Description

This one won’t get me any extra points for originality, but yesterday, the EU approved Liberty Global’s mega-transaction with Vodafone, creating one of the most asymmetric opportunities I can recall stumbling upon in recent years. LGI shares opened the day flat despite the announcement, which was when I started to write this idea. Unfortunately I wasn’t quick enough and a late rally sent the shares up 7.5% for the day, taking away a small part of the upside. 

Use of proceeds including the size of buybacks and other variables may change the upside here to anywhere between 30% and 100% over the next couple of yers, but the magnitude of the opportunity in my opinion comes from a setup that I’ll describe as “Heads - I win some, Tails - I win plenty”. This is the kind of things that make me comfortable putting a big chunk of my fund/net worth in. 

LGI is far from an undiscovered gem. It’s more of a widely followed name that used to be a hedge fund hotel until turning into the complete opposite over the last 24 months - now mostly viewed as an over-leveraged European cableCo with exposure to some of the most regulated telecom markets in the world, a now-abandoned roll-up strategy, Brexit exposure, messy financial statements and a highly promotional, excessively-paid CEO. With that said, it is now incredibly cheap, still has one of the best capital allocators of all-time as Chairman and a major shareholder, as well as a CEO who’s highly incentivised to drive up the share price. 

LGI was written-up several times for this website. Goirish’s 2016 writeup is the most comprehensive and gives a good overview of the company’s history and levered-equity model, while slim’s writeup from 2018 provides a more recent overview of the different business units and discusses the then-recently-announced transaction to sell LGI’s operations in Germany, Hungary, Romania, and the Czech Republic to Vodafone for €19b (11.5x EBITDA). 

Given the assumed-familiarity with the name, I’m not going to repeat what previous authors have laid out, but will instead focus on why I think it’s going to be hard to lose money from here, and what can still go wrong. Although important to long-term owners, I’m also not going to get too deep into the future prospects of Virgin Media, Telenet and VodafoneZiggo (the remaining business units which should account to >95% of proportional EBITDA going forward). At some point in the future it might be worth laying out the case for Virgin and discuss whether it’s an 8x or 10x EBITDA business, but I don’t believe this is necessary in order to make 30%-45% return over the next 12-18 months.  

How this writeup is going to look:

1. Snapshot of LGI post Vodafone and Sunrise transactions. 
2. Risks related to the Sunrise deal not closing and/or unwise use of proceeds.
3. Why this opportunity exists.
4. Incentives.

1. Snapshot of LGI post Vodafone and Sunrise transactions

Following a little over a decade of gathering European cable assets, LGI changed course and started disposing the same assets about 1.5 years ago. In December 2017, it announced the sale of its small Austrian operations to T-Mobile for €1.9b (11x OCF), which closed in the 3rd quarter of 2018. In May 2018, LGI announced the sale of its operations in Germany, Hungary, Romania and the Czech Republic to Vodafone for €19 billion (~11.5x OCF). This one went through a much lengthier approval process, with different headlines popping out almost on a weekly basis. The EU Commission has finally approved the transaction yesterday (Thursday) and it is now expected to close by the end of the month. Then lastly, in February this year Liberty has agreed to sell its struggling Swiss business, UPC Switzerland, to local competitor Sunrise telecommunications for CHF 6.3b (9x 2019 expected OCF). This deal isn’t expected to face antitrust hurdles but there seem to be some noise coming from Sunrise’s largest shareholder, Freenet, who has been pushing for a renegotiation of a different deal structure but is unlikely to succeed in stopping the deal from going through (more on this later).

The VOD deal is expected to close by the end of the month, and the Sunrise deal should close by the end of the year. This will net LGI with $14.6b of cash (excluding transferred debt), plus an upstream of ~$500m of Unitymedia YTD FCF, which LGI is entitled to according to the merger agreement. Adding $550m of FCF from continuing operations (per guidance), we come up with the following snapshot of available cash for share repurchases or M&A (god forbid) between now and YE19:  

Management has indicated several times over the last year that it will prioritize buybacks over other use of proceeds given the depressed valuation, although they seem to prefer buying gradually in the open market over tendering for a huge piece of the company. Analysts seem calibrated on a massive buyback over the next 2.5 years, but they’re also modelling a moderate increase in share price every year so the result in their models doesn’t appear as dramatic as it could be if shares remain depressed. For example, Jefferies expect $9.2b of buybacks from mid-2019 till YE21 at an average price per share of $35. Barclays on the other hand managed to come up with a model that shows the company buying back 81% of its market cap over the next 4.5 years (80% of that by year-end 2021), while still coming out with a $30 price target. If we assume that shares go to $30 today and stay there for the next 2.5 years, then by YE21 LGI would have 338m shares and a normalized fcf (ex-project lightning) of $1.4b, or $4.14 per share (13.8% FCF yield).    

This may sound shallow but the sheer amount of buybacks, coupled with the tendency of cable assets to produce consistent cash flows, is in-fact the crux of the thesis for the next couple of years. Valuation is already depressed at 6x pro-forma OCF multiple, and if they can reduce share count at a rate of 15%-20% per year, how do we lose money here? Obviously if shares drift slowly upwards over the next few quarters, then buybacks become a little less effective, and at this point we can start talking about Virgin’s strategic positioning and LGI’s mid-term plans to unlock more value. If shares remain flat or go down further, we are likely to get one of the more extreme acts of cannibalization in the history of capital markets. Given the nature of these assets (high collateral value, FCF generative) and the people involved, it’s hard to see how the 2nd scenario doesn’t end with a huge payoff to patient investors.

2. Risks related to the Sunrise deal not closing and/or unwise use of proceeds.

Up until yesterday, the biggest risk to the thesis was a surprise blockage of the VOD transaction by the EU. IMO this would’ve put LGI on a dead-end, with both roll-up and scale-down strategies having failed. Luckily this is now behind us and the next imminent threats seem far less scary.

i) Freenet blocking the Sunrise/UPC deal. Freenet is a German telecommunications group that owns 24.5% of Sunrise. Although it’s unclear whether Freenet representatives' on Sunrise BoD actually voted against the UPC deal, Freenet’s CEO has been pretty vocal in recent months about his dissatisfaction with the deal structure (cash only, requires massive equity raise from Sunrise) and was advocating that the two sides should renegotiate the agreement. Market was slightly spooked when in April, Freenet blocked a proposal on Sunrise’s annual meeting to increase the share capital of the company. This was a special resolution that required two thirds  of the votes to get approval, and Sunrise’s 24.5% were enough to stop it due to turnout of only 62% of shareholders. However the actual UPC merger will be voted upon later this year (expected late October, after approval of Swiss regulators), and only requires a simple majority to pass. The special resolution received 59.3% support so it would’ve passed if only a simple majority was required. Both LGI’s and Sunrise’s management team seem confident that the deal would get approved even without Freenet’s support, both suggesting that turnout tends to be high at Swiss EGMs, with the vast majority voting in line with board recommendations.  

ii) LGI goes on a reckless shopping spree (a-la CWC deal) instead of returning most of the cash via buybacks. I believe the idea that LGI is not done acquiring over-regulated European assets has been the heaviest weight on the stock since the Vodafone deal was announced. This is somewhat justified - given recent deals including the CWC debacle and the VodafoneZiggo JV, which saw LGI entering the Dutch mobile market just as competition started heating up and ARPU began free falling. Management has been pretty blunt about not considering any content deal, nor entering new markets at this point. This leaves us with two realistic options - acquisition of a UK mobile operator by Virgin, and buying Vodafone’s 50% stake of VodafoneZiggo (a third would be Telenet acquiring Voo but this seems small and wouldn’t require any cash from LGI). I have no special insights into LGI’s plans regarding these, but I think market fears are overblown and neither of the transactions would require a major chunk of LGI’s cash pile. With VodafoneZiggo, it’s still unclear whether LGI would be a buyer or a seller when a decision comes due (depends on the valuation according to management), but the company has implied that in case they do decide to take Vodafone’s 50% stake, a direct acquisition by LGI is less likely than a merger with Telenet. In that case LGI is expected to roll its 50% stake in the JV to Telenet, and will likely not need to inject more than €500-600m of cash in a Telenet rights offering to keep a 60%-65% stake in the combined entity. This deal can actually be pretty accretive as it will not only unlock another set of cost synergies (especially given the geographical and cultural closensee of Belgium and Netherlands), but could also allow Telenet, the only LGI’s subsidiary that is a full tax payer, to shelter some of its earnings through LGI’s Dutch NOL assets.  

Acquisition of a UK mobile operator is probably a slightly bigger risk here, but management went on a road show recently and has consistently communicated a prudent approach on that front. First, they seem to admit the mistakes around the CWC and VodafoneZiggo transactions, and insist lessons were learned. Second, they descibe Virgin Media as “strategicaly complete” with its current full MVNO contract. They also acknowledges that a mobile network acquisition would make sense at some point due to synergies, but would only want to buy one at a “fire sale” price, which they think is realistic given there’s probably more than one willing seller at the market currently, with no potential buyers in sight. Some analysts estimate that O2 could eventually be taken-out at less than 6x, which seems to be where LGI management is aiming. If this is true, given the amount of synergies and LGI’s love of leverage, Virgin could basically self-fund the deal by gearing back to 5x-5.5x in the short-term, or use a ~$3B cash injection from LGI. 

To summarise, none of the above deals seem to have the potential for major value destruction, nor taking away LGI’s firepower for buybacks. If anything, at the prices currently discussed, both should be highly accretive and significantly increase FCF due to another round of synergies and tax savings. Maybe more importantly, even if both deals are pursued, LGI is likely to retire 30%-45% of its shares in the medium term if shares remain at their current levels. 

3. Why does the opportunity exists 

The obvious reason is that this has been a train-wreck over the last few years, and that there are very few assets that appear less attractive to investors currently than European telcos. An alternative theory would be that there are simply too many variables currently to come up with a decent model that shows a base-case with a huge upside from here. The stars need to align pretty nicely here for this to double (i.e. massive buybacks on the cheap, return to growth in the UK and a value unlocking catalyst/M&A). In the most straight forward / realistic scenarios, fair value seem to be around $35-$40 per share simply because the market doesn’t let LGI buyback $8b of stock cheap enough. $35 per share is a nice upside from here but perhaps not something that would attract enough investors into a very complex story in a hated industry? 

Just try and model FCF per share going forward (or look at different sell-side models that are flying around), and you’ll note that the amount of vaiables make this almost impossible -

• How many shares will be bought back and at what price?
• How do you model a huge cash pile yielding nothing on a balance sheet filled with debt?
• What happens with VodafoneZiggo? LGI made it clear that the current state is probably temporary but indicated they might be a buyer, seller, or joint-owner through an IPO.
• How’s vendor financing going to affect FCF in the short/medium term?
• When long will Project Lightning keep going?

There are simply too many unknowns to come up with a clear model, although the results of the operating units are pretty stable and predictable. I’ve spent a few days building a model and playing with different scenarios and I ended up with anything between $3.5 and $7 in FCF per share in 2022, which I would say is a pretty wide range. It’s a hard pitch (just look at the clumsiness of this writeup), but the bottom line is that in practically every scenario it’s extremely hard to lose money from here, or come up with a FV below 30$ per share. I don’t mind if the shares run another 30% from here and I’m forced to rethink and perhaps sell some. I also don’t mind shares staying where they are or going lower, and the company reducing share count by 15%-20% a year for the foreseeable future. It’s a pretty nice setup and I’m happy to play. 

            4. Incentives

There has been some justified criticism around excessive executive compensation in LGI, especially with CEO Mike Fries getting over $20m in cash and equity every year while both the company and the shares underperform as of lately. Some have even suggested incentives aren’t aligned, as shareholders stand to benefit the most if LGI is broken to pieces and Virgin gets sold, while Fries is incentivised to keep the show running as long as possible.

While some of the criticism is justified, I don’t think there’s misalignment of incentives. First, Malone owns 31m shares which are still a major chunk of his net worth (~12% according to Forbes), and is only getting paid $500k a year for his role as Chairman. For all I know he still calls the shots, and I bet he wouldn’t let it keep running if he didn’t think there’s more value to extract. Second, while Fries is undoubtedly excessively paid given the company’s recent performance, he owns 10.1m shares and another 6.3m options/SAR with an average strike price just below 30$ per share. If he can run the share price to $40-45 simply by not doing anything stupid while buying back as many shares as possible, he stands to gain more than $300m, which will dwarf his $22m maximum annual pay.  

Catalyst

• Buybacks
• More buybacks
• Sunrise/UPC deal goes through