Description

Liberty is a collection of high-quality, growing media assets run by a very shrewd major shareholder. The 37% discount to NAV is just too wide and will get closed one way or another. The stock is basically cheap due to dead money concerns that are more-or-less overblown, and in any case are not an issue for patient capital.


Valuation
Liberty is a holding company that has evolved through decades of John Malone’s dealmaking in the media business. The main components of value are QVC (about 40% of NAV), News Corp (18%), InterActive Corp. (4.3%), Expedia (3.8%), Time Warner (7.6%), Sprint (7.3%), and Motorola (4.1%). I estimate the NAV at $12.28. Currently, the stock is at $7.73, implying a 37% discount. Historically, the shares have traded at a 15 – 50% discount. NAV is growing.

While I’m valuing the company’s public holdings at market prices (plus associated hedges), I would argue these holdings are a representative sample of a sector – big media – that is hardly frothy at the moment and might even be cheap. Witness Carl Icahn’s actions to unlock value at Time Warner (TWX), John Malone’s actions to unlock value at News Corp (NWS, NWSA), and Barry Diller’s actions to unlock value at InterActive Corp. (IACI). And according to VIC member mitch395, Sprint is a value as well.


Why is it cheap?
Most analyses of Liberty attribute this discount to one or more negatives typically associated with holding companies.

1)Taxes – on the 3Q05 conference call of November 9th, management basically implied that the potential tax liability from a “brute force” liquidation of the company’s holdings would be about $3.60 (based on my NAV estimate and comment that the stock was then trading at a 10% discount to the after-tax NAV). But frankly I don’t think there is any serious observer of this company that truly believes Malone will end up incurring even a fraction of this sum. Just look at his 20+ year track record of legally avoiding taxes time and again. There are much more important factors driving the discount.

2)Transparency - the downside of this tax avoidance is complexity. For example, Liberty’s public equities are largely hedged through a myriad of derivatives. The most significant of these involve some convertible debt instruments called exchangeable debentures. Liberty issued most of these around the height of the stock market bubble in 1999-2001, and in doing so essentially pulled in cash in return for issuing a convert for which the buyers were grossly overpaying. Due to the overvaluation of the underlying shares, buyers were way too optimistic about the value of the embedded call options. In addition, Liberty got a significant tax shield due to the spread between the roughly 9% imputed interest rate Liberty uses for tax purposes and the roughly 3.25% it actually pays). So the point is, this is not needless complexity, and it’s not complexity designed to disguise reality. It all serves to create value.

So yes, Liberty is an analytical pain in the neck. And to some extent the derivative positions can change a bit before you know it. But look, you’re a smart fellow, and besides I’m going to save you some time by posting my detailed NAV model (hopefully in next couple days).

Besides, it’s getting simpler. Liberty was a far more complex company when it was spun off from AT&T in 2001 than it is today. Since then the company has done two spin-offs of its own: Liberty Global in 2004 and Discovery Holdings in 2005. There will be more simplifying transactions to come. Liberty has acknowledged that the new Liberty Capital will be quite complex relative to its size and that it will therefore be incumbent on management to do a better job of explaining all the tax issues, potential transactions, etc.

3)Dead money concerns – I think this is by far the main reason for the discount. Malone has made it clear that he wishes to eliminate the discount and will seek to transform Liberty from a holding company to more of an operating company. Like all great value investors, Malone is patient and won’t tip his hand and spoil a chance to get a great bargain. Thus, investors are left wondering when the next move will come. Further, with the spins of Liberty Global and Discovery, all the significant remaining assets appear to have some sort of near term impediment to separation (though a number of these probably will likely take only a few months to a couple years to overcome – more on this later).

Adding to this concern, a quick glance at the chart shows a flattish stock over the past two or three years. But that’s misleading. Factoring in the spinoffs of Liberty Global and Discovery Holdings, the stock has gone up more than 30% since the middle of 2002.


Before I talk about how the discount might narrow, let me stress that a narrowing of the discount is NOT the only way to win here. Intrinsic value is growing significantly at QVC, which accounts for about 40% of Liberty’s NAV. And again, there are signs that many of the big media names in Liberty’s portfolio could be selling at distressed prices.

Since QVC is such a big piece of the pie, it behooves me to provide a little detail. QVC is the world’s largest home shopping network with 60% of the US market, as well as operations in the UK, Germany, and Japan. This is a high quality business, as barriers to entry are high, and its scale allows for far better economics than its nearest competitor, the Home Shopping Network. QVC is fairly mature in the US but still has significant growth opportunities abroad.

EBITDA grows in three ways. One is to increase the number of households that get the channel. Pay TV penetration is still growing at 2-3% in the US and faster internationally. And more importantly, QVC can still gain carriage on cable systems that have not yet signed up for QVC’s service. So that’s one driver.

The second driver is getting each customer to buy more. It turns out that only about 8% of all homes that receive the QVC channel actually make a purchase each year, and this number has been fairly consistent for a decade. Nevertheless, QVC has been able to increase the average revenue per active customer about 6% per year since 1996, with double digit increases in recent years. International growth in revenue per customer growth is even faster and will probably remain so for a while. As QVC becomes more established in a market, consumers are willing to make larger purchases.

The third driver is improving EBITDA margins. The cost structure consists of call centers, affiliate fees to cable/DBS firms, distribution costs, credit card fees, and bad debt. A close look at these costs suggests that future margin expansion in the US is unlikely - domestic EBITDA margins have been about 20% for over ten years. But internationally there is room for improvement. In 2001 when Comcast consolidated QVC’s results, international EBITDA margins were negative. By 2003, they were at 12%, and by 2004 they had improved to more than 16%. Like revenue per customer, international performance will likely continue to approach US performance.

But wait, there’s more! (As they say on TV) QVC’s website, QVC.com now generates nearly $800 million in annual domestic sales, making it one of the largest online retailers and 15% of total QVC revenues. This represents a 33% CAGR – comparable with companies like eBay and Amazon.com, which grew revenues at 44.1% and 27.6% respectively over the same period, though admittedly off a larger revenue base. (eBay has twice the sales, Amazon.com has 3X.) For what it’s worth, eBay and Amazon are selling at cash flow multiples in the high 20s.

Some have worried that QVC sales will slow as the types of home entertainment proliferate. I basically don’t. If this were to happen it would show up in lower sales per customer. But since 1996 we have seen a dramatic acceleration in VOD, DVR, and digital cable, yet no evidence that QVC’s results have been affected.

So when you add it all up, EBITDA is growing at a high-teens rate, and management expects growth to continue at about a 10-12% pace for the next five years. While current markets offer ample room for growth, it should be noted that China and India may someday provide additional opportunity. (Incidentally, the business model requires a fairly large market to achieve scale, so potential markets are currently limited to the current ones plus China and India.) Given this growth and the fairly low capital intensity (D&A only 30% of EBITDA), I think the 13X EBITDA multiple I use to value QVC is very reasonable, even before you consider that QVC will not pay taxes for the next couple years due to NOLs, and that Malone is probably going to find a way to shield the bulk of future taxes.

By the way, many analysts have used Liberty’s purchase multiple in the Comcast transaction as a benchmark for the current valuation of QVC. That’s too conservative. In September 2003, Liberty purchased the 56.5% of QVC that it did not own from Comcast for $14 billion, which implied an 11.4X multiple based on 2004 operating cash flow. But this valuation was likely suppressed for three reasons: 1) Comcast had right of first refusal and was under pressure to reduce debt. As such, Comcast was not willing to step up to purchase QVC and accepted Liberty’s offer, 2) domestic ops had had a couple below-trend growth years in 2002 and 2003, 3) fast-growing QVC.com was still a relatively small part of the total at the time.


Malone can/will take the following steps to close the discount to NAV:

1) Tracker
On Nov. 9th Liberty announced plans to issue a tracking stock of its interactive commerce assets. The new stock (“Liberty Interactive”) should consist of QVC and the company’s IACI, EXPE and a few other smallish interactive holdings. This probably will represent somewhere between 70 - 85% of the company’s asset value.

The remaining assets would be retained in an investment vehicle (“Liberty Capital) with an emphasis on developing growth operating assets. The overall strategy has not yet been fully defined, but will likely involve swapping some of the public holdings for operating assets and/or opportunistic distressed investing. Greg Maffei was recently hired to run it.

The announcement was met with a resounding snore from Wall Street, as the shares didn’t budge. But it actually makes decent sense as a prelude to a full legal separation of the two entities, which Malone has indicated is probable in two to three years. There’s good reason not to do a legal separation today, as there are still substantial tax attributes that are very beneficial to the company as a whole that would not be available if we do a separation earlier than two to three years.

Also, there is some true economic benefit of the tracker in the meantime, namely increased options to repurchase equity (i.e. they will be able to buyback either the Interactive tracker or Capital, or both, depending on which becomes relatively more attractive. Management recently stated “we certainly wanted to have sufficient capitalization that if [the Liberty Interactive] equity underperforms, which we don’t expect, that it could systematically shrink its equity.”

Frankly, I’m not counting on the tracker to help close the discount. But I don’t think you need to. There are numerous other ways.


2) Vulture investing
While most analysts like to talk about cashing in Liberty’s various public equities (and I do too), I think the most important transactions could very well be ones that we can’t foresee today, since we don’t know what opportunities will present themselves. Many of the shrewdest Malone deals could probably not have been predicted two years in advance. For example, Malone has been held back by a frothy LBO market, so any broad economic weakness could actually help to enhance Liberty’s value as it would likely remove much of the competition for certain media assets.

As an astute investor once said, “the opportunity set today is not the only one that should be considered.” (1) Or as Malone more bluntly put it at the AGM, “just because it doesn’t seem that there are lots of opportunities out there today, it doesn’t mean that there won’t be lots of opportunities tomorrow. This is especially true in a rising interest rate environment with an unstable high-yield market … we believe that a lot of the private equity deals that have been so highly leveraged will come unglued in the next couple of years and give us the opportunity to do some very favorable acquisitions in that space, probably coming at them through the debt side.” Note that it wouldn’t be the first time Malone created value in the distressed markets – he did quite well with the 2001 UPC high yield debt tender that was the genesis for Liberty Global.

Bottom line – the debt markets are likely to crap out and Malone will be there to pluck the bargains.


3) Swapping public equities for operating assets (in a tax-free deal, of course)
This is Liberty’s primary modus operandi for avoiding capital gains taxes, and Malone has repeatedly expressed a desire to turn passive equity stakes (that the market usually discounts) to operating assets, particularly media content (as opposed to media distribution). Here’s my take on what is likely/unlikely to happen:

News Corp
There has been much speculation on a deal that would move Liberty’s public voting stake in News Corp (NWS) back to NWS in exchange for certain operating assets of NWS – possibly its stakes in the National Geographic Channel, which would be a nice fit with DISCA (which Malone controls). Liberty has unwound 174.4 million NWS shares from associated hedges over the last nine months and now has ready access to these shares in the event a deal can be reached. Talks between the two sides stalled, however, over the summer of 2005. Meanwhile, NWS extended its poison pill provision in October 2005 to last another two years, and in the process squashed hopes for a near-term catalyst.

In any event, Malone has used Liberty’s significant NWS stake (including 18% of voting shares) to publicly prod NWS CEO Rupert Murdoch into adopting “a systematic process of focusing a little bit more on shareholder returns and a little less on empire building …” Malone probably has multiple goals here: 1) just what he said – get Murdoch to stop the empire building, which has hurt Liberty somewhat as NWS comprises about 18% of Liberty’s NAV, 2) obtain better terms and/or a quicker resolution on a share-for-operating assets swap.

Bottom line - a major deal is definitely possible. Sure, I don’t know exactly when.


InterActive Corp/ Expedia
Malone is keeping a close eye on the split up of InterActive Corp. and has said that if the market undervalues any of the pieces then L could be a buyer of those assets. One potential deal would involve Liberty’s IACI stake being exchanged for control of QVC’s main home shopping rival, the Home Shopping Network. IACI seems to be focusing on Internet assets, which raises the possibility that IACI might be interested in shedding its HSN stake. This would put Liberty in control of the largest two of the three largest home shopping channels (NBC owns the third).

I’m not entirely clear on just what the synergies might be here, suffice it to say I have heard some folks raise doubts. In any case, it’s not clear to me that IACI would be keen on re-acquiring the 21% ownership in Expedia that it just spun off. Moreover, such an exchange could have taken place at any time over the last two years and yet nothing has happened. Finally, Liberty has time and again stressed that it views these holdings as strategic assets.

Bottom line – I’m not counting on this one.


Time Warner
Liberty has expressed interest in increasing its ownership of cable networks and TWX certainly has a few to chose from, such as the Cartoon Network, Court TV, CNN, HBO, TBS, and TNT. Time Warner owns 100% of all these networks except Court TV, of which it owns just 50%. Interestingly, Liberty owns the remaining 50%. One possibility, therefore, would be for Liberty to exchange its shares in Time Warner for the portion of Court TV that Time Warner currently owns.

A transaction with TWX could be complicated by the fact that Liberty has effectively written a covered call on 100 million of TWX shares through its 0.75% senior exchangeable debentures, which are different from Liberty’s other exchangeable debentures. They not only give Liberty the right to redeem the debentures after April 2008 but also allow the bondholders to put the debentures back to Liberty on March 30 of 2008, 2013, and 2018. If Liberty unwinds its stake in TWX, these debentures effectively become more like a naked call on TWX. Should the TWX bondholders exercise the call option, Liberty would either need to buy $100 million shares of TWX in the open market, pay the $1.8 billion principal in cash, or issue Liberty stock worth $1.8 billion and face dilution. Liberty probably would not want to issue equity at these prices, and may not want to part with TWX shares at their current prices. Additionally, Liberty would lose out on the tax shield of the debentures.

With 171.2 million TWX shares, Liberty might therefore only be able to use 71.2 million in any strategic transaction. These should, however be sufficient to buy Time Warner’s 50% stake in Court TV and probably a bunch of other stuff too.

In place of an exchange for operating assets, or perhaps in conjunction with one, it’s possible that Liberty could sell some of its shares into TWX’s announced $12.6 billion share repurchase program. But this would require Liberty being willing to part with its shares at market prices – not necessarily going to happen.

Bottom line – a definite maybe.


Buyback
While management is acutely aware of the discount placed on its shares, I don’t expect significant share buybacks unless the stock got a bit cheaper. That said, Liberty has done significant repurchases and management has recently stated they’ll do one again if they can’t find more attractive investment opportunities.

I’m actually comfortable with this current hesitation to buy back shares. For one thing, the cash for a buyback would likely either come from a sale of some public equities (with all the complications mentioned above), or from levering up. Liberty is actually likely to lever up since QVC is expected to become a taxpayer in a couple years after it uses up Liberty’s NOLs. An acquisition with some capital intensity would be attractive, therefore, as the depreciation charges coupled with any interest coming from debt used to make the acquisition could help to shield EBITDA from taxation. Malone has said some acquisitions for QVC have been explored lately.

Also, Liberty is basically a content player in a world where media distribution (cable, satellite, etc.) has consolidated significantly. As with any industry, companies that sell to a consolidated distribution sector need scale in order to have pricing power. Shrinking its equity base would make it more difficult to achieve this scale (although, again, if Liberty shares got cheap enough they’d probably be tempted).

Bottom line – a buyback would probably happen if the discount widened another 10% or so.

Apologies for the length of this writeup, but it’s a complex story and I hope this level of detail will save some VIC members a good bit of time.

(1) attributed to Seth Klarman of the Baupost Group

Catalyst

1) the often overlooked fact that NAV is growing (and public equities might be selling at depressed valuations)
2) an opportunistic purchase we currently can't foresee (most likely a media LBO that comes unglued)
3) probable deal w/ News Corp
4) possible deal w/ Time Warner