Description

Valuation matters. And for that reason, I recommend buying shares of Liberty Global. VIC and the wider value community are painfully familiar with the Company and as levcap65 wrote in July 2019, “this has been a train wreck”. However, at the risk of adding another chapter of misery, I think the story has meaningfully changed for the better and the stock is set to outperform from these levels. Liberty Global is the purest value investment I am currently aware of, with the shares trading at an enormous discount to demonstrable value and clear catalysts to realize substantial upside. While Liberty Global has been written up multiple times in the past and thoroughly discussed, two important deals announced in 2020 create a meaningfully different profile that warrant a separate treatment. In this, I run through the pro-forma profile of the company, demonstrate the large margin of safety, and outline potential for >160% upside to fair value. 

The John Malone cable playbook is fairly simple – acquire growing cash flow streams that can be leveraged to either repurchase shares or make synergy-rich acquisitions. The key to this model is growth. At 4-5x leverage, $100 of cash flow growth can be leveraged into $400 - $500 of incremental debt capacity. As long as cash flow is growing, the Malone flywheel spins virtuously and profitably. Until 2015, Liberty Global followed this path and enjoyed a >480% return in the first ~11 years since IPO. Then, due to a variety of factors including onerous regulation and intensifying competition, growth hit a wall, removing the oxygen on which the leveraged-equity model relied. The ensuing years have not been kind to shareholders with the stock down 60% from the 2015 peak. 

Today, we find a very different Liberty Global with a very different strategy. Rather than pursuing enterprise growth via the levered equity strategy, the company has shifted to monetizing assets, improving remaining markets via fixed-mobile convergence, and driving for FCF via reduced capital intensity. 

The Math

The shares are demonstrably undervalued today with an enormous margin of safety. At $21/share and 594 million shares outstanding, Liberty Global has a market cap of just under $12.5bn. Pro-forma for recently announced mergers in the UK and Switzerland, Liberty Global will have holding company cash of $4.8bn, various non-core investments of $1.6bn, a controlling stake in publicly-traded Telenet worth $2.7bn at market (arguably undervalued at a >10% FCF yield), and a 50% joint-venture interest in VodafoneZiggo worth an estimated $3.2bn. That comes to about $12.3bn or ~$20/share. Counting some expected cash generation through year end, investors are paying nothing for the equity value of the UK, Switzerland, Poland, and Slovakia as the implied equity value of these subsidiaries is approximately zero. Critically, substantially all of Liberty Global’s large debt pile is held at the subsidiary level, non-recourse to the parent. This means that the equity layer of these assets cannot be worth less than zero to the parent. And with each of them throwing off substantial FCF to the parent, the equity value is plainly positive. 

The following assets have approximately zero implied equity value in the Liberty Global share price:

VMO2 JV – UK combination of Virgin Media and O2

Liberty will own 50% of the newly formed JV between Virgin Media and Telefonica-owned O2. The merger brings together Virgin Media’s fixed network and O2’s mobile service in a converged offering. In 2019, the two generated a combined $4.7bn of OCF and over $2bn of operating FCF (before interest), with estimated cost synergies of approximately $590 million. On a post-synergy basis, OCF should approximate $5.2bn before any revenue benefits from the converged offering. The JV will be capitalized with $23.6bn of debt, meaning any multiple above 4.5x OCF is “in the money” for the equity (5.0x before synergies). As an example, if the JV is worth 8x OCF, that it worth $8.9bn or ~$15/share to Liberty. At 10x, which is around where private transactions have occurred, Liberty’s JV interest is worth $14bn or $23.70/share; more than Liberty Global’s entire current market value. 

Switzerland

UPC Switzerland has been a thorn in Liberty’s side for years. Fierce competition has led to intense ARPU pressure and subscriber erosion. In 2018, Liberty struck an attractive all-cash deal to sell the asset to mobile operator Sunrise in another example of fixed-mobile convergence. Management vigorously defended the deal, but Sunrise’s largest shareholder Freenet opposed and narrowly blocked the combination. At issue, it seemed, was Freenet’s need for cash combined with the rights offering required to consummate the deal. Believing in the strategic and financial benefits of the combination, Liberty has turned around and offered to purchase Sunrise for cash, giving Freenet liquidity. 

UPC Switzerland and Sunrise generated combined EBITDA of approximately $1.4bn in 2019. After expected synergies, the combined entity should do about $1.6bn. With pro-forma debt an estimated $6.7bn, a multiple exceeding 4.2x is in the money for the equity (4.9x before synergy). At 8x, the equity is worth $6.6bn or $11/share. 

So far, we have $20/share for cash, investments, VodafoneZiggo JV, and Telenet, ~$24/share for Virgin Media/O2, and $11/share for Switzerland. That is $55/share. The stock is selling for $21. It’s true that there are corporate costs that I’m not capitalizing, but I am also not counting any value from Ireland (which is not included in the UK JV), Poland, or Slovakia. 

Pro-forma FCF

With organic growth opportunities more limited, Liberty Global has turned its focus toward FCF generation via reduced capital intensity across the enterprise. Further, the UK and Swiss deals are materially accretive to FCF which will turn the company into a cash machine. The precise level of FCF is complex, but we can outline the high-level calculation. 

Management initially guided for FCF of ~$1bn in 2020. On the 2Q20 call, they reiterated the guidance while noting a good chance of exceeding it. This figure includes a ~$300 million expected upstream dividend from VodafoneZiggo, and the full burden of newbuild capex in the UK (“Project Lightning”) which totaled nearly $400 million in 2019 (likely lower going forward). I will not adjust out any of this spending for now. It also consolidates Telenet which is only 61% owned by Liberty. Adjusting out the minority interest in Telenet reduces proportionate FCF by about $200 million. So before the UK and Swiss deals, call it FCF of ~$800 million. 

Building up to a pro-forma figure, we see dramatically higher FCF particularly post synergies. The VMO2 JV should do about $2bn of operating FCF before interest and synergies. This is split roughly down the middle, with 48% from legacy Virgin Media and 52% from O2. Pro forma interest expense should run about $1bn, assuming a 4.5% interest rate, for FCF of $1bn. Assuming $500 million of cost synergies (below the guided $590 million), we get $1.5bn of post-synergy FCF for VMO2. Liberty’s 50% interest in the JV would be $750 million. 

In Switzerland, legacy UPC did ~$300 million of operating FCF in 2019. To account for continued competitive pressure, call it $250 million run-rate going forward. Sunrise did about $210 million of operating FCF after normalizing excess capex in 2019. Combined, that’s operating FCF of $460 million before interest and synergies. With pro-forma debt of $6.7bn and assuming a 4.5% interest rate, that’s about $300 million of interest for pre-synergy FCF of $160 million. With expected pretax synergies of $300 million, tax adjusted at 20% that is $400 million of post synergy FCF. 

Putting it all together, we have $750 million from VMO2, $400 million from Switzerland, $300 million from VodafoneZiggo, and $300 million proportionate from Telenet for a total of $1.75bn. That is before corporate overhead (a few hundred million) and smaller contributions from Ireland, Poland, and Slovakia. That is a 14% FCF yield. 

Looking Forward

What comes next? That is difficult to say with certainty, but there are a number of options. 

With Telenet and VodafoneZiggo performing well in Belgium and the Netherlands respectively with converged strategies, one option would be to merge the two entities. Telenet is publicly traded with Liberty owning just over 60%, and VodafoneZiggo is a 50/50 JV with Vodafone. The latter has been performing particularly well of late (by European standards!), and would likely yield a high multiple in the public markets. Telenet is a cash cow. There would likely be large cost synergies to putting the two together. Liberty could effectively take VodafoneZiggo public by having Telenet buy out Vodafone and then exchanging Liberty’s interest for Telenet equity. 

Local listings could be forthcoming. Management has repeatedly pointed out that Swiss investors like to invest in Swiss companies, and with rates pinned at zero, consistent cash generators like cable/telco typically enjoy high valuation multiples. Once the UPC Switzerland and Sunrise merger is complete and gaining traction on synergies, I would not be surprised to see this subsidiary listed separately in Switzerland either partially or in full. Liberty was willing to part ways with this market a year ago and we believe they are still willing to do so. 

In the UK, we could see something similar. A merged VMO2 will certainly have the scale to stand on its own. Liberty could spin off VMO2 or do a partial listing to force the market to ascribe equity value to this large asset. While we’re speculating, it’s worth pointing out that Comcast is present in the UK via its 2018 acquisition of Sky. Was Brian Roberts’ venture across the pond a one-off or a foothold for a larger expansion? Comcast certainly has a lot on their plate at the moment, but it’s possible that down the road there are opportunities to partner in some way. 

Separately, Virgin Media owns valuable fiber network assets while O2 is contributing tower assets which also command high valuations. Some sort of carve out of either or both of these unique assets would be value enhancing. In January, Liberty created a new legal entity called Liberty Networks and asked the regulator for permission to build out a wholesale fiber network across the UK. Infrastructure funds have shown a keen interest in these types of investments and Liberty is likely to partner with them rather than finance the expansion from their own balance sheet. 

Private equity is showing interest in European cable and telecom. A consortium of KKR, Cinven, and Providence recently struck a deal to acquire Spanish telecom challenger Masmovil. If Liberty is unable to find industrial partners for assets like Poland and Slovakia, private equity could be a willing acquirer. 

More broadly, it is unclear whether Liberty Global will pursue a full wind down or is reshuffling for a new expansion. Supporting the wind down, private market values for European cable assets remain high and Liberty could realize substantial returns from here, as outlined in this writeup, by merely following a monetization strategy. On the expansion side, it’s worth noting that the regulatory environment in Europe is improving. In May the Luxembourg-based General Court annulled a European Commission decision to block a 2016 merger between O2 and CK Hutchison. While that deal is long gone, it was a warning shot to the Commission that they had been overzealous in their anti-competitive views of mergers. Recently, EU competition chief Margrethe Vestager has softened her stance on mergers and even suggested that she would welcome cross-border combinations. This is coming at a time when telecom valuations are depressed across Europe. Cheap valuations and a more friendly regulatory environment are likely to accelerate deal making across the continent. If a round of rationalizing M&A breaks out across Europe, who better to capitalize than Liberty?

Share Repurchases  

Liberty Global has shrunk shares outstanding by 30% over the past three years. At a demonstrable discount to NAV, continued share repurchases are highly accretive to per-share value. Although repurchases have been aggressive by almost any measure, given the large cash balance some may have been disappointed that they were not even more aggressive. Management has likely been preserving firepower for deals like the Sunrise acquisition. Post deal completion, with the UK and Switzerland “fixed”, repurchases could accelerate, particularly if the share price continues to languish. 

Why does this opportunity exist?

 It would be difficult to overstate the level of shareholder fatigue in Liberty Global. The shift away from the traditional Malone playbook of growing cash flows and levered equity returns left shareholders with a complex entity with mixed operating results and a broken thesis. Further, several recent disappointments including the failed initial Sunrise deal have left investors wary. And in part, the situation is tautological – despite corporate actions that clearly create value such as closing a large sale to Vodafone in Germany and share repurchases below NAV, the share price has not gone up. If value-accretive M&A and share repurchases do not make the stock go up, why buy it when it is easier to buy a Covid winner that goes up nearly every day? Or so the narrative goes.  

Conclusion

Liberty Global is undervalued based on the sum of its parts, with the entire market cap underwritten by cash, investments, and stabilized operating subsidiaries in Belgium and the Netherlands providing a healthy margin of safety. Recently announced deals in the UK and Switzerland add significant value that is not being recognized in the market price. As these deals close in 2021, I expect the value of the Company to be more fully realized. In the meantime, share repurchases at a meaningful discount to NAV continue to create per-share value. Put simply, the investment case for Liberty Global rests on careful analysis of the corporate balance sheet and valuation; two endeavors that some might argue belong in a museum these days. I disagree, holding firmly to the belief that, despite the daily pounding of evidence to the contrary, valuation matters.

Risks

• Unexpected failure to close deals in the UK and Switzerland

• Value-destructive use of capital and corporate actions

Catalyst

• Closing announced deals in the UK and Switzerland

• Clarity on use of holding-company cash

• Further corporate actions to realize value