Some New Ideas

This caught my attention:

http://www.zayo.com/investors/owners-manual-for-zayo-investors

Any publicly-listed CEO that mentions Buffett as a role model typically catches my eye. The stock doesn’t look cheap at the moment but I haven’t dug deep into this one yet.

This is definitely an industry I want to study more in-depth in the near future. Bandwidth demand will only grow exponentially over the next decade – both on the enterprise and consumer side. The continued proliferation of data-intensive devices, both outside and inside the home, is just one driver of this trend.

There are many ways that you can play this big data trend – directly or indirectly. I like the cable firms, and in particular, Charter. Charter may look expensive on an EBITDA basis (currently trades at a 2015E 9.59x EBITDA multiple as per my Capital IQ), but you have to take into account that the majority of their growth CapEx cycle has recently been completed, at least on the residential side. Charter recently finished a multi-year CapEx program of transitioning their footprint from analog to all-digital, so their CapEx was very elevated. That was a major sunk cost. Going forward, I expect their total CapEx will continue to shrink, until their capital intensity is ~13-15% of total revenues, which I still think is conservative on a maintenance CapEx basis; 1) They’re going to continue to grow their higher-value subscriber base which will further spread their fixed costs, 2) the cost of set-top boxes will come down dramatically, 3) upgrading their broadband speeds to maintain their competitive advantage on the high speed residential data side will only require changing a few electronic pieces in the plant. They are, however, pretty aggressive in capitalizing their subscriber acquisition costs; they include the cost of labor in this figure. I don’t think this is too big of a deal, since I think their churn will continue to improve as subscribers now have a much better video product, and are offered a very competitive triple-play bundle. Its been shown in the past that every incremental service added to the bundle improves customer lifetime.

Now if we look at their free cash flow generation, everything else is moving in the right direction. Currently they hold a lot of high-yield debt that was raised coming out of the bankruptcy period, so even if we assume rates will go up, I think their long-term cost of debt will only go up modestly or even remain flat as they grow their subscriber base (taking back share from DBS and increased subscriber penetration). I believe their average pre-tax cost of debt is around 6% right now (could be wrong, too lazy to check), and they’ve been raising long-term at more attractive prices. With the large NOL, they’re probably not going to pay any cash taxes until 2018/19, and there’s real potential to further increase their tax basis via more M&A. CableOne which will be spun-off from Graham Holdings, Brighthouse Networks are potentially targets. Of course there’s also Greatland Connections longer-term which Charter will have a 33% stake post the Comcast/TWC merger. If you want to be fancy you can do a pair trade and short Cablevision – I think Malone is too smart to buy them out at this price, but I could be wrong. The cable networks remain stuck in a tragedy of the commons, and continue to leverage their hoarded content rights to raise programming costs aggressively, so I don’t think these sub-scale cable firms will remain independent for much longer as their video margins continue to get squeezed. Charter is the only viable consolidator, as Comcast/TWC will have close to ~30% of the total US pay-TV market, a cap set by the FCC a long time ago. I’m not even sure they’re going to be able to push their deal through without more concessions. But you never know, I’m sure they have an ARMY of lobbyists in Washington, fighting against title II and for pushing the deal through. If Charter isn’t going to do more M&A, then they’re probably going to buy back a shit ton of stock. Malone and Maffei are directors and hold a large stake via liberty broadband, so it’s almost guaranteed that they’re going to shrink the equity. I rather have a leveraged equity shrink capital return strategy than a dividend. As for Rutledge, he’s by far considered the best operator in the industry, and has track record of improving subscriber level economics.

So it’s not hard to see that their free cash flow per share is going to explode to the upside and I think they’re going to create a ton of value over the long-term, regardless of whether title II caps their broadband pricing. The great thing is that valuing Charter is not simple because of all the moving parts and pending transaction – a typical “Malone thing”. This is why I think the shares remain undervalued today. Institutional managers can keep buying TWC since it pays a dividend, and ignore Charter. I will keep buying Charter and Liberty Broadband shares.

Here’s an excerpt from my letter to investors:

“Prior to Mr. Rutledge coming on board in late 2011, Charter was a mis-managed, over-leveraged and under-invested asset. Due to these factors, Charter was a victim of substantial subscriber share losses mainly to direct broadcast satellite (DBS) players with superior video offerings[1]. We believe that this competitive trend will continue to reverse – as it already has for the past several quarters – with Charter taking back the vast majority of incremental subscribers from DBS and local DSL operators. Our view is that Charter is still in the early to middle-innings of a complete turnaround into a premiere cable asset with a superior upgraded video and broadband product relative to competitors. Despite the market’s concern of credible industry-wide headwinds such as absolute declining video subscriber numbers and programming cost inflation, we believe these negatives will have a light impact on Charter’s ability to generate substantial FCF over the coming years. Contrary to common belief, the US broadband industry remains a secular growth story as ~30% of US households still don’t have a broadband connection. Charter’s current broadband footprint remains under-penetrated at ~40%, and we believe this figure could approach closer to 50% over the next 5 years. As opposed to Charter’s video business which has been experiencing declining gross margins due to programming cost inflation, the broadband business’ economics are much more attractive; gross margins are typically greater than 90% and the cost to transmit bandwidth in cable pipes is literally pennies on a per gigabits basis.

Charter’s competitive position in the US telecommunications industry is a very attractive one as it owns a de facto local monopoly on residential high-speed data services in the majority of its footprint. The major Telco competitors have limited fiber overbuilds in Charter’s rural and Tier II city-focused footprint; AT&T’s U-verse and Verizon’s FiOS are currently present in ~34% and ~3% of Charter’s footprint, respectively. Post TWC-Comcast transactions, these figures will come down to ~30% and ~1%. Aside from Verizon’s superior fiber-to-the-home FiOS product[2], no other service in the market today, including U-Verse, can match Charter’s broadband product. In order to match cable’s hybrid fiber coaxial (HFC) network’s ability to provide broadband speeds of up to 100 mbps or greater, the Telcos will have to overbuild their entire copper-based network, replacing it with fiber optic cable. This is an extremely capital-intensive and time-consuming process, and the returns don’t look enticing to say the least. To illustrate, if we take into account the typical gross margin for an average triple-play[3] AT&T U-verse or Verizon FiOS subscriber, which we believe should be around $60-$100 on a monthly basis[4], the payback period can easily stretch to 6 years.[5] Based on these challenging economics, the Telcos have only focused on overbuilding in the most affluent, densely populated US cities in order to generate a satisfactory rate of return; these urban areas are a very minimal slice of Charter’s total footprint.

In addition, cable’s HFC network provides the most cost-effective infrastructure to provide higher broadband speeds. With DOCSIS 3.1 technology, Charter can easily provide data speeds of up to 1 gbps or more with very little incremental capital.[6] With the continued massive proliferation of data-intensive devices such as smartphones, technology wearables, and tablets, speed requirements will only grow exponentially. Charter and the cable industry are best positioned to cost-effectively fuel the insatiable demand growth for high-speed data services over the next coming decades. The bottom line is that Charter owns a captive growth market, with de minimis future competition.”

[1] Satellite Pay-TV packages typically include over 200 HD channels, exclusive programming, Video on Demand (VOD), “TV Everywhere”

[2] Charter’s Optimum broadband product can match FiOS in terms of download speeds, but not on the upload side

[3] Triple-play is a bundled broadband, video, and telephone package

[4] This is not taking into account the typical 2-year heavily discounted pricing promotional period

[5] We assume the total subscriber acquisition cost (SAC), including line installations and infrastructure investments for a new customer is on average $3,500; this is also taking into account that this is on an undiscounted basis

[6] In the upgrade process, several electronics are replaced in the Cable plants which is relatively light capital spending

Liberty Global: Think the C shares are worth somewhere between $60-70 in a year or so, assuming they trade at a leveraged FCF yield a few hundred basis points premium above their long-term pre-tax cost of debt, which I think is reasonable for the equity of a high-quality, growing cable business. I want to start accumulating this one aggressively if it goes to the low 40’s. They just closed the Ziggo transaction, and I think like the Virgin Media (which I think they stole) deal, the synergies are going to surpass their initial estimates. An interesting thing about Ziggo’s accounting is that they actually expense their set-top boxes so their EBITDA is understated relative to comps. That’s very conservative in cable land since these boxes can make up around 50% of a cable firm’s total CapEx in a modest growth year. I’m sure Malone noticed that and paid the right price for this asset. The Netherlands was one of the markets that was having trouble over the past year or so for Global, because of KPN’s aggressive pricing and FTTH roll-out. Now with Ziggo merged with UPC Netherlands, they’re going to cover most of the country’s footprint, not to mention benefiting from the enormous cost synergies. The Netherlands is one of the densest population zones in Europe I believe, along with Belgium. To be quite frank I can’t believe the local regulators allowed them to even do this transaction. Perhaps they think KPN’s FTTH roll-out will provide adequate competition. What’s most important is that in all of Global’s major European markets, the incumbant Telcos will most likely price rationally longer-term in order to generate a satisfactory rate of return. A duopoly or 3 player market that continues to raise prices on consumers, now that’s an attractive industry I want to be in. The next leg in this story is continued share shrink. Management said that they will return ~$3.5 billion via share repurchases until 2015YE which is around 10% of the market cap today. If you factor in operating cash flow growth of mid to high single digits, they should be able to achieve leveraged free cash flow per share growth close to 20% if not higher for the next several years. They remain way ahead in the technology product curve in Europe relative to the US, and have the luxury of bundling mobile, improving subscriber lifetime values, and a large B2B market opportunity. They also don’t have to deal with programming cost inflation in the high-single digits, as the media ownership remains quite fragmented in Europe and they don’t have to pay enormous re-transmission fees to the local broadcasters. Also Netflix is a catalyst for broadband growth as they continue to expand in this continent.

Again, this is an extremely complicated entity, even more complicated than Charter, so that’s why shares are undervalued. I think I probably spent months studying the industry last year, but it was a very interesting project and well worth it.

Fox, BSkyB, DISH, DTV, Time Warner and Discovery: Looks like Murdoch is showing signs of becoming a more disciplined capital allocator. He didn’t chase Time Warner till the end of the Earth. I suspect that he wanted HBO, which is an extremely unique and valuable asset IMO. Premium channels aren’t supported by advertising fees, so I think their business models will be less affected in an unbundled world. In fact Time Warner has announced that they are offering HBO on a standalone basis without having to subscribe to a cable bundle. Pay-TV subscribers typically have a choice of upgrading to HBO in their packages for $15 at the retail price point, so I think even if HBO retails at $15 over the internet they should do OK and won’t canabalize much of their existing business. I actually don’t think many people are going to cut their cable package just because all they wanted to watch was HBO. What they’re doing is going after the same market Netflix is going after, millennials like me that don’t subscribe to a cable TV package. I’m not a huge sports fan so I don’t need to pay $100 a month for that entertainment.

Charlie Ergen knows this, and wants part of this market as well.

http://www.wsj.com/articles/dish-network-unveils-web-video-service-1420481845

What’s interesting is that ESPN, the largest hoarder of exclusive sports rights, is included in this package, for just $20. Now this is a bit troubling for the Pay-TV ecosystem, in my view. I think sports has traditionally kept the bundle intact. DISH still has a DBS business but it’s becoming an increasingly less valuable component of DISH shares. So on one hand it could cannibalize their DBS business, but on the other hand he wants to start building an online streaming business for a growing OTT market. ESPN gets by far the highest affiliate fees per sub at the wholesale level out of all the networks, above $5 per month. Now if I were the ESPN guys, do I risk part of my ~$435 million or so in annual affiliate fees, and huge advertising fees as well within the bundle or do I think its a bad idea to be part of DISH’s streaming bundle? I think they’re playing a potentially dangerous game here, and if I were a distributor, why would I buy ESPN at the wholesale price and offer it at retail when subscribers can cut the bundle and just get their sports online? Either they’re really confident that the MVOs aren’t going to push back hard or Ergen’s a brilliant negotiator. I think it might be a bit of both.

The spectrum holdings in DISH are becoming increasingly valuable, IMO. Citi’s Jason Bazinet recently published an intriguing report on DISH, suggesting a move to spin off the spectrum assets and “light it up” at wholesale prices to a wireless partner. With 4 wireless players in the US that are starving for spectrum, this would be a viable move to avoid tax leakage. I don’t think there’s a chance in hell that Mr. Ergen is going to sell the spectrum and pay $10+ billion in taxes, which is more than the value of the DBS business if you put a 5-6X EBITDA multiple on it. He holds over half the shares and has a track record of compounding DISH at roughly 20% per annum. So I think he’s either going to do what Mr. Bazinet has suggested or sell the firm to Verizon or whatever option that maximizes shareholder value. The market’s still not comfortable because of the uncertainty with respect to the end game for the spectrum holdings, creating opportunity. At the end of the day there’s huge key man risk here, and you have to put a lot of faith in Mr. Ergen for this thesis to work out. Haven’t initiated a position but I think he’s a genius and I would put his track record on par with Softbank’s Son.

Discovery shares have taken a huge hit lately. I’ve read John Hendrick’s biography which gave me a good background on how Malone accumulated a large position in the company today. I like the business, a lot. They’re the world’s top non-fiction media company, period. The great thing about this type of content is that you don’t have to hire expensive actors like Brad Pitt to produce high-quality shows, and the shows easily transcend across languages, gender, age cohort and cultures globally. What gives me pause is the resetting of growth expectations and their exposure to the bundle. I have to dig deeper into these issues but noticed that they’ve been acquiring production assets in Europe such as All3Media, SBS, and Eurosport. Malone probably wants to increase Discovery’s exposure to production assets as the bundle slowly breaks and content gets re-priced higher. This is smart. I’ll get more interested if shares fall down to the mid 20’s.

http://www.wsj.com/articles/discovery-channel-founder-jumps-into-video-stream-1421268320

Time Warner is also another business I would love to own at the right price. If you look at Jeff Bewke’s track record, it’s been pretty good. Spinning off AOL, TWC, and Time. I noticed in the latest K that they’ve sold their multi-billion dollar Time Warner HQ in NYC. I think these are small details that signal a CEO who is focused on maximizing shareholder value. The next catalyst is probably related to highlighting HBO’s value. I’m not sure what he’s going to do, but I would love to own this franchise eventually – at the right price. Will be interested at $70-75 per share.

DirecTV – Sourced the original idea from Ted Weschler’s pick at Berkshire. Still in love with this business, so I’m going to hold it until the AT&T deal closes or it goes to $100 per share.

I think it’s an interesting merger arb play right now, and I am only playing this since I understand the business pretty well so I won’t cry if the deal breaks.

This opportunity exists because:

1) AT&T pays a fat dividend, so if you want to hedge AT&T you have to pay this and the arb guys don’t like this

2) only $28.5 of the $95 per share consideration is in cash, and the rest is AT&T stock with a collar so you have considerable exposure to T stock

3) Market’s overly concerned with US pay-tv consolidation and the FCC/DoJ’s response, but I don’t think the TWC/Comcast deal should have any impact on the DTV/AT&T deal

4) There’s no reverse breakup fee in the deal. I think AT&T learned their $6 billion dollar lesson when they tried to acquire T-mobile in 2011. Lol.

Overall, I expect the deal to close without too much “hassle”. In pretty much 100% of the areas with competitive overlap between DTV and AT&T there should be at least 2 additional video competitors post this transaction – a local cable firm and DISH.

My edge here is that I’m relatively agnostic to whether the deal breaks or not since I like DTV longer-term, but still think the risk/reward is favorable with a higher expected value of the deal closing. Assuming in my base case scenario that T rallies back up into the collar in the next several months, you could be looking at an unlevered ~25% annualized IRR on DTV assuming the deal closes near the end of q2. Not bad for a low interest rate environment.

As for DTV longer-term, most satellite bears underestimate the resiliency of DTV’s subscriber base. Literally 40-50% of their US subscriber base is probably with DTV just for their exclusive sports programming. In fact this is so important that AT&T did the deal contingent on DTV extending their Sunday Night football contract with the NFL. Like I mentioned previously, Sports has largely been keeping the bundle intact, and if DTV can continue to offer exclusive sports content, they should be able to keep churn low for a very long time. At the same time they’re the largest Pay-TV distributor in the world, with more than 35MM subscribers. These subscriber relationships are very valuable, and I think most bears have ignored the fact that DTV can eventually offer exclusive sports content even on an online streaming platform. In fact this would be an extremely capital light business model – no more satellites, set-top boxes, broadcast centers, trucks, etc. Of course the economics of a streaming business would be different, but its definitely worth something. And management actually tried to buy HULU a year or 2 ago from the consortium of cable networks, so they’re probably thinking the same thing. I think the reason the NFL kept their relationship with DTV is mainly because they have the largest subscriber base out of all the MVOs, and know that they can maximize their revenues by signing a contract with a MVO with access to the largest number of high-value subscribers. At the same time, Latin America continues to grow nicely and has a long runway, and DTV has a massive competitive advantage there over cable. Factor in the accretive leveraged buy backs with management “arbing” the stock at a near 10% FCF yield with a sub 5% pre-tax cost of debt and you have a nice setup for sizable equity returns.

The Tower Operators – Crown Castle, American Tower, SBA

Great Businesses, high barriers to entry, good pricing power, levered to secular growth in wireless data, good returns on capital. Too expensive.

Qualcomm – Potentially a good way to play the big data and mobile growth via their licensing business. I don’t understand the technology risk, so I’ll leave it at that. I know they have a giant cash hoard and it trades at a reasonable multiple if you back that out.

Carrier-neutral Data Centers – Equinix, Telecity, Interxion

Now this is a great way to play the “big enterprise data” trend. I’ve been studying this industry for the past year and am convinced that these guys will do extremely well over the next decade or so. There’s a lot of minor details that you have to dig through in order to get a good understanding of the business model but I’ll say this: The maintenance CapEx is way less than what the market perceives. Enterprise clients actually own the IT hardware themselves, so these guys don’t pay for that equipment. The real upfront CapEx is the building itself (growth CapEx), and minor stuff like cooling equipment and battery related equipment (maintenance). The big selling point for potential customers is the interconnection to other enterprise customers who share the same data center. The incremental margins for this business is close to 100% and there’s a real network effect for sharing a data center with other customers. This is a much better business model than on the wholesale side where pricing is much lower. So you have high barriers to entry, recurring revenues, strong secular growth, pricing power, and I think Equinix, Telecity, and Interxion are quite rational on the supply side, so I don’t see oversupply as a large risk.

US and Canadian Auto Retailers:

This is a main area of DD for me right now. Simple thesis that I’m developing right now is that I think you could see pretty out-sized upside on the parts & service segments of these businesses, along with considerable consolidation in the industry. If you look at where the real money is made in this business its in the auxiliary services like financing, insurance (where gross margins are near 100%) and in parts and servicing. I use to own an interesting subprime auto-lending business called Credit Acceptance so I know a little bit about the financing side. For the dealers, they take 0 financing risk when sourcing an auto loan, and simply clip a fee based on the size of the loan. Combined, these segments typically make up more than 50% of gross profits for an average dealer. Also I think we’re in a sweet spot in the automotive cycle where you’re going to see a larger portion of the fleet aged between 0-5, where the vast majority of vehicles get serviced under warranty. Another interesting fact is that there’s been a sizable decrease in the total number of dealerships in the US over the past decade or so, leading to increased profitability for current dealers in a less crowded market. If you think about it most dealers operate in local monopolies where they have geographic exclusivity to sell a particular OEM brand. I think this attractive industry structure should provide improving returns on capital going forward. Another leg of the bull thesis is consolidation. All together, the publicly-traded US auto retailers barely make up 10% of sales in the US market. There’s going to be a lot of mom and pops ready to retire or semi-retire soon that are looking to sell their family-owned businesses. The OEMs have become less stringent on public ownership of dealerships, and are actually encouraging more consolidation. This is quite a simple process, you buy a private dealer or group of private dealerships at 4-8x EBITDA at private market valuations (higher multiples for Japanese or German Dealerships), professionalize management, improve operations, leverage IT and overhead costs etc. and then you get a “awarded” a publicly traded 10x multiple – simple arbitrage right? Most private owners would prefer a clean transaction with cash, and should be willing to sell at these multiples to well-funded public companies that have the most attractive source of financing. In terms of the auto cycle, I’m not sure if we’re anywhere close to the peak. SAARs are at 17MM per year I think? Most sell side analysts seem to think the peak will be in 18′, I’m not so sure. All i know is that I would rather own a local monopoly where a large portion of the business consists of a recurring, higher-margin revenue stream in P&S, rather than own a super price competitive, economically-sensitive, unionized, capital-intensive OEM business. (Btw, I think Stevens Fiat idea is good but I’m a bit nervous about the CEO’s grandiose spending plans although I think the ferarri piece is very valuable). The great thing about these businesses is that they’re still small-caps, so big institutions can’t touch em. One last thing I should point out is that the floorplan financing that these auto retailers get shouldn’t be considered real debt, since its collatorized by the existing inventory, which I think is de facto OEM inventory – but its just really in the hands of the dealers as distribution points, so I would adjust the enterprise value for this debt. So I think there’s a huge market consolidation opportunity here, and I think these stocks should do well in the US. I’m most excited about the Canadian traded company, its the only publicly traded one in Canada with an even more fragmented industry. They have a fantastic management team so I’ll let you find out yourself which one it is for fun.

Guess who else sees this opportunity?

http://www.wsj.com/articles/berkshire-to-buy-car-dealership-group-1412253366

Altisource: Not very interested in this company, other than the fact that I don’t think Erbey is as ethical as some may think he is. Here’s what I said in an earlier comment:

“Personally after giving it more thought I find it strange that Erbey steps down after a regulator turns his company into a de facto government run enterprise. One would think that he would fight harder against Lawsky given his background. So lets think about this… apparently he worked 24/7, literally moved to Virgin Isles just to save the company taxes, and he had no kids etc. A large part of his life’s work put into Ocwen and its related companies, and amid these allegations, simply steps down? I would guess that there’s probably more behind the scenes here, and more skeletons in the closet. Apparently Lawsky has a reputation and track record for overstepping his authority. Check out the AIG case. But the private sector knows this, so I would think Erbey would at least dispute/countersue Lawsky’s ridiculous demands. But no, he just steps down. Looks like there’s too many “unknown unknowns” here.”

If they become a distressed play I’ll consider taking a closer look. Steven will provide an update post if he wants to. Always do your own DD.

End of rant.

-R

1) All content of this blog, including correspondence between the author and readers, represents only the authors’ personal opinions and is neither investment advice nor a recommendation to buy or sell a security. No information presented on this blog is designed to be timely and accurate and should be used only for informational purposes.

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Interesting Links

1) 

Dear President Obama,

Who would want to provide higher broadband speeds if they can’t charge higher prices to cover the incremental capital invested?

If telecommunication firms aren’t incentivized to provide higher speeds then America would be worse off in the global economy.

Let’s keep capitalism alive.

2) http://blogs.wsj.com/digits/2014/12/10/germany-emerges-as-net-neutrality-antagonist/

Germany and net neutrality.

3) Charter’s CEO on net neutrality and the Pay-TV ecosystem

http://video.cnbc.com/gallery/?video=3000331562

http://video.cnbc.com/gallery/?video=3000331653

4) “Industry Lifer” vs. “Deal Maker”

http://www.wsj.com/articles/SB10001424052702304773104579268150284074022

The way I see it, Time Warner Cable has been an under-performing company and management has pursued a strategy of returning capital to shareholders at the cost of upgrading their systems to remain competitive. It’s no surprise that they’ve bleed a large number of subscribers over the past several years. I’m sure short-term oriented money managers like the dividend yield and the near-term capital returns.

5) FCC Chairman Tom Wheeler’s Blog Post:

http://www.fcc.gov/blog/closing-digital-divide-rural-america

6) Slides from Liberty Broadband’s investor day – these are not posted on their investor relations website.

http://www.sec.gov/Archives/edgar/data/1091667/000109166714000224/libertybroadbandinvestor.htm

7) Charlie Ergen is an underrated genius.

From the DISH 2014 Q3 Conference Call:

“….I think the spectrum you have could be worth as much as the entire market value of [Dish] presently.” – Leon Cooperman.

The reality is that wireless providers don’t have the bandwidth firepower to compete against a fixed broadband network infrastructure. Wireless spectrum is scarce and expensive. Cable companies with their DOCSIS based technology are best positioned to fuel the insatiable demand for faster and more high speed data more cost effectively versus the competition. Set-top boxes and associated CPE are also increasingly becoming more commoditized and thinner, which should yield substantial CapEx savings.

What do you think will happen to Charter’s levered free cash flow?

8) Keeping the bundle alive with “TV Everywhere”

http://www.wsj.com/articles/directv-disney-in-distribution-pact-that-includes-out-of-home-offerings-1419374326

I think most of the Satellite bears forget that DirecTV and Dish could potentially shift their subscriber base to a pure over the top model over the long-term, similar to what Netflix did with its DVD delivery service. The economics will obviously be different but those subscriber relationships are still quite valuable.

-R

Back in the Game and a Quick Update

Wanted to leave a quick note before the start of the weekend. I’ve recently come back from backpacking Europe and it was an amazing experience. Travelling the world can broaden your perspective on life.

Quick update on ideas:

1) Liberty Global: Can it really be a 2 for 2?

http://www.bloomberg.com/news/2014-11-28/vodafone-said-to-eye-takeover-of-malone-s-liberty-global.html

I love levered equity plays with an inherently superior business model attached; investing with Cable king Malone has indeed been very profitable for shareholders. I think the complicated holding structure of Liberty Global and the fact that they don’t pay a juicy dividend is keeping traditional yield hungry investors away, creating an opportunity to invest in a best in class run company at a reasonable levered FCF multiple. Shares have run up quite a bit since part one of my write-up, but there’s still quite a bit of upside left on my conservative estimates if you’ve been holding this. 1) The German broadband market remains under-penetrated with the majority of dwellings requiring tenants to pay for cable as part of their rent, 2) Ziggo was recently acquired, and synergies will be substantial in the Netherlands as they role out quad-play vs the incumbents and re-sellers, 3) Cable remains a strategic asset in Continental Europe, as wireless players starved for spectrum are now seeing the value of having a strong fixed broadband network. 4) Major OTC product offerings remain at an infant stage in Europe; Netflix has recently expanded into Germany, and I expect Liberty Global to up-sell their tiered broadband offerings. My apologies for the lack of numbers, but the real value of Liberty Global is actually 5 major European cable companies, and I’m too lazy to load up my spreadsheets that took forever to build. I’ll try to put up a reasonable intrinsic value range in the future. Thesis remains intact, this is almost the same playbook as Telecommunications.

2) DirecTV: Now a Risk-arb play

You’re getting an unlevered ~9% spread relatively uncorrelated with the broader markets which is pretty decent in this low interest rate environment. The deal is expected to close in 6-7 means which means the IRR should be around 18%. There’s definitely some risk involved with the deal, as the FFC has recently paused the clock. Quite frankly, I wouldn’t want to be a holder of AT&T stock, but if the deal were to fall through, owning DirecTV wouldn’t be the worse thing in the world. I still like the business, but the easy money has been made. You can also hedge out some of the risk by short selling AT&T. Maybe play this only when you have a too much cash sitting on the sidelines and don’t mind owning DirecTV for the longer-term.

3) Interactive Brokers: Hidden Value and an Owner-Operator

I love hidden value plays. Here you have a market making business that appears to be a mediocre business or at best average business, obscuring the true profitability of the holdco. The hidden gem is the brokerage business, which has been growing nicely. For those of you that have never used Interactive Brokers as your discount broker, I highly recommend giving it a try. It’s by far the best discount brokerage service, and has the lowest cost service in a relatively commoditized market. The float is relatively limited which is part of the undervaluation as the founder holds most of the shares. This will be a full write-up in the future.

4) EBAY: Activist Play and Spin-off

The management have been horrible. There have been no share buybacks for nearly the past 5 years except for offsetting stock options. I’ve never seen a CEO step down entirely and not take the same position in either the spinco or holdco. I think when Paypal and eBay split up, there will be a major multiple re-rating and the capital allocation discount will largely disappear.

5) Long Charter Communications/Liberty Broadband and Short Cablevision

Cablevision
1) The stock is currently priced with a large takeover premium. Historically Cablevision has traded at a premium compared to the other publicly traded Cable operators even though it has a smaller subscriber base of around 3mm because of the attractive demographics in the greater New York City region. Cablevision has the highest ARPU per subscriber in the industry at ~$155 and has a best in class video, broadband and telephony package along with lots of great upgrades. They also have the highest penetration rate across their footprint at ~55% I believe. Even though broadband in America is still a growth market (which the market also under-appreciates when it comes to cable names in general), I believe Cablevision has limited room to grow or up-sell its subscriber base. Essentially Tom Rutledge who many industry experts say is the best operator in the industry did a fantastic job growing the business before leaving for Charter. Going back to the takeover premium, Cablevision is now trading more in-line with comps on an EV/EBITDA basis, which I think in general is not a very useful valuation multiple for valuing cable companies anyway (the tooth fairy is not going to pay for large the CapEx spending). In short I don’t think there are any willing buyers at these prices. Comcast/Time Warner Cable are busy dealing with the FCC/DOJ and merging. Charter is focused on growing its business in rural America where it is very little FioS/U-verse overlap. I also don’t think Malone would use Charter/Liberty Broadband to pay even a small premium to the current multiple for Cablevision given that a large majority or 100% (still need to confirm) of Cablevision’s footprint faces FiOS competition. DTV/AT&T are also busy merging and it would be quite foolish for Verizon to acquire CVC after they just spent $23B on their FiOS to the home product as part of their NYC expansion plans. WRT getting acquired or getting taken private by the Dolans or a PE firm (which would offer no synergies if a private takeover were to occur), I believe it will only happen at much lower prices, and it’s only logical that the Dolans would like a lower price.

2) I’m not convinced Cablevisions’ cash flows will be “stable” in the next several years. Simply google Verizon’s FiOS roll-out into the Greater New York City area and you will find articles saying that they haven’t even successfully made the product available for sale yet. A reason for this is probably because Verizon has to get permission from every landlord to connect their lines into the building. This has been taking a long time, but it’s reasonable to assume that they will successfully roll-out their product and have it available for SALE by sometime next year latest. According to their franchise agreement with New York City in 2008 they agreed to have it available to ALL of Greater NYC by June/July of this year already, but I don’t think that was completed. The current mayor is pushing them hard to get this done ASAP. FiOS is already currently being heavily promoted in limited areas, at prices lower than CVC’s optimum product even though FiOS is a superior product. So this is potentially a large part of my thesis, and if you look at historically case studies of what happened to parts of Comcast’s or TWC’s footprints after encountering FiOS or U-verse overbuilds, it’s not a pretty picture. Some regions had cumulative subscriber losses of up to 40% over a few short years. You can easily see large subscriber losses in CVC’s footprint even under conservative scenarios. A quick counter-argument may be that CVC has a more loyal and affluent subscriber base so they will experience less churn and I think the market already has this perception as CVC’s recent results have not shown any meaningful acceleration in subscriber losses since FiOS is not 100% for sale yet across their footprint, but even a 20% total reduction in their subscriber base will hurt them big time over the next several years. I have to confirm exactly what their total exposure is to FiOS is though, but I know for sure that it’s greater than 50% of their total footprint.

Couple this with programming costs increasing annually in the low double digits (10-12%) on a per subscriber basis and their cash flow will quickly start to evaporate as they will have less subscribers to spread their fixed costs across. The operating and financial leverage is HUGE in this one. In fact management know this and have been shedding assets (sale of Bresnan to Charter for eg.) over the past few years to pay down debt. They keep cutting costs and fat and soon they will be touching bone. Just read over the past several 10-Ks and you’ll see plenty of one-time restructuring/miscellaneous costs. The capital structure situation does need to be more closely monitored however, for this idea to work. For valuation I do have them at a negative levered FCF yield for 2015/2016 depending on how well they manage their costs and subscriber loss ranges. They might even have to cut the dividend which would tank the stock as catalyst.

3) Cablevision’s management team is not the best to be polite. Half of the board and senior executive management team are comprised of family and related family members. They’ve had many conflicts in the past, even tried taking Cablevision private twice before. Even Malone stepped down from their board in the past as he knew it was essentially the Dolan’s company. Think about it, you let a pioneer of the industry and the most successful person in the cable business step away from your board – I don’t think that’s very smart. Rutledge was very good and a pioneer of the triple play, but now he’s gone so who’s going to steer the ship? Even if there was another superstar brought in, I think the upside is still pretty limited given my previous points and the FiOS competition. In short, they’re in a sticky situation and have been dealt a tough hand by being concentrated in New York.

In short, Cablevision is getting squeezed from both sides and is a victim of its own success. On a side note, I regret not digging deeper in Charter initially when Malone bought out Oaktree and party’s stake in the company. It was clear what his intention was and in a way the business strategy was very sound. Expand slowly in rural America where there is less competition from the Telcos and slowly take back share from the DBS players – similar to the TCI days when he targeted rural areas first. Ironically the most attractive market in America gives CVC the best in class Cable economics on the revenue front, but also is a great market for FiOS deployment.

Have to run now, have a great weekend everyone!

DirecTV Update and the U.S. Enterprise SaaS sector

Looks like AT&T decided to acquire DirecTV after all. I’ve sold my shares and am currently looking at opportunities in the U.S. enterprise SaaS sector. I think there’s tremendous potential here for the astute investor to pick the right long term winners. Unlike the great social networks, the enterprise SaaS space is less well known and isn’t suffering from being in a crowded market as many B2C plays are. Businesses that exhibit highly scalable, recurring revenue business models with large target markets and limited competition are always high up on my radar as potential investments. Many SaaS companies have these characteristics.

In general, what might you want to be looking for in a good enterprise software company?

In addition to the above, I think some of these things might be a good place to start.
1. A great product that customers love, which usually leads to referrals. The product being mission-critical is also a huge plus, and helps with maintaining pricing power.
2. A large and diverse customer base that represents many industries.
3. Relatively low churn; this is key as churn is a key business driver in any SaaS business.
4. A sizable market opportunity.
5. A great company culture. I think this is more important than what most people give credit for. If you have a shitty company culture, you wont attract the best engineers, which means your product will likely suffer. In such a human capital intensive business model, company culture is critical…

Many “old school” value investors might automatically write-off hot SaaS companies as potential investments because of an unfamiliarity with the technology side of the business, and valuation concerns. I don’t think there’s a SaaS bubble at all, and that many great SaaS businesses add a ton of value to their customers, which will only grow over time. Some of the top VCs in Silicon Valley with great long-term track records are piling on tons of money into the enterprise software space, and as more of these startups go public the key to making money will be to investing in the right ones.

DirecTV Update & The Future of the Pay-TV Industry

It has been a while since I have updated my thesis on DirecTV. The stock has had a good run since my write-up as the market has re-rated the shares to a more reasonable multiple. The Brooklyn Investor, a high-quality investing blog I follow also recently wrote-up DTV here for those of you who are interested. What caught my eye was the Brooklyn Investor’s point surrounding the cost of distributing content in the current Pay-TV ecosystem.
In all honesty, I had little to no clue how the Pay-TV ecosystem would look like 10 years into the future when I first bought my shares in DirecTV at $50. But did I really need to have a crystal ball to justify buying into a good business that earned returns on invested capital greater than 20%, had high incremental returns on capital and growth prospects in Latin America, was cannibalizing its own shares at good valuations, and was run by a fantastic management team? Oh yeah, it was also selling at around a 10x multiple! Maybe I didn’t know it back then, but perhaps the real reason I should have used to justify buying DirecTV was because of its long-term cost advantage.

 

Satellite is an attractive business because it’s actually relatively asset-light compared to Cable and Telco fiber. A mini-dish and set-top box for every home, several broadcast stations, call centers and a few strategically positioned satellites is all that is needed to run a ubiquitous satellite TV company. This, vs. a ton coaxial fiber or fiber optic needed for every home or business, that needs constant upgrading every several years in order to remain competitive, and you can see why cable and Telco fiber are much more capital-intensive businesses and why media moguls Rupert Murdoch, John Malone and Charlie Ergen were all bidding for Satellite orbital slots when they first came to auction. They all wanted to own a piece of the new death star which was Direct Broadcast Satellite. As an aside, one relative advantage cable has over telco fiber is that although DOCSIS technology continues to get upgraded for faster bandwidth speeds, the vast majority of the cable industry’s CapEx is front-loaded, so only the “last mile” to the home has to be upgraded, vs. Telcos who have to replace their entire copper-wire infrastructure. This is also why Liberty Global holds a competitive advantage over Telcos in Europe.

 

So back to DirecTV. Having a cost advantage is enormous in a scale-driven business. Direct Broadcast Satellite technology provides the means to efficiently broadcast several hundred HD channels, bargain for exclusive content such as the NFL Sunday Night Ticket and generate superior unit economics (IRR) relative to Cable/Telco; DirecTV’s subscriber churn is the lowest amongst US peers, its ARPU is the highest, and despite paying higher Subscriber Acquisition Costs (SAC) and programming costs per sub than its Cable and Telco peers, DTV ends up ahead because it has a less capital-intensive business model that delivers superior content to a stickier customer base. Looking back, this should have been the original rationale for buying DirecTV. And I believe Satellite TV’s cost advantage will remain even 10 years from now. Let me explain.

 

Nearly everyone is worried about internet-TV disrupting the Pay-TV ecosystem and everybody and their mother “cutting the cord”. I suspect when some of these major networks such as ABC, FOX and CBC start selling highly-rated channels directly to consumers, the economics would be questionable. Let’s not forget that the Cable networks will most likely have to charge more on a per-channel basis online in order to make up for their lost advertising revenues that they would otherwise receive in the current ecosystem. So I believe either online advertising rates will have to go up in order to justify a large-scale move into a direct-to-consumer model, or even a wholesale model to broadband providers, but either way, the Cable networks remain incentivized to maintain the current ecosystem and will not want to see their affiliate fees evaporate overnight.

 

Another phenomenon that I believe most industry pundits and analysts have failed to recognize is that the cable firms have basically been indirectly subsidizing the bandwidth costs of OTC players such as Netflix, Hulu, etc. If you take the view that we are going to fully transition towards an Internet-TV based world, then that would mean that currently Cable TV service revenues are subsidizing their broadband service, and broadband service in turn, I believe, is currently subsidizing online streaming services. Quite simply, broadband providers have yet to fully monetize their broadband service. A lot of people think that US broadband services are a rip off because of the speeds you get relative to the price you pay. But what about the other important component of a broadband connection – bandwidth capacity? As more and more video is consumed online, bandwidth demand is going to explode upward and I don’t think Comcast and company are going to idly sit back and let online streaming providers “free ride” the system. After all, Netflix’s largest operating costs after content are probably their server expenses. I would not be surprised at all if the Cable/Telcos eventually implement usage-based pricing for their broadband service in order to make up for the eventual lost cable TV revenues. Let’s not forget that Americans on average still watch a shit ton of television per day, around 4-5 hours on average I believe. Given the explosion in growth in smartphones and tablets, I think its safe to say that online video consumption will continue to grow rapidly, and someone, probably the OTC guys are going to have to eventually pay that price.

 

One last point I want to make regarding the Internet-TV threat: I believe the internet-TV industry will remain quite fragmented in terms of content type for some time, and it would be rather difficult for any one player to become dominant across all content categories, yes, even you, Netflix. This is partly due to the nature of the industry, but also because online rights will remain competitive. Online streaming services don’t have the luxury of scale to buy up every single content category like Satellite/Cable/Telcos do. This is not only due to a lack of scale but a tradition of content producers and distributors securing long-term, content deals. Netflix may be wise to strategically pursue exclusive original content series such as House of Cards to help differentiate their platform, but will they be able to expand into Live News, Sports, or even killer nature shows? I think not. Exclusive content comes at a high price, especially if they are online rights. To me Netflix looks like a cheaper version of HBO, and even Reed Hastings admits that HBO is Netflix’s largest long-term competitor. In fact the only reason not everyone can watch HBO online without a Pay-TV subscription is because Time Warner doesn’t want to piss off the the DBS/Cable/Telcos. Platforms such like HBO, Starz and Netflix tend to focus on theatricals and original series, so they won’t appeal to every type of customer, and especially those that want a very broad range of content.

 

Eventually everybody will have an online video streaming service, including DTV. In fact DirecTV is already starting to complement its existing satellite TV service with an online-video product. As more customers demand “TV-everywhere” and place-shifting television, TV distributors will focus on building their online product. That’s why I think DirecTV tried to buy Hulu earlier last year. And with DTV’s large existing customer base and strong relationships with content providers, they should have no problem scaling a solid online video service. Who knows how it would actually look like, but I wouldn’t be surprised if it was sports focused.

 

So to sum it all up:

1) Despite all these fears of the death of the Pay-TV industry, the market has basically misunderstood the DirecTV story for a while now, and using some second-level thinking, it’s safe to conclude that DTV’s business will not get fucked overnight.

2) Online streaming providers such as Netflix are basically selling their services at an artificially low price, but they can’t have their cake and eat it too. Eventually the economics of online streaming will not be as attractive.

3) The US Pay-TV industry is very slow to change, but even if the bundle breaks DTV can successfully transition to an Internet-TV world. Some of the best investment opportunities are created by uncertainty and taking a contrarian view. As long as one is able to price in the risks and come up with a range of possible future outcomes, one can make money.

4) DirecTV is led by CEO Michael White, who was hand picked by John Malone. This guy knows what he’s doing, and is a very savvy and disciplined capital allocator. Eventually they may spin-off the Latin American business when the time is right which would help unlock shareholder value.

5) If all else fails DTV’s backdoor play is to merge with DISH, and maybe even AT&T will buy them both eventually :). Although I’m not betting on it, it does provide some downside protection.

6) By the way, John Malone actually holds a lot DirecTV shares, and someone may want to confirm this, but last time I checked he owned ~3% of DirecTV’s total shares outstanding. Malone was former chairman of DirecTV, and he was basically forced to step down by the FCC as he had competing cable assets in Puerto Rico. Let’s also not forget that the Berkshire guys own the largest stake in the company, and oh yeah, they are pretty damn good investment managers.

7) I am an idiot for selling a bunch of shares when DTV was in the low 60’s. I didn’t maintain conviction when I should have. Sometimes that happens when you maintain a very overweight position (it was more than 30% of my portfolio at one point). Mistakes come with learning to become a better investor, and I have a long way to go. At least I put the money back into Liberty Interactive :).

For those of you who read sell-side research, I would recommend following Jason Bazinet @ Citigroup, Matthew Harrigan @ Wunderlich Securities and Craig Moffet. They seem to know what they’re talking about in the Cable and Satellite industry.

 

For now I am holding on to my shares, and have modelled out my IRR assumptions for DTV below. Click on the DirecTV icon below and you will see my income statement and key driver assumptions. A 12% IRR at a modest 14x multiple is nothing crazy, but will beat 99% of institutional investors out there, including hedge funds, mutual funds, pensions, and endowments.

My DirecTV Income Statement and Operating Model – You may have to zoom in:
       DirecTV Model

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Disclosure:

The author is this post owns shares in the company mentioned (DTV) and may purchase or sell shares without notice. This post represents only the author’s personal opinions and is not a recommendation to buy or sell a security. No information presented in the post is designed to be timely and accurate and should be used only for informational purposes. Readers of the post should perform their own due diligence before making investment decisions.

Liberty Global – TCI 2.0 – Deep Dive into Media Companies Series, Part 1

“I used to say in the cable industry that if your interest rate was lower than your growth rate, your present value is infinite. That’s why the cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money. If you do any arithmetic at all, the present value calculation tends toward infinity under that thesis.” – John Malone

Part I of a Series of Deep Dives into Media Companies

Liberty Global – TCI 2.0

Date: 03/08/2013 | Ticker: LBTYA/K | Price: $43.55/$42.19 | Market Cap: $33.75 billion/ Idea Type: Great Capital Allocator/Sum-of-the-Parts

I’ve been reading a lot of business biographies lately, especially ones covering media moguls such as Ted Turner, Robert Murdoch, the Roberts and even Richard Branson[1]. One commonality I discovered through reading these bios was how focused these entrepreneurs were on building their empires at almost any price, without taking into any serious consideration the potential downside. Bad deals were the norm. For most of these men net worth was a relatively low priority. Instead their obsession was on building the largest media empire possible. Overpaying for licenses to coveted orbital satellite slots, or holding on to cash sucking newspaper businesses were just a couple of examples of a disregard for value mentality. I fear this same mentality remains largely prevalent today in the “new generation” of internet/media entrepreneurs in Silicon Valley.

Bad deals such as Facebook’s recent acquisition of WhatsApp is a prime example. Unless you think Facebook’s shares are worth closer to 10-25% to where they are trading today (I believe the consideration included $12B in stock and $3B in RSUs), there is no way in hell that WhatsApp is worth anywhere near $19 billion to any rational buyer.

If there is any media mogul that is disciplined about capital allocation and return on invested capital, that would have to be John Malone. As a shareholder to a company I am basically entrusting the management to rationally deploy the company’s capital to maximize returns. As a long-term investor, I would want to partner with the right people who are good stewards of my hard-earned capital or why the F#&$ should I entrust them with my money? Great capital allocators are rare to find in any industry, and the difference it makes to a company’s long-term value that is run by a great capital allocator and a horrible one can be enormous.

By the way, if you are looking for an actionable idea this post is probably not for you, but if you like reading about the cable and media industry then read on!

Synopsis

At the latest Liberty Media Capital annual meeting John Malone hinted that future growth opportunities in the cable industry would most likely be greater outside the United States. Although this should have been obvious to me already given my observation of the slowly shrinking U.S. Pay-TV industry, I decided to take a closer look at Liberty Global (LGI).

LGI is basically a large collection of cable operations across Europe, the UK, Puerto Rico and Chile. It is actually the largest cable operator, globally.

In my view, LGI’s strategy of rolling up the fragmented cable industry in Europe is very similar to the Tele-Communications Inc. (TCI) playbook back in the 1980’s. For reference, TCI was started by a cattle rancher, Bob Magness in 1968. When Malone took over as President and CEO he built up TCI from a bankrupt company to the largest cable company in the United States, generating 30%+ returns for shareholders. The end game was an overvalued sale to AT&T in 1999. I don’t recall what the transaction multiple was, but I think AT&T paid something ridiculous, maybe something in the mid-teens EBITDA range for a cable business on the verge of facing serious satellite competition.

For LGI, we have seen this leveraged equity shrink story play out before, although in a more favourable competitive environment. During the old TCI days, Malone had a virtual monopoly on the distribution side, and large controlling stakes in major cable TV networks such as Turner Broadcasting that supplied the high-quality programming. Telcos were also not a threat back then; direct-to-home Satellite was just an emerging delivery system, and there was no over-the-top internet-TV threat.

The Thesis

The holding co. is quite complex, but my thesis is quite simple; I believe LGI is poised to continue to gain broadband share and build scale across growing European markets mainly via inorganically through acquiring smaller cable assets and organically through up-selling video and broadband services to an underpenetrated market. I see 30% upside under my base case scenario which is nothing amazing.

1)     Europe remains fertile ground for accretive M&A activity across Cable and Telco industries. On top, you get the best capital allocator in the cable and media industry, John Malone and Michael Fries steering the ship, and I expect continued accretive leveraged buybacks going forward. I believe the industry’s next phase will continue with lots of M&A activity and rationalization of markets. Complementing this consolidation outlook is an overlooked theme in that LGI’s core markets consist of either a duopolistic or oligopolistic structure, with operators mainly competing on broadband speeds.

2)     I believe the market has under-appreciated the LGI’s superior market position and fixed network relative to their main competitors (the incumbent Telcos) as consumers continue to display an insatiable demand for data consumption and faster speeds. LGI should benefit greatly from its competitive advantage in broadband by offering superior speeds and should be well-positioned to monetize higher speeds over the long-term. European Telcos are currently in the middle innings of a large CapEx cycle of upgrading their copper wire infrastructure to support faster speeds, but I believe the market has overly discounted this competitive threat.

Why does this opportunity exist?

1)     Liberty Global is an extremely complex holding company, with cable operations across most of western and central Europe along with minority and controlling equity stakes. As you can imagine, there are many moving parts to this story. Sometimes complexity may turn off investors that want to invest in simple and clear ideas. However, I think complexity can sometimes be an advantage to the enterprising investor who’s willing to invest the time to uncover key value drivers and hidden value behind an investment.

2)     LGI is a horizontal acquisition machine which makes at least 1 sizable acquisition a year, which adds to the difficulty in reaching the “right” pro-forma valuation. In addition, LGI won’t typically show up on any “value screens” since its unprofitable on a GAAP income basis.

3)     LGI pays no dividend, so it doesn’t attract yield hungry investors and thus trades at a lower multiple of EBITDA relative to European and Telco peers.

What I think the Market Sees:

1)     A complex holding company/structure with sizable operations in 14 different countries

2)     A capital-intensive business with CapEx consistently above 20% of total revenues and a business that generates sub-10% returns on invested capital

3)     Overall declining net video subscribers as fierce competition such as Telcos takes market share away with new network investments into VDSL coupled with vectoring and the threat of Fiber overbuilds

4)     A highly indebted company with a gross debt to EBITDA ratio of more than 5x

5)     A company that has historically  reported negative net earnings on a GAAP basis

6)     A company with its top-line being pressured by a weak consumer environment and a struggling Euro zone economy plagued by weak southern economies

 

What I See:

1)     A highly predictable, non-cyclical and growing leveraged free cash flow machine with unmatched scale operating in healthy, affluent, western European markets

2)     An opportunistic consolidator in a large, fragmented European cable industry

3)     A company with an optimized capital structure given the stability of the business model, and headed by one of the best capital allocators in the industry

4)     A company with unmatched product superiority in broadband internet, which should become a long-term secular growth driver supported by a structural change in viewer habits

5)     GAAP income is a meaningless metric here; moreover, negative pre-tax earnings are a positive, since LGI can save on cash taxes; I believe the right metric for LGI is free cash flow per share

6)     All this and a rather reasonable valuation; LGI is currently trading at slightly more than 13-14x free cash flow per share in 2014 by my estimates, which I think is unwarranted

Company Overview

Liberty Global (LGI) is the largest cable company globally, offering video, telephony and broadband internet services to over ~48 million RGU[2]s in 14 countries including 12 in continental Europe. Over the past several years, LGI has strategically re-positioned itself into growing markets in Western Europe, and divested cable assets in Japan and Australia. In terms of cable market share LGI is the largest in 9 of 12 European countries. They are the largest cable provider in every country they operate except Germany, The Netherlands, and Romania.

 

LGI typically makes at least one major acquisition a year, and this year I believe they made a great one in buying Virgin Media (VMED) for ~9x EBITDA post-synergies. The initial $180 million in cost synergy estimate turned out to be very conservative and estimates have been doubled, but I will circle back to VMED later on. LGI also holds a 28.5% equity stake in Ziggo (the largest cable operator in the Netherlands), most of which was acquired throughout 2013 for an average price of around 25-26 Euros a share I believe.  They also hold a 58.4% stake in Telenet (the largest cable operator in Belgium), an 80% stake in VTR (a cable operator based in Chile) and a 60% stake in Liberty Puerto Rico. The latter two assets are considered non-core by management, and I believe there is a good chance that they will eventually be sold at a later date, at a good price, of course.

Most of my analysis will be focused on LGI’s 5 core markets of Germany, UK, The Netherlands, Switzerland and Belgium that make up ~86% of LGI’s 2014e operating cash flow (OCF). OCF is a key driver and management considers OCF the same as adjusted EBITDA, so for the purpose of this write-up they will be used interchangeably.

Pro-Forma Consolidated Financials

Pro-Forma Consolidated Financials

I: Geographic Mix by Revenues                                              II: Bundling Mix:

bundling mix geo mix

Source: LGI Corporate Website

 

Brief Industry Overview

At first glance Europe’s telecommunications industry is much more fragmented compared to the US. While I believe there are less than 15 cable operators in the US today, and literally 2 major Telcos, there are ~120 mobile operators, ~1,000 Telcos, and ~7000 cable operators in Europe. While the Cable industry appears balkanized, cable coverage is quite ubiquitous across LGI’s core markets, with cable coverage well north of 90% of households in Switzerland, The Netherlands and Belgium but slightly lower in the UK and Germany.

 

Industry Growth:

Looking at the top-line, there are two key growth drivers here: 1) up-selling to the existing subscriber base with digital, High-definition (HD) and increased bandwidth (speeds) services which will drive ARPU growth and 2) volume growth through increased broadband and mobile growth, especially in Germany which will drive RGUs, and growth in B2B and mobile.

1)     There remains a large opportunity to up-sell additional video services to the subscriber base which will grow ARPU. The largest trend here is the steady migration of subscribers going from analog to digital TV services. Europe remains well behind the US in terms of digitalizing their subscriber base, and I believe digitalization levels will eventually approach near 100% in Europe, following the footsteps of US cable operators as a necessity to remain competitive against Satellite competitors. Currently ~50% of LGI’s TV subscriber base is still on analog TV and advanced TV platforms such as DVRs, HDTV and Video on Demand (VOD) will help with this transition. ARPU typically doubles when a subscriber converts from analog to digital which is accretive to long-term cash flow as incremental costs and CapEx lag behind. Finally, an underappreciated growth driver will be higher ARPU from broadband as LGI slowly monetizes higher speeds down the road, which I believe the market has not priced in.

2)     LGI benefits largely from operating in affluent, relatively underpenetrated Western European countries where dense cable builds are yielding attractive economics. Within these markets, Germany remains the fastest growing broadband market in Europe as penetration remains relatively low (please see table above). The average broadband penetration rate in LGI’s footprint is 28%. Broadband penetration rates are relatively low across Germany and the UK, as shown in the chart above. Moreover, deployment of Horizon TV to core markets such as Germany, Switzerland, The Netherlands and growth in the B2B business, which is in a similar fast growth stage similar to the US should help drive top-line. Europe also offers lower churn given that content costs remain subdued and cable-TV bills remain very affordable, along with aggressive triple-play bundling. Most Pay-TV operators are reporting yearly churn of less than 15%, which compares favourably vs. US operators which usually report above 20%. I believe increased bundling remains a large opportunity as LGI has a large % of its subscriber base on single play. Comcast has only 23% of their base on single play operating in the more mature US market.

product penetration

Note: For my modeling assumptions on video and broadband ARPU, RGUs and other key drivers for LGI’s most important markets, please see in Appendix in part II.

Competitive Landscape

1)     Broadband speeds and capacity will be the key competitive differentiator over the longer-term as users continue to transition from linear TV to internet TV on multiple devices such as mobile.

2)     Unlike in the US where premium content is in the hands of several large cable networks, in Europe most content is available free-over-air supplied by broadcasters with the exception of the UK. In Europe, content players are relatively fragmented and programming costs are not out of control like in the US. On a monthly per sub basis, LGI pays on average 15-20 Euros for programming costs vs. US cable operators that typically pay $35-40.

3)     It’s reasonable to expect LGI to experience video subscriber share losses over the foreseeable future and higher churn rates as Telcos slowly upgrade their networks and as analog subscribers churn. However, cable is still capturing at least 60-70% of the incremental broadband growth across its markets. Cable seems to offer higher speeds are very competitive prices, similar to Telcos. I think going forward; the two key competing variables will be speed and price.

4)     All the major incumbent Telcos in every LGI core market should have VDSL rolled out over 2014-2016. Major trends are quite similar to the US where LGI is losing Pay-TV market share to incumbent Telco’s IPTV product but is still gaining share on broadband.

5)     Based on my research, I believe the industry will remain rational in all of LGI’s core markets as the incumbent Telcos and main cable rivals have shown a consistent history of co-operation, limiting discount promotion periods, and eventually monetizing their heavy CapEx cycles by raising prices.

I may be stating the obvious here but in the Cable business scale is everything, in fact, I would say scale is lifeblood of a cable company. In simple terms, scale allows a cable operator to secure high-quality content from programming networks and other content vendors; scale allows a cable operator to secure this content at attractive prices given the increased bargaining power; scale allows a cable operator to purchase hardware such as set-top boxes at attractive terms and rationalize other operating and IT networks such as call centers and trucks; scale allows a cable operator to provide a leading technology roadmap including high-quality user interfaces and innovative new products; scale allows a cable operator better access to capital markets and attractive financing terms.

Aside from scale, cable as a business offers a great value proposition to the customer, is recession resilient, and operates within an oligopolistic industry structure consisting mainly of incumbent Telcos and Direct-to-Home satellite competitors. Given these business characteristics, I can see why Malone loves employing his leveraged equity shrink playbook.

LGI Core Markets: Germany and UK: ~50% of LGI’s OCF

1)     Germany:

UnityMedia KabelBW (subsidiary of LGI) is the second largest cable TV provider in Germany with ~6.7 million video subscribers; 4.5 million are on analog and 2.2 million are on digital. Kabel Deutschland is the larger cable company in the country. Deutsch Telekom (DT) would be the incumbent Telco in Germany. DT is targeting two thirds Fiber-to-the-Curve (FttC) coverage by 2016.

UnityMedia KabelBW’s footprint passes through ~31% of German homes. An interesting fact about the Germany market is that ~60% of UnityMedia’s subscribers are part of large housing associations which provides a captured customer base. Housing association tenants must pay their basic cable bills as part of their rental contracts with the housing association. Housing associations usually have very long-term contracts with Cable operators in the range of 10+ years, and as such, provide a stable, predictable recurring stream of cash flows and are a perfect customer base to cross-sell high speed broadband.

The other interesting fact about the German cable market that shocked me is that carriage fees are paid by the public broadcasters to distributors. As a result, carriage fee revenue streams are not only at risk of disappearing, but could be moving towards a model similar to the US where the cable operators are paying a retransmission fee back to broadcasters. I believe it is the only market in Europe that still has this practice. In the US, the high growth in retransmission fees has been a central topic in network/distributor negotiations. Regarding the current dispute over carriage fees in Germany (public broadcasters have stopped paying them and German cable operators have threatened to cut their broadcasts), I believe it is unlikely that the German cable operators will begin paying a fee to the public broadcasters and I have already conservatively assumed 0 carriage fee revenues in my model going forward.

In terms of growth, Germany looks like Holland 10 years ago. I believe there is considerably upside from broadband penetration; currently, penetration levels are at ~70% and I think will approach closer to 90% to match penetration levels in Holland. Growth will come from volume primarily, but I also believe pricing will increase. I think German cable TV service is currently underpriced for several reasons: 1) due to a lack of real pricing increases when the industry was more fragmented, 2) the Pay-TV segment remains underdeveloped, and 3) a ceding of distribution and control to housing associations to set cable prices. Now that Malone and LGI have consolidated the second and third largest cable operators in the nation, I believe that cable TV pricing will increase at a faster rate than the historical ~2%, supported by a rational Telco incumbent and increased Pay-TV and digital penetration.

2)     The Netherlands, Belgium and Switzerland

These are the three countries in Europe that pretty much have ubiquitous cable coverage across homes. Across the rest of Europe, cable coverage is closer to 75%. Another commonality among these countries is that population and network density is amongst the highest of all of Europe, leading to more attractive economics. All three countries have very attractive market structures in fixed-line.

UPC Netherlands is the second largest cable TV provider in the Netherlands with ~1.7 million video subscribers; ~650,000 on analog and 1.1 million on digital. UPC Netherlands passes through ~37% of Dutch homes. LGI also has a 28.5% minority stake in Ziggo which is the largest cable operator in the Netherlands. Together, Ziggo and UPC Netherlands passes through roughly 90% of all Dutch homes. KPN, the incumbent Telco, has a JV that passes through 20% of all Dutch homes with Fiber-to-the-Home (FttH). KPN has been steadily losing share in broadband and has seen its operating results struggle lately, so the market has been concerned that they would begin entering a price war with Ziggo and UPC Netherlands. I believe this will not likely be the case as KPN is only one of two Telcos in Europe that is heavily investing in FttH, and I think they will most likely want to see that investment generate good returns via higher pricing. Also, there is evidence that the competitive environment remains rational as KPN raised prices by ~3% on July 1st just last year. Recent history also supports that they are a rational market player as they raised prices on their IP TV service from 11/month EUR in 2011 to 15/month in 2012.

Ziggo is a great asset that LGI currently holds a 28.5% stake in and I believe LGI will acquire the rest of this company in the near future. Ziggo passes through ~56% of homes in The Netherlands. Ziggo’s EBITDA figure is depressed relative to the typical industry metric since Ziggo doesn’t capitalize their  set-top boxes and instead fully expenses this line-item as they acquire new subscribers. This is extremely conservative accounting as I’m not aware of too many cable companies that fully expense this line-item; some partially expense it as part of their subscriber acquisition cost like DirecTV, but the rest is usually capitalized.

With respect to the recent deal to acquire the rest of Ziggo, I think they actually paid a good to fair price given the strategic value of this asset. Considering that Ziggo’s EBITDA is understated, the large cost synergies available from streamlining major costs with UPC Netherlands, and the growth from bundling mobile services, 11x 2014 EBITDA (pre-synergies) is quite a reasonable price to pay to consolidate cable in the Netherlands. Population density is very high in the Netherlands; in fact, the country has the highest density in Western Europe with 487 people per square km. This leads to very attractive cable economics in large urban clusters as scale effects really kick in.

ziggo stake analysis

netherlands marketshare

LGI has a 58.4% stake in Telenet which is the largest cable TV provider in Belgium with ~2.1 million video subscribers; 550,000 on analog and ~1.5 million on digital. Telenet currently serves ~46% of the total television market and passes through 62% of all Belgian homes. The Belgian market is one of the most saturated in the world in terms of broadband penetration with close to 80% of all homes having broadband service. Higher broadband speed adoption rates have definitely picked up as average speed of entire broadband customer base is around 61 Mbps with over half of base surfing on speeds above 50 Mbps. The market is pretty much a duopoly as the combined market share of Telco incumbent Belgacom and Telenet is ~90% resulting in limited price competition.

LGI is the largest cable TV provider in Switzerland with ~1.5 million video subscribers; ~850,000 on analog and ~600,000 on digital. UPC Switzerland passes ~57% of Swiss homes. This market is probably the most rational out of LGI’s core markets, since its national regulator has been extremely passive with dealing with any anti-competitive behavior. Switzerland is another duopoly between Swisscom and UPC Switzerland. 

switzerland market share

I will have to update the rest of this write-up for recent major news affecting Liberty Global… stay tuned!

Appendix I: Financial Model of Liberty Global’s largest markets – Germany and the UK, base case scenario

Germany Model

UK model

 


[1] Branson might have been an exception as he typically weighed the downside of his business decisions

[2] Revenue Generating Unit (includes video, internet, and voice subscribers)