Description

HSN Inc. is a high-return business that Mr. Market is willing to sell to you for just 4.8x free cash flow.

Background.
HSNI was formed by the August 2008 spin off of IAC's retailing assets. The primary business is the Home Shopping Network (HSN), an internet and television shopping network that reaches about 91mm US homes. The secondary business is Cornerstone Brands (CB), a collection of decent quality home and apparel catalogs (Frontgate, Ballard Designs, Garnet Hill, Smith+Noble, The Territory Ahead, TravelSmith and Improvements). More details can be found at www.hsni.com.

Retailers are unloved because consumers are cutting back on spending which is revealing the operating and financial leverage inherent in retail stores. However, HSN's business model, while still exposed to the difficult economy on the top line, is quite flexible. HSN can optimize sales by using real time data to reallocate TV air time to the best selling products or categories, or to run specials on inventory that must be moved quickly. Most products are proprietary in brand, price or configuration when featured on TV and quantities are designed to sell out on air. This creates a sense of urgency to buy now unlike most retailers who create incentives to buy later by having frequent sales. There is lower inventory mark down risk because if a product doesn't sell HSN knows quickly and can react quickly and the inventory is either drop shipped from vendors or in a central location rather than spread over a few hundred stores. That is also a plus for working capital. TV shopping has relatively low semi-fixed costs. There are no physical stores requiring multiple distribution centers and regional and store level management. Traditional retailers also have minimum per store staffing requirement whereas HSN can flex call center staff to meet demand.

From 2006 through 2008, HSN had revenue of $1,885M $1,893M and $1,957M. In that time they had adjusted EBITDA of $222M, $174M and $160M. The decline in EBITDA since 2006 is probably over 50% cyclical and the rest structural. Gross profit margins are down by 3.0% because of a change in mix from jewelry and fashion to home and electronics, promotional pricing in fashion, increased shipping and handling costs and higher return rates. Promotions, return rates and some of the mix change are cyclical. S&H is a wildcard, but in August HSN increased these fees to offset rising costs. The other piece of the EBITDA decline is a 1.1% increase in G&A to revenue, which was driven by a bigger executive team, stock comp expenses and bad debt.

Cornerstone's contribution to HSNI was negative EBITDA in 2008. I am going to make this easy by assuming CB has no value in my base case scenario. CB revenue was a contribution of $995M, $1,016M and $867M in the years 2006 through 2008. EBITDA in those years was a contribution of $74M, $60M and -$1M. Even in 2005 with only $784M in sales compared to $867M in 2008, CB was able to operate profitably ($54M EBITDA), so their problems should be fixable. Barry Diller paid $720M for CB in 2005!

HSNI had a 27% pretax return on capital in 2008, defined as EBIT over beginning of period working capital plus other tangible assets; it was 35% excluding CB losses.

Why is this interesting?
HSNI could be worth $18 as a standalone company. I estimate 2008 free cash flow of $80M or $1.42 per share excluding CB losses. This reduces cash flow from operations minus capex ($97M) for normal cash taxes and the current capital structure ($25M) and adds back the negative CB EBITDA-capex ($8M). $18 is a little over 12.5 times free cash flow and about 7.9 times EBITDA. Unlevered free cash flow is about $100M and net debt $230M so EV/free cash flow is also 12.5 times at $18. This all assumes CB is worthless. I would highlight that if CB was sold for $1 a $720M tax asset would be created worth an undiscounted $252M or $4.45 per share. Another way to approach the CB sensitivity is that the business averaged $47M of EBITDA over the past 4 years including the 2008 loss and if they could get back to that level each EBITDA turn is worth $0.80 per HSNI share.

Another interesting aspect of this investment is that Liberty Media, which owns 30% of HSNI, has publicly stated their interest exploring an acquisition of HSN. During Liberty's fourth quarter conference call on 2/25, Greg Maffei said "as far as HSN we are restrained... until... May of 2010... before we make any kind of offer for the Company as a whole. Not saying that we will, but we do believe we are the natural probably owner at some point for that company." Liberty made similar comments during an investor day (9/26/08), Goldman Sachs conference (9/17/08) and Merrill Lynch conference (9/9/08). At the Goldman conference, Maffei commented on the price, then $13.97, being low "particularly if you imagine some kind of a disposal of the catalog business and taking the tax effect of the loss that they would suffer on that..." Now a QVC/HSN marriage has been talked about for years, so it may never occur. But the stars are aligning to some extent as HSN is at a cheap price and there will be no barriers to a deal in a little over one year.

HSN's CEO is Mindy Grossman. Her track record is impressive at Polo Jeans and Nike apparel. Forbes and Women's Wear Daily have some good old profile articles on her. Grossman has been working to improve the product mix and customer service, which led to an increase in the customer base and revenue since 2007. She appears to have the right strategy because sales have significantly outpaced competitors QVC and ShopNBC, and broader retail for that matter, over the past five quarters (see investor presentation slides).

What are the risks?
--HSN offers two to six month interest free installment plans called Flex Pay. The receivables total $130M at 12/31 which is down 12% from 2007. This portfolio turns over very quickly which means problems surface through the income statement rather than lingering on the balance sheet. Bad debt accruals exceed write offs, so while the risk must be monitored it presently appears benign.
--HSNI has $409M of gross debt or 2.6x adjusted EBITDA. There are no near-term maturities. $20M of the revolver was repaid after 12/31 and $15M of the term loan amortizes in 2009. The credit facility calls for a maximum leverage ratio of 2.75x funded debt to adjusted EBITDA and HSNI may breach that covenant in 2009. EBITDA of $136M would push them to 2.75x (after amortization and revolver repayment). However, this is likely to result in slightly higher fees at worst because net debt to EBITDA is only 1.5x due to a $177M 12/31 cash balance. I can't think of any banks rushing to add to their non-accrual loans right now. HSN also has valuable assets they could monetize if they get into trouble (potentially well in excess of $100M even at distressed prices) such as an owned 600,000 square foot headquarters building on 65 acres in FL and the CB business with an upscale customer list of 19M buyers >12 months, 4M < 12 months and 6M email addresses.
--The CEO commutes to FL from her home in NY.
--Exposure to a leveraged balance sheet and consumer spending.

Important background information.
http://www.sec.gov/Archives/edgar/data/1434729/000119312509069499/d10k.htm
http://www.sec.gov/Archives/edgar/data/1434729/000104746908009572/a2187612zposam.htm
http://www.sec.gov/Archives/edgar/data/1434729/000119312509077298/ddef14a.htm
http://www.hsni.com/events.cfm 

Catalyst

--Increased investor interest (conference calls are typically 30 minutes or less)
--Change in attitude toward companies with leverage and consumer exposure
--Buyout speculation as the two year spin off anniversary approaches
--More clarity is provided on the future of CB
--Time