Value Investors Club / Liberty Capital Corp (LCAP/A)

Description

Liberty Capital (LCAPA) is trading at a 35% discount to NAV (or upside to NAV of 50%+ from current prices), largely reflecting the potential tax impact on the sale of its very low cost-basis AFS portfolio. Frustrated with the seemingly perpetual discount that Liberty Media has historically traded relative to its NAV, John Malone is taking increasingly aggressive actions to address this issue, the most recent of which include: 1) the spin-offs of Discovery Communications and Liberty Media International and 2), and the creation of a tracking stock structure for remainder of Liberty Media, consisting of Liberty Interactive (QVC, equity stakes in InterActiveCorp and Discovery) and Liberty Capital (AFS public securities portfolio consisting of NewsCorp and TWX equity, other public and private holdings, and Starz/Encore).

Malone’s “financial engineering” has been successful in the sense that the spin-offs and the new tracking stock structure have further isolated Liberty’s NAV discount, which is now mostly reflected in the LCAPA shares, and the reason for the discount is now more economically apparent than ever: The AFS (available for sale securities) portfolio is worth $19BN and with a low cost basis of an estimated $3BN, any sale of these securities would be taxed at Liberty’s corporate rate (40%--equating to a ~$6.3BN tax liability). If the Company were to liquidate its AFS positions today, LCAPA shares would be worth about $87-$88/share (which is where they are currently trading vs. an NAV of around $134/share). However, the final component of Malone’s plan to eliminate most of the remaining discount is to tax-efficiently monetize LCAPA’s public security stakes, particularly in News Corp and Time Warner, through cash-rich or outright asset swaps.   It is no secret that Liberty has been actively negotiating with News Corp and Time Warner on various tax-efficient transactions between the companies, including cash-rich swaps with TWX (swap TWX stock for Atlanta Braves & cash), a cash-rich swap of NWS shares held by Liberty in exchange for Fox TV stations (or other NewsCorp assets) or an outright swap of these shares for NewsCorp’s 38% stake in DirecTV.

Malone’s strategy of spinning off Liberty assets over the past two years, coupled with the extensive discussions that have taken place with TWX and NWS, and the fact that TWX and NWS also have strong motivations to do transactions with Liberty (as both are shrinking their capital bases), render it highly probable that LCAPA will be successful in striking tax-efficient deals over the next 1-2 years. When this occurs, the NAV gap existing in the LCAPA shares will be narrowed considerably with a 40%-50% potential upside to $134/share. In the event that monetization takes longer-than-expected, the downside is fairly limited as the LCAPA shares are already trading at “taxable liquidation value” and the shares represent meaningful exposure to several high-quality media/telecom holdings (NWS, TWX, MOT, VIA, CBS, S) that many would argue are still undervalued (most of these ideas have been written up as undervalued longs on this Board). Thus the LCAPA situation has a compelling risk-reward payoff, a high-probability catalyst, and represents a private-equity like investment vehicle in public form (without steep management fees) that is headed by one of the most successful and savvy deal-makers/investors in the media business whose interests are well-aligned with those of LCAPA shareholders.

Although NWS recently successfully extended its poison pill provision for another 3 years and now has better negotiating leverage over Liberty (who owns 19% of NWS voting shares), there is a strong motivation from NWS’ perspective in being able to buy back $10+BN of its shares and solidify Murdoch family control of NWS for years to come (the poison pill extension vote was fairly close, at 57% supporting and 43% dissenting). Moreover, NWS may be further motivated by a shift in strategy that acknowledges that distribution assets (DirecTV, SkyI-talia, BSkyB) are no longer as attractive given they lack the high-speed data component of the “triple-play” to more effectively compete against CATV and Telco providers (more on this later).

Notwithstanding the complicated corporate structure of years past, Liberty Capital is now fairly easy to analyze/understand. The Company can essentially be broken down into these components: an AFS and derivatives portfolio worth almost $19BN, operating assets (Starz, OnCommand & other businesses) worth about $3BN, and net debt of another $3BN. This collection of assets less outstanding debt is worth $134/share or over 50% higher than LCAPA’s current price of $88/share.   So what accounts for the difference? Over the years, the market has applied a “holding company discount” to Liberty Media shares, which has been defined in various ways, including a discount due to double-taxation, a lack of ownership of operating assets, a complicated corporate structure, an “uncertain strategy” discount, a John Malone discount, a financial engineering discount, etc. With the spin-offs of Discovery, Liberty International and the creation of the LINTA/LCAPA tracking stock structure, it is more apparent than ever that the discount mostly reflects the potential tax liability on the liquidation of the AFS portfolio. The cost basis of the AFS portfolio is about $3BN (per Co. and analyst estimates) while the fair value is near $19BN; if the AFS portfolio were to be liquidated today, on a per share basis the NAV would drop from $134 to a tax-effected $88 (which is exactly where it is trading today). While some other components of a “holding company discount” that have historically been assigned to Liberty have some validity (e.g. complex structure, limited disclosure on derivatives, no operating assets), addressing the tax issue will likely be the most significant driver of the stock price (which is what Malone/Liberty management strongly believes--as exemplified by their public comments and financial/restructuring actions). Once the tax issue is addressed, Malone will likely start spinning off, merging, or selling pieces of LCAPA on a tax-free basis, including any TV stations, baseball teams, or potentially the DTV stake that Liberty might own as a result of tax-efficient transactions with NWS and TWX.

Tax-efficient Transaction Options and Share Price Impacts:

The largest potential impact on the Liberty shares will be addressing the 19% voting and 17% non-voting stake that Liberty holds in NewsCorp stock (worth $10.8BN). The cost basis of the NWS shares alone is estimated to be at around $1.7BN, which implies a potential tax impact (assuming liquidation) to Liberty of $3.64BN or ~$26/share.   To the extent that Liberty completes an asset or cash-rich swap with NWS, a large part of the LCAPA discount will be eliminated as the tax liability associated with these shares will be essentially eliminated. One option that Liberty has been discussing with NewsCorp is a Section 355 transaction, whereby Liberty can swap its low-cost basis NWS shares for some assets (must be at least 25% of the value of the total consideration) and mostly cash (up to 75% of the transaction value), which would result in minimal tax liabilities on these swapped assets. Other assets that NewsCorp could be willing to swap in a cash-rich transaction would include a portfolio of Fox’s owned and operated TV stations outside of its major markets. Assuming operating cash flow of anywhere between $100MM-$200MM (depending on the number of TV stations sold) at a private market valuation 12x-13x would represent at least 25% (the minimum value threshold for a cash-rich swap) of a potentially $5BN-$10BN cash rich split. Other assets that NWS could also be part of a 355 transaction would include its Free-Standing Inserts business (worth $2BN-$3BN) or its Publishing Division (worth $1.5BN-$2.0BN).

To investors’ surprise, beginning in mid-September, there have been press reports surfacing that Liberty could exchange its NWS shares for NewsCorp’s 38% stake in DirecTV (worth ~$10BN). This might actually not be as surprising as initially believed because there have been increasing indications that NewsCorp is not so enamored with the satellite/DBS business. In Italy, there have been reports that NWS was planning to sell Sky Italia to Telecom Italia; in the UK, BsyB bought a DSL provider to offer its own broadband bundle in the wake of “triple play” competition from other cable providers; there have been some reports that BskyB was considering a management-led buyout; and Murdoch has commented publicly that DirecTV faces tough cable and telco competitors in the US (that can offer the “triple-play” bundle) and that a merger of DTV and Echostar would make a lot of sense in the wake of this competition. With regard to the last point, while there may be some FCC hurdles in merging DTV and DISH (they’ve tried it unsuccessfully before), the competitive environment has changed and from an economic standpoint, the combination would result in huge cost savings (this is what Malone may be looking at as an end-game for DirecTV). While it is impossible to determine exactly what actions Murdoch or Malone will take, the point is that it appears that NewsCorp and Liberty have more numerous asset swap options than initially believed, which in turn increases the already high probability of something taking place, and potentially within a sooner timeframe.

Liberty has also stated that it has been in discussions with Time Warner to swap out a portion of its Time Warner holdings ($3.4BN total) for the Atlanta Braves and cash. In a 355 transaction, the Atlanta Braves would be worth about $400MM-$500MM, which added to about $1.2BN in cash, would represent a value of about $1.7BN or the equivalent of 86MM time Warner shares (roughly half of Liberty’s stake). With these shares having a cost basis of an estimated $260MM, the tax impact per LCAPA share in an outright sale of TWX stock would be about $4/share, which would thus be eliminated with the swap. There is a high possibility that Time Warner may be willing to swap other non-core assets (which could add another $4 per LCAPA share in tax elimination value) for its stock given that Time Warner is undergoing a massive $20BN share repurchase program as the primary means of accreting value to shareholders.

Thus if Liberty can come to swap agreements with Newscorp (for TV Stations, other businesses ,or DirecTV) and Time Warner (Atlanta Braves or other assets), the potential tax impact selling NWS and TWX stock of $34 per LCAPA share would be eliminated, thereby driving LCAPA’s stock price closer to a “tax-effected” value of $122 a share (40% upside potential).

With regard Liberty’s stakes in other AFS securities, including Sprint, Motorola, Embarq, Viacom, and CBS, it is unclear as to what sort of tax-efficient means may be employed to address the low cost basis and tax impact of liquidating these securities. Malone could just as easily address these investments with similar deals (in particular cash/rich asset swaps which would be easier with Viacom/CBS given they are media companies). With the remainder of the AFS portfolio (ex. NWS and TWX) having a value of ~$4BN and a cost basis of around $830MM, the tax impact of liquidation would be about $1.27BN or $9 per share. If Malone is successful with doing a transaction with NewsCorp and Time Warner, the market will likely assume that the other AFS securities have a high probability of being addressed with similar strategies; LCAPA’s shares may then no longer trade at as large of a discount to the tax-affected liquidation value of the remaining AFS shares.

Liberty Capital Valuation:

Below is a chart valuing the operating businesses, the AFS portfolio, and the adverse tax impact that a liquidation of the AFS securities. A few notes on the valuation of the owned businesses:

--For Starz/Encore and On Command, the assumed multiples of 5x-7x, which would be at a discount to more valuable assets such as Showtime (10x) and HBO (12x) that produce their own programming.
--Other assets such as IDT, True Position, and Fun technologies are assumed at acquisition cost.
--Values for other assets, private investments, some of the smaller stakes in public securities, and the net derivatives positions have been assumed from the 6/30 balance sheet.
--For all AFS securities, the values are current market prices of the respective stocks.

Business        % owned    FY07 EBITDA    Multiple    Value
Starz            100%        $185            7        $1,295
OnCommand        100%         $50            5      $250
IDT            100%                                 $400
Fun Technologies 55%                                 $190
True Position    89%                                $300
Non-Consolidated Other Private                        $600
   Total Business Value                               $3,035

Fully Diluted Shares O/S                              140.5
Business Value/Share                                $22

Public Securities
                 % owned    # of Shares(MM)    Current Price      Value
NewsCorp (NWS)        19%        188.0            $21.8            $4,091
Newscorp (NWS/A)      16%        324.6            $20.9         $6,795
   Total Newscorp                                                 $10,886
Time Warner (TWX)    4%      171.2          $19.8            $3,386
Sprint/Nextel (S)    3%       85.0          $17.2          $1,463
Embarq (EQ)            3%          4.3          $51.5          $219
Motorola (MOT)         3%       76.3          $23.6          $1,802
Viacom (VIA)           1%          5.1            $38.2            $195
CBS Corp (CBS)         1%          5.1          $27.9          $142
Open TV (OPTV)        29%         39.4           $2.9          $113
Priceline (PCLN)       1%        0.1          $40.7          $4
Other Equity & Debt Securities                                    $1,000
Derivatives                                                        ($443)

Total Public Equity Value                                        $18,767

Fully Diluted Shares O/S                                           140.5
Public Equity Value/Share                                           $134

Total Value of LCAPA                                           $21,802
per Share                                                         $155

Net Debt                                                        $3,020
   per Share                                                         $21

Net Equity Value                                                 $18,782
   per Share                                                        $134

Cost Basis for AFS Porfolio                                       $3,000
AFS Value Less Cost Basis                                        $15,767
Tax (at 40%) = Max. AFS Tax Liability                           $6,307

After-Tax Equity Value                                           $12,475
   per Share                                                         $89

Risks:

Because NewsCorp extended its poison pill provision for another three years, Murdoch doesn’t have a “gun to his head” to do a transaction with Liberty right away. However, NWS does want to shrink its capital structure and buy in as many voting shares as possible.   In three years, Murdoch will have to face the same issue with regard to losing more control of NWS (the vote was actually relatively close this time around with 57% approving the poison pill provision but 43% dissenting). Moreover, Murdoch has the chance to buy back a very large chunk of shares that he likely believes are trading below intrinsic value.

A possible swap for NWS shares in exchange for the 38% stake in DirecTV would still result in the inheritance of the NWS’ cost basis of DirecTV (at ~$14 a share, currently trading around $20 a share), thus there would not be a complete elimination of all tax liabilities should Liberty decide to sell/merge DirecTV.

LCAPA’s shares’ value are 90% tied to the value of its public securities portfolio and changes in the valuation of NWS and TWX in particular can have a large impact on the valuation of LCAPA. The thesis of the LCAPA shares are predicated upon one believing (as I do) that NewsCorp and TimeWarner are undervalued or at least fairly valued equities. If one believes them to be under-valued, there is an additional element of a margin of safety as any appreciation in these shares will be reflected in LCAPA shares regardless of whether a transaction happens.

To the extent that Liberty ends up with TV stations, the Atlanta Braves, and other disparate businesses (including DirecTV), there may still be a discount applied to the shares; Malone is likely to potentially split-off or sell some of these businesses, however doing so will again take time. If Liberty swaps for a DirecTV stake, it would likely be positive for Liberty, as these are cash flow generating assets that Liberty will have access to (assuming dividends are paid) and can be levered (to buy back DTV stock and increase Liberty’s ownership). A merger with DTV and Echostar further on down the road could result in tremendous accretion given the massive cost synergies (programming and satellites) that could be realized, although again, this would be a longer-term event.

LCAPA is a tracking stock which means that the assets and liabilities assigned to LCAPA are legally assets/obligations of all of Liberty Media (including the assets “tracked” by Liberty Interactive). Should there be an adverse event (i.e. litigation, acceleration of debt), Liberty Media could be required to uses Capital’s assets to pay Liberty Interactive’s liabilities. Moreover, there is an inherent conflict of interest in having one Board of Directors for both trackers that may render decisions that adversely affect one tracker to the benefit of the other; however with most of the “holding company discount” being isolated at LCAPA, it is highly unlikely that Malone would support any type of value destruction at this entity.

Catalyst

--Liberty conducts tax efficient asset swaps with NWS and TWX

--Price appreciation of Liberty Capital's Investment Portfolio

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			2006	2007
Price:	87.70	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	12,360	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT