Description

Liberty Media Group (ticker: LMCK)

Conclusion:

Liberty Media Group is undergoing a transformation from a small asset base comprised of various equity stakes in publicly traded companies, to a large asset base dominated by a high quality operating business, Formula One.  The transaction to catalyze this transformation is the acquisition of Formula One, and LMCK is now back to the classic Liberty playbook of controlling a high quality asset and using it to drive strong long-term equity returns through a tax-efficient levered equity shrink model.

Business Description:

Formula One is an excellent business: it has an irreplaceable brand and strong viewership that has resulted in steady revenue growth.  The quality of the revenue is further enhanced by the stability of long-term contracts with price escalators.  30-35% of revenues is from race promotion fees where venues pay for the rights to host a race; these are typically 5-10 year contracts with annual escalators.  Another 30-35% of revenues is from broadcasting fees, which are typically 3-6 years with annual price escalators.  Advertising is another 15% of revenues; title sponsors, trackside sponsors, etc. with 3+ year contracts typical.  The remaining 20% of revenue includes hospitality, licensing, etc.  EBITDA benefits from the fact that the largest cost in the business is variable: the revenue share with the teams.  Lastly, FCF conversion is excellent as the business is capital-light (the promotors and teams bear the capital burden), and the cash tax rate is very low due to its foreign domicile.  Regarding management, while there have been colorful reports on Bernie Ecclestone in the press, he has built a great business, the business will be controlled by Liberty, and Chase Carey, whom I assume most are familiar with from DTV and FOXA, will be chairman of Formula One.

A quick description of the transaction: on September 7^th, Liberty Media announced a two-step transaction to acquire Delta Topco, the parent company of Formula One.  The first step closed on September 7^th, where Liberty acquired 18.7% for $746m in cash.  The second step to acquire the remaining 81.3% should, subject to regulatory approval and a shareholder vote, close in Q1’17 funded by 138m LMCK shares, a $351m LMCK exchangeable note with a reference price of 105% of the $21.26 reference price, and another $354m in cash.  Upon closing of the second step the company will be renamed Formula One Group with the ticker FWON.  CVC, the private equity sponsor of Delta Topco will continue to own ~25% of the business, and CEO Bernie Ecclestone ~2%.  I think it is worth noting that the EV at which Liberty is acquiring the business is lower than what press reports had indicated CVC would seek an IPO, and that CVC is remaining a shareholder.

Why LMCK is Cheap / Misunderstood:

Before the announced Formula One transaction, LMCK was already trading at a double-digit discount to NAV, driven by its small size, eclectic asset mix, and perceived lack of strategic direction.  While the stock has appreciated since the Formula One deal was announced, I believe the stock is still cheap.  I don’t believe the quality of the Formula One business has been fully appreciated, I think there is still some sticker shock at the high teens EBITDA multiple payed, despite a much more attractive valuation on cash flow, and lastly the stock is still a tracking stock with other attributed assets and has yet to fully close on the deal.

Earnings Power:

I believe that revenue at Formula One can continue to grow at low to mid-single digits, mainly through escalators in the contracts briefly described above.  In 2019 revenue growth should step up more materially due to the newly signed agreement with Sky that has been widely reported on in the press.  Any ability to increase digital presence for Formula One, grow the number of races and extend more into the Americas and Asia, as well as add title sponsors to existing races would be upside to my numbers.  While EBITDA growth has been flat due to team share growing, Liberty management has suggested that impact is behind us and as a result I expect EBITDA to grow slightly ahead of revenue.  I expect unlevered free cash flow to grow from ~$500m today to +$650m in 2020, and I expect levered free cash flow to grow from ~$250m today to +$400m in 2020 (this is inclusive of both the F1 term loan interest as well as the Liberty ’23 and ’46 exchangeable interest).

Valuation:

I expect LMCK (and subsequently FWON) to generate an IRR of over 20%.  That is based on the earnings power for Formula One described above, the public equity holdings remaining at current prices (which I think could be conservative in the case of the material stake in LYV), the current capital structure (I have Formula One de-levering to ~5x through EBITDA growth), and FCF from Formula One used to shrink the float.  I apply a 10% discount to the public equity stakes, for conservatism, and for the possibility that they could be separated into a tracking stock down the road that could trade at a discount.

Balance Sheet & Liquidity:

Formula One currently has net leverage of approximately 7x.  While this is very high, the company’s revenue is highly contracted and steady, and the largest piece of the cost base (revenue share with teams) is variable.  Additionally, capital needs are extremely low, as are cash taxes, so cash conversion is very high (~95% of EBITDA on average).  The Formula One debt is also non-recourse to the other assets at Liberty.

Catalysts:

·         Liberty investor day: I expect Liberty management to help shed light on the quality of Formula One, as well as the company’s future prospects, at the Liberty analyst day this fall.

·         Second closing and name/ticker change: the second closing is expected in Q1’17 and is subject to regulatory approval and a shareholder vote.  The name and ticker will change to Formula One Group and FWON upon closing.

·         Transition to asset-based stock: after 5 years Formula One will qualify as an ATB and can facilitate a transition from a tracking stock to an asset-backed stock.

Risks:

·         Team profitability: it is difficult for teams to be profitable.  While the revenue share to teams has improved, this is still a risk.  That said, Formula One has been in business for 67 years and always found new teams.

·         Viewership: viewership has declined since Formula One has move to higher priced pay TV contracts from lower priced free to air.

·         Leverage: while the business has a very steady FCF model, it’s also very highly leveraged.

Catalyst

Catalysts:

·         Liberty investor day: I expect Liberty management to help shed light on the quality of Formula One, as well as the company’s future prospects, at the Liberty analyst day this fall.

·         Second closing and name/ticker change: the second closing is expected in Q1’17 and is subject to regulatory approval and a shareholder vote.  The name and ticker will change to Formula One Group and FWON upon closing.

·         Transition to asset-based stock: after 5 years Formula One will qualify as an ATB and can facilitate a transition from a tracking stock to an asset-backed stock.