Description

Investor confusion, credit market fears, and difficult to value hedges, derivatives and tax liabilities have caused Liberty Capital’s tracking stock to trade at an~80% discount to tax-effected NAV and at a 90+% discount to tax-efficient NAV.  Moreover, I believe the downside to this investment is very limited, as haircuts to underlying assets still have LCAPA trading at a meaningful discount.  To the extent that the market would ever ascribe a “zero” value to the tracking stock, this would imply the tracker would be deemed “insolvent”(liabilities greater than assets).  Of course it is impossible for a tracking stock really to be insolvent, because the assets and liabilities of all three Liberty Media trackers are assets and obligations of ALL of Liberty Media, LLC.   If the market were somehow to ascribe zero value to LCAPA, the most likely outcome pursued by John Malone would be a collapse of the Liberty trackers—a reversal of the tracking stock structure that was created a few years ago.  This structure was created by Malone to improve transparency/reporting of the parts of Liberty Media’s businesses, enable investors to value each part based on its own relevant metrics, facilitate tax-efficient sales/spinoffs of assets, all with the overriding goal of closing the stock price’s discount to NAV. 

Given the meltdown in the credit and equity markets, the market seems to be attributing a tracking stock discount to the structures, with LCAPA having the most significant discount to NAV.  To the extent that Malone believes the LCAPA assets minus liabilities are not being valued appropriately, it would make perfect sense to collapse that tracker into LINTA.  As a reminder,  Liberty Media LLC’s income/assets/liabilities are currently “tracked” by LCAPA  (representing all the financial instruments and private investments of Liberty), Liberty Interactive (QVC, Starz and other investments in the “interactive” space), and Liberty Entertainment (LMDIA, which holds the 55% stake in DirecTV and will be spun-off to shareholders and eventually merged w/ DirecTV equity).

 

While it is undetermined when the 55% of DirecTV holdings in LMDIA will be spun off (there is still a large NAV discount between DirecTV equity and the tax-effected value of LMDIA shares as well), I assume that the spin-off does eventually take place—if it does not, then there will be more value ascribed to all of Liberty Media, LLC.  For my purposes I will focus on the stand-alone value of LCAPA & reasonable haircuts to its private investments, and the value of LINTA (should LCAPA be collapsed into LINTA).

There are five major reasons why LCAPA is trading at such a steep discount to NAV:  1)  Many analysts on the street are not correctly calculating the true tax liabilities of LCAPA in relationship to its exchangeable debt; 2)  investors are afraid of the mark-to-market (MTM) the public equity holdings and/or solvency risk (especially Sprint and Motorola)  3) the private holdings carrying values may not reflect true MTM values; 4) there are a host of derivatives, hedges, and options that are difficult to value/track; 5)  the credit risk of overall Liberty Media.

 

The following is my estimation of LCAPA’s NAV.  The NAV is based on valuation of the public AFS (available for sale) portfolio, the in-the-money shorts/puts of 70% of the Sprint position, 66% of the Motorola position, and 10% of the Time Warner Position.  Note the private investments are largely based on cost (more on this later).  The NAV based on current market  is  nearly $16/share on a fully-taxed basis, and $37/share on a tax efficient basis (assumes Malone can do additional tax efficient asset swaps of investments and debt tenders, as he has historically been famous for). 

 

 

	# of shares (MM)	Price/share	Total Value ($MM)
Time Warner (TWX)	102.0	10.03	1,023
Sprint (S)	87.0	1.94	169
Motorola (MOT)	74	4.45	329
Viacom (VIA)	7.6	18.08	137
Embarq (EQ)	4.0	31.73	127
Priceline (PCLN)	0.4	69.25	28
LodgeNet (LNET)	2.0	0.62	1
Crown Media (CRWN)	9.1	1.88	17
Total AFS Public Holdings			1,832
Debt/Mezz Investments			269
Atlanta Braves (Forbes Est)			450
Starz Media/Overature Films (cost)			420
True Position (cost)			400
CNBC Revenue Sharing Agmt (DCF)			180
Greenbay TV station (cost)			60
Manazines/Programming/Other (cost)			160
Total Private Holdings			1,939
Cash			1,879
Market Value of AFS Hedges (as of 3Q)			2,423
Est. Change in Hedge Value since 3Q (net of Tax)			320
Current Est. Value of Hedges			2,743
Total Assets			8,393
Face Value Exchangeable Debt			(3,440)
Other Debt			(1,510)
Capital Gain on Exch. Debt since 3Q			490
Deferred Tax Liability (as of 3Q)			(2,280)
Lower tax liability w/ MTM as of 3Q			110
Swap Settlement costs since 3Q			(128)
Total Liabilities			(6,758)
NAV			$1,635
# of shares (MM)			101.8
NAV/share (tax effected)			$16.06
NAV/share (tax efficient)			$37.38
Current Share Price			$3.40
Discount to NAV (tax effected)			79%
Discount to NAV (tax efficient)			91%

1.  The first issue that investors (including many on Wall Street) miss is how to account for the exchangeable debt attributed to LCAPA and its related deferred tax liabilities.   Back in 2000-2001, Malone believed that the equities of Viacom, Time Warner, Motorola, and Sprint/Embarq were overvalued.  As a way of raising cash & capitalizing on this over-valuation, Liberty issued long term exchangeable debt with very low coupons (between 0.75%-4%) that gave investors the right to convert the debt to the common stocks mentioned above (depending on the bond issue/the specifics of each stock underlying each bond issue are not important as Malone’s trade worked and all are significantly out of the money).  Associated with the exchangeable debt are deferred tax liabilities (shown in the table above as a subtraction from NAV) that reflects a couple of things.  First, since the date Liberty issued its exchangeable debentures, it has claimed interest deductions on such exchangeable debentures for federal income tax purposes based on the "comparable yield" at which it could have issued a fixed-rate debenture with similar terms and conditions. In all instances, this policy has resulted in Liberty claiming interest deductions significantly in excess of the cash interest currently paid on its exchangeable debentures. As  of YE 2007 (disclosed in 10K), Liberty (includes all the trackers) has deducted $2,847 million in cumulative interest expense associated with the exchangeable debentures since the Company's 2001 split off from AT&T/TCI . ("AT&T"). Of that amount, $844 million represented cash interest payments.  As non-cash interest grows over time, so does the tax liability, as Liberty will need to repay the IRS at the time of debt maturity (between 2023 and 2031 depending on the 5 debt issues).   Secondly, to the extent that the debt trades below face value, Liberty increases its tax liabilities.  This is because any for difference between the face value of the debt and the mark-to-market (MTM) value, Liberty can tender for outstanding debt at a price below face and book a capital gain (which would be taxed).  This is the result of the tax treatment by the IRS (Liberty was effectively getting cash and “shorting” Time Warner, Sprint, Motorola, etc).  The mistake made by many investors/street analysts is they calculate NAV using the face value of debt, but fail to reduce the potential deferred tax liability.  If you use the face value of debt to calculate NAV, you would also have to estimate the “capital gain” if Liberty were to tender for debt based on current market prices as an offset to the tax liability on the debt.  Given that all these exchangeable bonds trade anywhere from 25-70 cents on the dollar (depending on issue), if I calculate the “capital gain” by taking the discount from par were the bonds are currently trading plus a reasonable premium (3-5 pts) multiplied by the corporate tax rate (35%), then the deferred tax liability would be reduced by ~$500MM (see table above).

2)    MTM of public portfolio:  Investors see AFS positions such as Sprint, MOT, and say there is large MTM risk here.  Yes there is MTM risk, however as mentioned above, 70% of the Sprint Holdings are hedged via 9MM shares sold short and 52MM puts struck at $47.5 (most of puts roll off/will exercised in 2009 and 2010).  With Motorola, 50MM of shares are sold short (68% of the position), and Time Warner only 9MM shares were sold short (10%).  As these positions are marked to market at the end of each Q, there is an associated capital gains tax liability (included in the total deferred tax liability in the table shown).    Let’s assume that the two riskiest investments Sprint and Motorola (whose bonds trade in the 40s—60s) go bankrupt and their equity value is zero.  After doing this, calculating the gains on the shorts/puts, and deducting the associated tax liability, LCAPA’s NAV would still be at $14/share (tax effected) and $35 (tax efficient)

3)    On top of the assumption that Sprint and Motorola are worth zero, let’s assume that all private investments value (carried at cost) are haircut by a draconian amount or 50% (includes the Liberty debt/mezz investments, the Atlanta Braves, True Position, TV station, etc,), NAV would drop to $4.40/share (tax effected) and $25/share (tax efficient).

4)    The derivaties/options are actually not that difficult to value, once you dig through the filings and come up with reasonable estimates on the cost basis of the shorts.  There is the issue of financing costs of the shorts (which really are not disclosed), however this is incorporated in the derivatives carrying value each Q.

5)    With the spin-off of Liberty Entertainment, won’t Liberty be a distressed single-B rated credit?  While the spin-off of Liberty Entertainment reduces the implied asset coverage of all of Liberty’s debt and credit ratings may be downgraded a couple of notches from the Ba2/BB+ (potentially to B1/BB-), the credit markets have figured out that there is a very low default probability associated with this name and price it as such.  Liberty 5-year credit default swaps are priced around 720 basis points, while the average B+/BB- rated HY credit is trading at around 1500-1800 bps.  There are also no liquidity issues w/ Liberty (has $1.9BN of cash attributed to LCAPA and another $1.9BN at LINTA or nearly $4BN combined) and covenants at QVC (at LINTA) allow for plenty of headroom for substantial EBITDA declines should the economy worsen).Collapse of the LCAPA and LINTA tracking structures; 2)  Cash balances used to enhance share buyback activity; 3)  as market values of AFS and derivatives positions fluctuate and LCAPA reports its quarterly numbers, investors should fully realize the deferred tax liabilities on exchangeable debt and investments also (and are actually reduced in a down market, preserving the NAV)

 

 

Because the LCAPA shares trade at the larger discount to NAV (70%) vs. LINTA (LINTA trades at a 43% discount to my calculation of NAV, or $2.10/share, while LMDIA also trades at around a 40% discount to the 55% of shares owned of DirecTV), it would make a lot of sense for Malone to collapse the LCAPA tracker into LINTA (a collapse is unlikely to happen with LMDIA, as he wants to effectuate a merger of the shares held by Liberty with the public shares of DirecTV—will probably involve some sort of re-levering of DirecTV one the credit markets reopen).  The market is currently penalizing LCAPA more harshly vs. LINTA (because of the more difficult to value aspects discussed above) and a way to correct this would be a collapse of the tracking stock structure.  Remember that John Malone’s motivation for the tracking structure was to narrow the discount to the overall NAV of Liberty, not to widen it.  In this environment, one could see him easily do this (I believe he is structure agnostic, not discount agnostic!)

 

Let’s say that I was wrong in my valuation (ie. the haircuts to private assets should be greater, TWX has more downside, etc), and that the market was ascribing a zero value to the LCAPA tracker and this tracker was collapsed with LMDIA.  The table below shows my estimated value of LINTA and adds the LCAPA shares (which are assumed to have no value).  Because of the inherent discount to NAV in LINTA (on both a tax-effected and tax-efficient basis) , the value of LINTA is still in excess of what you would pay for LCAPA currently (trading at a 28% discount tax-effected and 55% tax-effieicent).  Remember that the assets and liabilities of each tracker are assets/liabilities of the entire Liberty media (there is no segmentation, which is the way the credit markets look at the name), so even if LCAPA is being deemed “insolvent” by the market, there is still a substantial margin of safety (backed by the LINTA assets) that really limit the downside to owning LCAPA.

 

	# of shares (MM)	Price/share	Total Value ($MM)
Expedia (EXPE)	68.7	8.15	560
HSN (HSNI)	16.6	5.57	92
Interactive Corp (IACI)	42	16.35	680
Interval (IILG)	16.6	5.34	89
TicketMaster (TKTM)	16.6	6.42	107
Lending Tree (TREE)	2.7	2.47	7
GSI Commerce (GSIC)	9.2	10.38	95
Total AFS Public Holdings			1,630
QVC (6x FY09 EBITDA of $1.5BN)			9,000
Starz/Encore (6x FY09 EBITDA of $275MM)			1,650
Total Private Holdings			10,650
Cash			1,925
Market Value of AFS Hedges (as of 3Q)			(163)
Est. Change in Hedge Value since 3Q (net of Tax)			20
Current Est. Value of Hedges			(143)
Total Assets			14,062
Face Value Exchangeable Debt			(551)
Other Debt			(8,380)
Capital Gain on Exch. Debt since 3Q			120
Deferred Tax Liability (as of 3Q)			(2,074)
Lower tax liability w/ MTM as of 3Q			110
Total Liabilities			(10,775)
NAV			$3,287
# of shares (MM)			594.0
Add'tl LCAPA shares, which assumes is worth zero			98.7
Total LINTA & LCAPA shares O/S			692.7
Adj. NAV/Share (tax effected)			$4.75
Adj. NAV/Share (tax efficient)			$7.58
Current LCAPA share price			$3.40
Discount to NAV (tax effected)			28%
Discount to NAV (tax efficient)			55%

 

 

 

Catalyst

1) Collapse of the LCAPA and LINTA tracking structures to alleviate the 70+% discount to NAV at LCAPA; 2) Increase share repurchase activity due to strong cash balances; 3) as market values of AFS and derivatives positions fluctuate and LCAPA reports its quarterly numbers, investors will begin to fully realize the deferred tax liabilities on exchangeable debt and investments also fluctuate (and are actually reduced in a down market, preserving the NAV).