Description

Liberty Media owns a diversified portfolio of public and private media businesses. L’s stock has been cut in half over the past two years and currently suffers from extremely negative sentiment towards the media & telecom sector, pessimism regarding the Company’s European cable initiatives and an aversion to complexity. None of these factors are “fundamental” in the longer term and create a unique opportunity for patient investors...

With a normalization of the current discount to NAV and growth of its businesses, Liberty is poised to generate a 40%+ IRR of the next 24 months.

Why I believe the stock is a buy:

ATTRACTIVE VALUATION:
(1) Liberty is trading at 43% discount to its intrinsic or “fair” value based on a sum-of-the-parts analysis (described later). This is the widest margin of discount at any point in the past six years.
(2) L’s portfolio of public market investments are worth $7.70/share with almost $4/share of that value derived from hedged securities. L’s $4/share of hedged public holdings provide some downside protection in the event of a decline in public holdings.
(3) With $1/share in net debt and $7.70/share in public holdings, the market is valuing L’s private market assets at less than $1.50/share. This represents an 82% discount to a “fair” value (described later) for these profitable and growing businesses.

[Note: I am recommending this as a long; however, one could short the public holdings in proportion to L’s ownership to isolate the value of the private assets.]

HIGH QUALITY BUSINESSES:
(1) L’s largest private businesses include Discovery Communications, QVC and Starz!Encore. All of these businesses dominate their respective programming niches, are growing cash flow at over 12% per annum and have high FCF characteristics.
(2) Over 80% of L’s public assets are represented by five blue chip securities – News Corp., AOL Time Warner, Sprint PCS, USA Networks and Motorola. Management views these as both strategic investments and “trading” currency to increase the scale and value of the overall Liberty franchise. Sprint PCS and Motorola are almost 100% hedged with both News and AOL poised to benefit from a recovery in the ad cycle, which has started to materialize.
(3) L has one of the strongest balance sheets in the media industry, which is a competitive advantage allowing L to capitalize on currently depressed values. L has $2.8B of net debt, which is covered 7 times by its portfolio of liquid public securities.
(4) Liberty’s “incubator” assets, including UnitedGlobalCom (Europe), Telewest (UK) and Jupiter (Japan), offer future upside that I have not valued for conservatism.

MANAGEMENT TEAM:
(1) L is owner-managed by a team widely regarded as among the best in the industry. John Malone is L’s largest shareholder, owning 7.5% of the Company. Other management own 1% with rights to options for another 3% (exercise @ $11.69/share).
(2) Management has a demonstrated track record over the past 20 years – 20.4% annualized returns. Anybody that has followed Malone knows that it is always good to be on his side of the table – see Liberty Media rights offering (1991).
(3) Insiders have been buying shares in the recent $8-$10/share trading range.

CORPORATE ANALYSIS:

Liberty’s collection of assets is focused on premium content and “last-mile” distribution. Liberty has a strong core of public and private holdings. The private holdings help balance volatility in the public portfolio. In total, L’s portfolio exhibits a balance of content, distribution, geographic diversity, and exposure to the ad cycle.

Principal Private Assets:

On an NAV basis, L’s private holdings represent roughly 50% of L's NAV or roughly $21B. Approximately 80% of the $21B is represented by Starz!Encore, QVC and Discovery.

Starz! (100% owned) is a premium movie channel, operating 15 channels with roughly 121 million subscribers. Starz! distinguishes itself from HBO and Showtime by only offering movies and limited-to-no original programming, which allows them to avoid programming costs and uncertain results. Starz! is the most profitable premium movie channel despite charging the lowest monthly fee. Starz! generates EBITDA margins of 36% vs. 30% for HBO and 21% for Showtime. The profitability is the result of favorable license arrangements with AT&T, limited programming costs and little marketing expense. Starz! has FCF margins in excess of 25% which is among the highest in the industry. Growth and profitability will be driven by the continued roll-out of digital cable and video on demand. For 2002: Sales of $969M, EBITDA $367M.

QVC (42.6% owned) is a home shopping network selling a variety of consumer accessories. QVC’s only significant competitor is the Home Shopping Network, which is part of USA Networks (20% owned by Liberty). QVC and HSN represent 85% of the multi-billion dollar home shopping industry. For 2002, QVC is expected to generate $841M of EBITDA (19 margin) growing at 10-12% per annum. QVC is a mature business but one that should grow its cash flow at rates in the mid to low teens. QVC is managed and controlled by Comcast which owns the remaining 58%. Liberty has a put right to sell QVC to Comcast over the next two years, which they intend to exercise. This will likely represent proceeds well in excess of $5B.

Discovery Communications (49.8% owned) offers 20 channels focused on informative and educational programming. Discovery has over 700 million subscription units worldwide. Of the 45 current domestic cable networks, The Discovery Channel is tied with ESPN for #2 in total subs behind Turner Broadcasting (TBS). Discovery is also among the Top 10 most highly ranked networks and is considered one of the premier cable nets. Unlike Starz! and QVC, Discovery is exposed to the ad cycle with roughly 50% of revenue from advertising and 50% from subscriber fees. For 2002, Discovery is expected to generate $372M of EBITDA on revenue of $1.75B. This somewhat distorts Discovery’s earnings capability as they have a number of “immature” channels that are ramping up profitability. Discovery’s mature channels are generating $550M of EBITDA offset by losses in the developing channels and consumer division – mature channels generate 50%+ EBITDA margins vs. current overall margins of 38%. Discovery is owned with Cox (24.9%) and AOL/Newhouse (24.9%). Discovery should continue to exhibit impressive cash flow growth and hence garner a premium multiple.

Liberty also owns Jupiter Telecom & Programming (50% interest) which is the largest cable operator in Japan with 1.7 million subs. Jupiter also owns a number of cable channels. In Europe, Liberty has interests in UnitedGlobalCom (#1 European cable operator) and Telewest (#2 U.K. cable operator). Both are in the midst of contentious restructurings so the future is to be determined. Given the uncertainty of these investments they have been held at cost. That said, I believe Malone and team will make these assets important value generators for Liberty.

Why has the stock performed poorly?

(1) Decline in Media & Telecom Assets. As we all know, the sector has been crushed. Liberty has not been immune to failed investments (such as Teligent, ICG and Astrolink). I estimate these failed investments cost shareholders $1-2/share in value, although L has been penalized significantly more. More fundamentally, L has been hit by a sharp decline in its public holdings. Last year it took a $6BN write-down for AOL, Telewest, News Corp, etc.
(2) Negative Perception of Complex, Holding Company Structures. There is a belief that L’s public market interests should trade at a discount as a result of double taxation (see tax implications later). While understandable, L has been an extremely tax-efficient vehicle and quite savvy in monetizing investments tax free. Secondly, investors seem to be ascribing a “complexity” discount. While complex, Liberty and Malone have a history of working for shareholders not against them and generating real value (see rights offering). I believe the excessive market sentiment creates an opportunity to buy L at an abnormally low price.

What are material risk factors?

(1) Continued Deterioration of Public Holdings. Most all of L’s public holdings are trading at 12-month lows. These investments could continue to decline. Although L has hedged much of its exposure, the Company still maintains material exposure to Vivendi, News Corp and AOL. [All of which could be short candidates based on your own perception. Personally I am short Vivendi]. That said, I have calculated that a 50% decline in the value of L’s top five public holdings (or 80% of the public holding value) would reduce the NAV by only 12% because of the hedging, still yielding a 30% discount to NAV. [Hedges are all with AA-rated counterparties]
(2) Prolonged Advertising Recession. In 2001, domestic advertising declined 9%, the worst single-year since 1938. Initial indications based on the broadcast and cable upfront market indicate that these markets have hit the trough and are likely to generate 5-8% growth in 2003. There is numerous other evidence that the broadcast/cable ad market is firming. Should the economy slow, L’s public holdings will be challenged but I’m happy to hold for the longer term as the value is there.

What are the implied tax implications?

It is believed that L trades at a discount to NAV largely as a result of the tax impact of asset sales. I do not believe the current 45% discount NAV is warranted on this basis.

At 3/31/02, the BV of L’s investments was $30.4B. Based on L’s book deferred tax liability of $6.7B, this implies an unrealized gain relative to book value of $17.8B ($6.7B / by 37.5% tax rate). Therefore, the net tax basis is estimated to be $12.6B, which is $30.4B BV less $17.8B implied gain. If Liberty liquidated its entire portfolio today at “fair” value of $15/share, the Company would receive proceeds of $40B. This creates a tax liability of $27.4B or taxes due of $10.3B. In the worst case scenario, this suggests a tax-related discount of 25.7%. I believe this is unjustified as Liberty will manage these assets over the long-term and it is unlikely assets will be monetized at one time. Second, Liberty has a track record of turning over assets at premium prices but doing so tax efficiently (generally they trade stock interests).

If you look at the more likely scenario of L monetizing certain non-strategic and other assets periodically over time this implies a discount in the range of 13-14% assuming all cash (which again is unlikely). Assets likely to be sold in the next couple of years include Sprint PCS, Motorola, QVC, E! Entertainment and Court TV.

Historically Liberty has traded at a discount in the range of 0-20%. Based on the analysis above and the historical range, I believe a normalized discount of 15% is reasonable.

VALUATION (in millions):

Public Market Investments: Value % Total
Sprint PCS $5.5B 13.1%
News Corp. $4.7B 11.3%
AOL Time Warner $2.5B 6.0%
USA Networks $2.1B 5.0%
Motorola $2.0B 5.0%
All others (18 stocks) $3.8B 8.8%
Total Public $20.6B 49.2%

Private Market Investments:
Discovery Communications $6.3B 15.2%
Starz!Encore $5.8B 14.0%
QVC $5.3B 12.6%
Jupiter Telecom $1.4B 3.3%
All others (a) $2.4B 5.7%
Total Private $21.2B 50.8%

Total Public/Private Value $41.8B
Less: Consolidated Debt $5.5B
Plus: Cash + Equivalents (b) $2.7B
Plus: Option Proceeds $0.9B
Equity Value $40.0B
FD Shares 2.6B
Per Share Value (NAV) $14.96

Current Market Price $8.48
Discount to “Fair” 43.3%


ADDITIONAL VALUE ANALYSIS:

Current Market Price $8.48
Plus: Net Debt Share $0.70
Current TEV Per Share $9.17

Less:
Value of “Hedged” Public (c) $3.72
Value of “Unhedged” Public $3.99
Value of Public Assets $7.71

Implied Market Value of Private $1.46
“Fair” Value of Private $7.95
Implied Discount 82%

Assume: 15% Holding Co. Discount

Public at 15% Discount $6.55
Implied Private Value $2.62

Private at 15% Discount $6.76
Discount to “Fair” 61%


PRIVATE HOLDINGS VALUATION ANALYSIS:


EBITDA Multiple Value

Discovery (d) $372 varies $6.3B
Domestic (Discovery/TLC) $394 17.5x $3.4
Domestic (Animal/Travel) $40 $30/sub $1.8
Domestic Developing $(60) $25/sub $0.5
International $117 17.5x $1.0
International Developing $(80) $5/sub $0.4
Consumer $(40) -- $0.1

Starz $367 16x $5.8B

QVC $841 15x $5.3B

Jupiter $2,750/sub $1.4B



Private Market Value: I have also performed discounted cash flow valuations for Discovery, Starz! and QVC. Interestingly, they were higher than the multiple values. The implied DCF value for Discovery = $6.5B, Starz! = $6.5B and QVC = $6.2B.


(a) Includes 50% interest in CourtTV, 84% interest in Game Show Network, Fox Kids Preferred Stock, 10% in E! Entertainment and various other assets.
(b) Pro forma for $680M from sale of Telemundo to NBC.
(c) Includes value of exchangeable debentures.
(d) Net of $2.2B debt.

Catalyst

(1) announced plans by management to utilize $500M or more of existing cash to buy back stock (3% float); (2) issuance of tracking stock in ’02 for international cable assets; (3) resolution of UnitedGlobalCom and Telewest restructurings in ‘02; (4) exercise of QVC put right which will highlight “fair” value of this private asset; (5) recovery of advertising sector with 5-7% broadcast and cable ad growth for 2003; (6) private market businesses growing at 12-15% with double digit FCF characteristics.