Liberty Interactive – Tracking Share Discount
In light of the stock price appreciation over the past few years, the original thesis hasn’t really changed. Maffei has said that despite the higher QVC trading multiples, leveraged share repurchases will continue. Now with the e-commerce businesses shifted to the Ventures Group, the QVC Group has become “much cleaner” to analyze. I believe the fact that this is still a relatively obscure tracking stock with hidden equity investments and irrelevant consolidated GAAP reported financials is the main reason behind the mis-pricing. Very few tracking shares exist in the market today, and due to the inherent complexity in managing additional business groups with their own stock currencies, many corporate management teams simply shy away from them. In fact there have only been a few opportunistic capital allocators that have really used them in the past including Dr. Malone and Charlie Ergen.
The main asset remains QVC. This was a business that was run by media mogul Barry Diller for a while, was owned in a joint-venture between the Robert’s and Malone’s Liberty Media until Malone acquired Comcast’s ~57% stake at quite a high transaction multiple. Like virtually almost all of Dr. Malone’s related companies, QVC is extremely well-managed. I also believe that if cord-cutting were to accelerate, the effect on QVC would be minimal. Unlike the cable networks’ lucrative affiliate and advertising fees that are at risk from unbundling and over-the-top, home shopping networks like QVC have a different model; they pay carriage fees (which I will go over in further detail below) to the Pay-TV operators that are net of gross sales. So even if their customers slowly transition to consuming their content online either through an existing bundle with “TV-Everywhere”, a skinny bundle or maybe even perhaps directly from QVC’s website, their revenue model will not be at risk. Essentially their model resembles more of a retailer than of a cable network, except they generate superior free cash flow compared to brick & motors. Finally, they have an attractive core customer base that are middle-aged women from wealthier households that are less likely to “cut the cord”.
QVC earned ~$960 million in levered free cash flow in 2014. They’ve been hit over the past few years by the weakness in the Yen from their Japanese business. I think this year they will earn ~$1,000 million in fcf, and afterwards this will grow at 5% per annum over the next 3 years, driven by 2%-2.5% top-line growth and a bit of operating and financial leverage. The business doesn’t have much operating leverage since most of the cost structure is captured in COGS, but the business is very predictable, has a favourable customer base with near 90% repeat purchases and operates in a virtual duopoly with HSN in the home shopping network category. I basically view this business as a steady long-term GDP+ grower.
On the capital allocation front, Maffei has said that he’s going to continue to shrink the equity. Backing out the other pieces of the QVC Group tracker, QVC’s implied fcf multiple is currently slightly less than 14x. Assuming the share price continues to appreciate, they should be able to buy back ~17% of the float over the next few years at a 2.5x leverage ratio. So their levered fcf per share growth should be a little over 10% per year over the next few years. On 2017 numbers QVC should be earning around $2.80 fcf per share. I would value QVC at 16x-18x this number or a 5.5%-6.25% yield; so the QVC piece alone is worth $45-$50 per share by 2017. For such a high-quality business with predictable growth across the entire cycle and really high returns on tangible capital, I think these multiples are justified. For reference, they’ve recently issued a 10-year note at slightly less than 4.5%. I think QVC’s equity will very likely grow at a faster rate than 4.5% over the next 7-10 years. Also, I think QVC is a better business than some of these comparable large-cap consumer staple stocks that trade at less than 5% earnings yields but generate a lower return on capital with similar or lower growth prospects. So I think a 16x-18x multiple is very reasonable for this business.
For HSN, it’s also a decent business and I think it’s slightly undervalued given their under-levered capital structure. It currently trades at roughly 9x this year’s EBITDA, and they have almost no net debt. Management recently distributed a $200 million special dividend and I think they should be on the cusp of a material capital return plan in the near future. On the more aggressive side, if they leverage up closer to QVC’s leverage ratio of 2.5x, they can easily return nearly $1B of cash to equity holders. If they choose to reduce the float, they can buy back up to nearly 30% of all shares outstanding at today’s market value. For our purposes I’ll conservatively value HSN at current market values, so at their 38% stake it’s roughly worth $3.50 in per share value.
I assume that the value of the Group’s Chinese JV will offset the minority interest from their 60% stake in QVC Japan. There are currently more than a dozen competitors in the China, and the Chinese JV hasn’t reached minimum efficient scale yet. These 2 pieces really don’t move the needle on valuation, and if the Chinese JV really takes off, that’s just additional free upside.
In terms of eventually combining HSN and QVC, Maffei has said that there won’t be much cost synergies from leveraging the combined production studios. The only large cost synergies that I can think of is increased scale from combining their distribution networks and bargaining power with logistics firms, and potentially reducing the carriage fees they pay to the multi-channel video programming distributors (MVPDs); basically guys like Comcast and DirecTV. Currently QVC pays 5% of their gross retail sales as a carriage fee to the local MVPDs that distribute their channels to their subscribers, and (I think) HSN pays this rate as well. If by combining the companies they can potentially negotiate a lower carriage, and take back some of that gross margin. Just this cost synergy alone can create quite a bit of value without any execution risk. The combined companies’ US businesses generated ~$9.6B in total revenues for 2014, so even a 100 bps of gross margin savings would equate to $96 million which will flow straight to pre-tax income and be ~10% accretive to fcf per share. But I think for now Maffei will be content if HSN continues to return excess capital to shareholders with share buybacks and dividends. Whatever they decide to do with their HSN stake, you can be rest assured that it will be done extremely tax-efficiently. Knowing Dr. Malone’s deep hatred for paying taxes, this is a given.
If we add up all the prices – HSN’s equity value based on today’s market price, and QVC’s value – Liberty Interactive is worth $48-$54 by 2017. At the mid-point of this valuation range, the stock should generate a 2-year IRR of 35% if you can buy the shares around $28. I’ve noticed that sometimes that the more illiquid B shares trade at a discount to the A shares, which they shouldn’t as these are the super-voting shares. So much for efficient markets.