million in merger and acquisition costs offset by an increase of $251 million in Adjusted EBITDA. The nine months ended September 30, 2013 also benefited from a $26 million restricted cash reclass. Limitations on Distributions Distributions by Charter's subsidiaries to a parent company for payment of principal on parent company notes are restricted under indentures and credit facilities governing our indebtedness, unless there is no default under the applicable indenture and credit facilities, and unless each applicable subsidiary's leverage ratio test is met at the time of such distribution. As of September 30, 2014, there was no default under any of these indentures or credit facilities and each subsidiary met its applicable leverage ratio tests based on September 30, 2014 financial results. Such distributions would be restricted, however, if any such subsidiary fails to meet these tests at the time of the contemplated distribution. In the past, certain subsidiaries have from time to time failed to meet their leverage ratio test. There can be no assurance that they will satisfy these tests at the time of the contemplated distribution. Distributions by Charter Operating for payment of principal on CCO Holdings notes are further restricted by the covenants in its credit facilities. In addition to the limitation on distributions under the various indentures discussed above, distributions by our subsidiaries may be limited by applicable law, including the Delaware Limited Liability Company Act, under which our subsidiaries may only make distributions if they have "surplus" as defined in the act. Historical Operating, Investing, and Financing Activities Cash and Cash Equivalents. We held $10 million and $21 million in cash and cash equivalents as of September 30, 2014 and December 31, 2013, respectively. Operating Activities. Net cash provided by operating activities increased $166 million from $1.6 billion for the nine months ended September 30, 2013 to $1.7 billion for the nine months ended September 30, 2014, primarily due to an increase in Adjusted 35 -------------------------------------------------------------------------------- EBITDA of $251 million offset by a $40 million increase in cash paid for interest, $15 million increase in merger and acquisition costs and changes in operating assets and liabilities, excluding the change in accrued interest and accrued expenses related to capital expenditures, that provided $12 million less cash during the nine months ended September 30, 2014. The nine months ended September 30, 2013 also benefited from a $26 million restricted cash reclass. Investing Activities. Net cash used in investing activities for the nine months ended September 30, 2014 and 2013 was $5.2 billion and $1.9 billion, respectively. The increase is primarily due to the investment of $3.5 billion of net proceeds from the issuance of the term loan G in long-term restricted cash and cash equivalents and higher capital expenditures. See "Liquidity and Capital Resources - Recent Events." Financing Activities. Net cash provided by financing activities was $3.4 billion and $397 million for the nine months ended September 30, 2014 and 2013, respectively. The increase in cash provided was primarily the result of Charter Operating entering into a $3.5 billion term loan G in September 2014. See "Liquidity and Capital Resources - Recent Events." Capital Expenditures We have significant ongoing capital expenditure requirements. Capital expenditures were $1.7 billion and $1.3 billion for the nine months ended September 30, 2014 and 2013, respectively. The increase was driven by our all-digital initiative, higher product development investments and ongoing insourcing initiative and the acquisition of Bresnan. See the table below for more details. Excluding potential expenditures related to the Transactions, we currently expect 2014 capital expenditures to be approximately $2.2 billion. We anticipate 2014 capital expenditures to be driven by our all-digital transition including the deployment of additional set-top boxes in new and existing customer homes, growth in our commercial business, and further spend related to our efforts to insource our service operations as well as product development, which we anticipate will comprise approximately $500 million of 2014 capital expenditures. The actual amount of our capital expenditures will depend on the pace of transition planning to service a larger customer base upon closing of the previously-announced transactions with Comcast. Our capital expenditures are funded primarily from cash flows from operating activities and borrowings on our credit facility. In addition, our liabilities related to capital expenditures increased by $31 million and $21 million for the nine months ended September 30, 2014 and 2013, respectively. The following table presents our major capital expenditures categories in accordance with NCTA disclosure guidelines for the three and nine months ended September 30, 2014 and 2013. The disclosure is intended to provide more consistency in the reporting of capital expenditures among peer companies in the cable industry. These disclosure guidelines are not required disclosures under GAAP, nor do they impact our accounting for capital expenditures under GAAP (dollars in millions): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Customer premise equipment (a) $ 282 $ 193 $ 908 $ 618 Scalable infrastructure (b) 113 78 307 210 Line extensions (c) 50 54 131 162 Upgrade/rebuild (d) 47 50 131 137 Support capital (e) 77 50 201 132 Total capital expenditures (f) $ 569 $ 425 $ 1,678 $ 1,259 (a) Customer premise equipment includes costs incurred at the customer residence to secure new customers and revenue generating units. It also includes customer installation costs and customer premise equipment (e.g., set-top boxes and cable modems). (b) Scalable infrastructure includes costs not related to customer premise equipment, to secure growth of new customers and revenue generating units, or provide service enhancements (e.g., headend equipment). (c) Line extensions include network costs associated with entering new service areas (e.g., fiber/coaxial cable, amplifiers, electronic equipment, make-ready and design engineering). (d) Upgrade/rebuild includes costs to modify or replace existing fiber/coaxial cable networks, including betterments. 36--------------------------------------------------------------------------------(e) Support capital includes costs associated with the replacement or enhancement of non-network assets due to technological and physical obsolescence (e.g., non-network equipment, land, buildings and vehicles). (f) Total capital expenditures include $115 million and $25 million related to our all-digital transition and $62 million and $71 million related to commercial services for the three months ended September 30, 2014 and 2013, respectively. Total capital expenditures include $368 million and $29 million related to our all-digital transition and $184 million and $216 million related to commercial services for the nine months ended September 30, 2014 and 2013, respectively. Recently Issued Accounting Standards In April 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-08, Presentation of Financial Statements and Property, Plant, and Equipment: Reporting Discontinued Operations and Disclosures of Disposals of components of an Entity ("ASU 2014-08"). ASU 2014-08 changes the criteria for reporting a discontinued operation. Under the new guidance, a disposed component of an organization that represents a strategic shift that has (or will have) a major effect on its operations and financial results is a discontinued operation. For disposals of individually significant components that do not qualify for discontinued operations presentation, an entity must disclose pre-tax profit or loss of the disposed component. ASU 2014-08 requires prospective application to all disposals that are classified as held for sale and that occur within annual and interim periods beginning on or after December 15, 2015, with earlier application permitted for disposals that have not been reported in previously issued financial statements. We are currently evaluating the impact of ASU 2014-08 to our consolidated financial statements. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers ("ASU 2014-09"), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The effective date of ASU 2014-09 is fiscal years beginning after December 15, 2016, and interim periods within those years, with earlier adoption prohibited. Companies can transition to the standard either retrospectively or as a cumulative-effect adjustment as of the date of adoption. We have not yet selected a transition method nor have we determined the effect of ASU 2014-09 to our consolidated financial statements. |