Description

QVCA ($26.00)

When you hear the letters Q-V-C, do you picture a television, a telephone or a dinosaur? What many investors viewed asa business model unable to withstand the onslaught of technology has actually been at the forefront of capitalizing on it. QVC is an international retailer, but with very unique characteristics which make it a high quality and capital light operation. As one of the leading retailers in mobile revenue, QVC has deftly navigated the changing retail landscape while maintaining unheard of customer loyalty. This dynamic has provided free cash flow visibility and allowed its world class management team to create shareholder value through capital allocation. After $2.7B in stock buybacks (approximately 20% of shares outstanding) since 2013 and a $2.4B value-enhancing acquisition late in 2015, we believe Chairman John Malone has set up the stock for a great run over the next 2-3 years. We expect that QVC will expand EBITDA meaningfully as the fruits of its Zulily (“ZU”) acquisition ripen and will repurchase another 20% of its shares which, in turn, could drive the stock to $40/share.

Business Overview

“Our customers are highly, highly loyal. We retain 89% of our customers from year-to-year. We do that every year. They buy 24 items a year. They do that every year. Those two metrics speak to the real stability of this business.” – QVC CEO Mike George

Quality. Value. Convenience. These are the three words that founder Joseph Segel chose to describe the station he was launching on television back in 1986. However, as it pertains to the quality of the business model, customer loyalty and minimal capital requirements are the most crucial components. QVC has no bricks-and-mortar stores to build, maintain or renovate. QVC has no inventory to stockpile in large warehouses. The company simply gathers talented, unique and innovative retailers and creates engaging programming around their products. Those programs are viewed in several countries, and the experience compels viewers to purchase featured products over the phone or on QVC’s web site. Adding to the appeal is the fact that almost 75% of the merchandise sold is exclusive to QVC. Over time, this has created a very loyal customer base. QVC boasts annual customer retention rates consistently in the range of 88%-90%, and the average U.S. customer makes 24 purchases per year and spends almost $1,500. Not surprisingly, with QVC's impressive customer loyalty statistics, 2008 revenue declined by only 1.3%.

“Almost half of the business today is e-commerce in the U.S., and within that e-commerce portion, more than half is mobile, that's a stunning development… but if you look at traditional retailers, you'd be hard pressed to find anybody who has those kinds of numbers.” – QVC CEO Mike George

QVC's consumer demographics have also gradually been getting younger, given the company’s success with new technologies over time. Currently, 30% of all new QVC customers are coming in through a mobile device. Believe it or not, QVC is #3 in mobile retail revenue in the U.S. behind Amazon (“AMZN”) and Apple (“AAPL”), and #2 for multicategory retailers (behind only AMZN). This sticky customer base with demographic tailwinds, combined with minimal capital requirements, allows management great visibility of future cash flow – a beautiful thing when you have a management team led by Liberty Interactive’s Chairman John Malone and CEO Greg Maffei.

Transformational Acquisition

“We made a relatively small bet, about 11% of our QVC Group enterprise value at the deal's closing for something we think can accelerate our growth, can bring great returns and help re-rate the QVC multiple, given a faster growth rate for the combined enterprise, so we're very excited about it.” – Liberty Interactive CEO Greg Maffei

On October 2, 2015, QVC completed the $2.4B deal to purchase ZU, an online retailer that went public in 2013. Once a high-flying stock driven by triple-digit growth rates, ZU shares had in recent quarters experienced a serious pullback as sales momentum decelerated and EBITDA margins languished in the low single-digits. However, with around $1.5B in annual revenues, ZU discovers up-and-coming vendors and targets young moms in the U.S. The company is still growing at ~15% and its profitability should benefit tremendously from being a part of a much larger operation with economies of scale and industry know-how.

“I think there’s a giant opportunity… this is one of the cases where one plus one may, in fact, equal three…” – Zulily CEO Darrell Cavens

On top of cost synergies that are expected to flow through starting in 2016, Q4 2015 already proved that revenue synergies will be the major financial benefit to the deal. Management believes the thesis surrounding this transaction was confirmed as meaningful ZU traffic in Q4 was driven by existing QVC online customers who flocked to the ZU web site. Additionally, 15% of QVC’s new customers in the quarter were originated as re-directs from ZU. We believe that this cross-pollination combined with ZU EBITDA margins of 5% (versus QVC’s 22% margins) expanding over time will propel ZU EBITDA from $71MM in 2015 to $200MM-$250MM by 2018. And from a strategic standpoint, this deal brings younger shoppers and up-and-coming retailers into the QVC ecosystem earlier.

Buybacks and more Buybacks

“We have a faster growth profile with Zulily included and we have a lower multiple, both appealing thoughts… I would argue a far more appealing candidate for share repurchase today than we were a year ago.” – Liberty Interactive CEO Greg Maffei

After announcing the purchase of ZU and watching QVC stock drop materially in response, Liberty Interactive CEO Greg Maffei reassured investors that leverage taken on in the transaction will not impede more share buybacks. In fact, Maffei thinks it is a better buy today given the strategic and financial benefits of the acquisition. Additionally, the balance sheet is strong with very manageable 2.9x net leverage – a multiple that will drop without any capital being allocated toward debt pay down as EBITDA grows. With $2.7B in share repurchases from 2013 through 2015, QVC management has shrunk the share count by approximately 20%. Clearly, Malone and Maffei viewed and continue to view the stock as a great value, and we would expect another 20% to be retired over the coming 3 years.

Valuation

“Our shares are wildly undervalued.” – QVC CEO Mike George

QVC stock currently trades at a multiple of 9x 2016 EBITDA. But with a 38% equity stake in the company’s biggest competitor, HSN Inc (“HSN”), included on the company’s balance sheet, QVC is really trading for 8.5x 2016 EBITDA, or 10x 2016 EBITDA less CapEx. We believe that given the captive audience and the capital light model at QVC, which leads to stability and visibility in cash flow, this business deserves to trade for 12x EBITDA less CapEx. When viewing this retail company in the context of the characteristics of its business model, we could suggest this is really a subscription type of business in quality and value. That is what we believe should be the focus, and we expect that as ZU proves to be a smart acquisition, QVC's multiple will expand. Looking out a year, we expect the stock to reach $37.50/share, or 12x 2017 EBITDA less CapEx of $2B. If we give the company credit for 2016 and 2017 stock buybacks, we arrive at a stock price of $43/share. And given the activist management team running the company with a history of value enhancingtransactions, an accretive combination with HSN could potentially increase the upside in QVC shares further.

Catalyst

 - Continued progress in revenue synergies between QVC and ZU

 - Cost synergy opportunities

 - Repurchase of 5%-10% of the market cap annually

 - Value enhancing transactions including a merger with HSNI