Background: Liberty Interactive (LINTA), a tracking stock of Liberty Media, represents wholly owned subsidiaries QVC and Provide Commerce as well as controlling minority stakes in IAC/Interactive Corp and Expedia, both publicly traded companies.

 

This writeup focuses entirely on the QVC portion of the business, which accounts for 70% of the value of the stock at market today.  The remainder (except the e-commerce assets, which are quite minor) can be hedged away on the public market if the investor doesn’t feel comfortable with their prospects.  I don’t want to get too sidetracked on IACI and EXPE, but I can certainly delve into it more if people are interested.  EXPE was written up on this board a couple of years ago, but that writeup missed a couple of significant parts of the story, and much has changed since then. 

 

Thesis: The current market valuation of LINTA significantly undervalues its main subsidiary and operating asset, QVC.  After backing out the value of its publicly traded assets, QVC trades at multiples of 10x and 16x forward EBITDA and earnings, respectively.  This represents a discount to its retail peers, despite QVC’s significantly higher growth rate, very low capital intensity, and dominant market position.  By comparison, Costco trades at a 2007 P/E ratio of over 20x, despite having similar historical and projected bottom-line growth (10%-15%) – and unlike QVC, Costco has to reinvest a major portion of the cash it generates in the business to keep this growth up!  There is no reason to believe QVC shouldn’t trade at a multiple closer to 25x.  The QVC stub is currently priced to return over 16% (6%+ FCF yield + 10%+ FCF growth) annually over the next 5+ years even without the benefit of any of the potential catalysts described later.  The effect of stock repurchases and potential multiple expansion should boost this return even further.

 

The market has been undervaluing this company for the following reasons:

 

-          Liberty Capital: Since the creation of the tracking stocks, the market has concentrated its attention on Liberty Capital, which has captured the headlines for its deals with News Corp and Time Warner.  Meanwhile, Liberty Interactive has been left to languish.

 

-          Opaque accounting: Liberty Interactive has not gone out of its way to make its story understood to investors.  For example, even though retail stocks are valued on P/E, LINTA does not report earnings pro forma for its significant non-cash intangible amortization charges, and only very recently have any research analysts taken note of it at all.  In addition, LINTA has a number of other complexities relating to its public stakes, minority interests, and taxes, and it takes a bit of patience and effort for an investor to sort out.

 

-          Tracking stock structure: Despite the tax advantages, investors don’t seem to like it.  However, the structure hasn’t stopped LINTA from returning nearly $1 billion to shareholders via repurchases in the last year. LINTA can be spun off completely starting in 2008 (once QVC has been owned for 5 years).

 

-          Potential tax overhang / complexity: This relates to LINTA’s stakes in IACI and EXPE, which would trigger a tax liability (around $2 per share) if sold, and generally add to the complexity of the stock.  However, there are many possible exits that would avoid the tax liability, which will be discussed in detail later.

 

-          Lack of history as a publicly traded company: QVC has not been publicly traded since it was taken private by Comcast and Liberty in 1995. This is significant because investors are not familiar with the returns QVC has produced since it was bought.  The 1995 buyout was worth $2 billion, half of which was funded with debt. (For reference, this was about 9x forward EBITDA and 25x forward earnings).  Liberty’s 2003 buyout of Comcast’s stake valued QVC at $13.6 billion (11x forward EBITDA). Factor in the effect of leverage, as well as the actual cash the company threw off over that period, and we have an IRR that probably came close to 50%, not bad for a relatively mature company over a long period of time.  If QVC had been a public company during that period, it would likely have been one of the top performing stocks in the last decade.

 

 

QVC is the leading home shopping network in the US, capturing approximately 60% of all domestic home shopping purchases, with most of the remainder going to HSN (owned by IACI). QVC owns home shopping networks in the UK and Germany, and 60% of QVC Japan.  Its customer base tends to be mostly female, aged 35-54, and its merchandise tends to be geared toward that audience (jewelry, makeup, clothes, home furnishings). Merchandise is a mix of name brands (Kenneth Cole, Bose, etc.) and proprietary brands, as well as a number of products from new vendors.  Prices are lower than they would be in retail stores, but margins are still ample because of the lower overhead and marketing expense associated with home shopping. 

 

 

-          Limited competition / market power: The home shopping market in the US is essentially a duopoly between QVC and HSN - the market split is approximately 60/30, with the remainder going to ShopNBC.  Entering the US market is difficult, if not impossible, as home shopping requires significant scale to cover fixed overhead costs, and getting favorable carriage deals with cable operators is difficult. 

 

As the leading home shopping network in the US, QVC also has the advantage of being much more attractive to suppliers (who typically have to sign exclusive sales agreements) which in turn further entrenches it.  QVC’s market power has allowed it to capture the benefits of increased efficiency and scale in profits, instead of having it competed away by new entrants and existing competitors as is almost always the case. QVC’s domestic EBITDA margin grew from 16% in 1996 to 24% in 2006 almost entirely due to reduced operating expense.  By comparison, HSN’s EBITDA margin is around 12%.

 

-          Loyal customers: 60% of people who buy from QVC in a given year buy again next year, a rate double that of catalog retailers.  Among those that buy more than once in a year, the repeat rate is 80%-90%.  Furthermore, longtime customers buy more than newer customers; customers that have shopped with QVC for 1-5 years spend $549 annually, while those that have shopped 15-20 years spend $1261 annually.  This last statistic helps explain why average spending per customer has almost doubled over the past decade, driving growth even as the share of cable subscribers that shop at QVC has stayed constant (about 8%).  These statistics also suggest that QVC will experience meaningful revenue growth naturally as the average tenure of their customers naturally rises over time.

 

-          Capital-light business model: The importance of this is difficult to stress enough, especially when comparing QVC to other retailers. QVC’s overall projected growth rate may not be that much better than that of many traditional retailers, but adjusting for the fact that growing traditional retailers often have to use nearly all of their free cash flow to build stores to maintain their growth, QVC’s shareholders fare much better because they can grow at the same rate without investing any significant cash.  In other words, QVC shareholders can have their cake (growth) and eat it too (cash flow).

 

-          Intelligent capital allocation: The most profitable business in the world isn’t worth much to shareholders if management is insistent on pouring earnings down a rathole, but that’s not a worry here.  John Malone has a significant stake in LINTA, which aligns his interests solidly with shareholders, so we won’t see large, overpriced acquisitions for the sake of empire-building.  Furthermore, the company is generally committed to keeping an efficient capital structure (they have stated that they are comfortable with debt levels of 4x-5x EBITDA), and that they will use cash to repurchase stock first as long as it remains at attractive levels, which they have certainly done quite aggressively over the past year.  Overall, their capital allocation policy is exemplary, and it should add significant value for shareholders. 

 

Regarding acquisitions, even though management has indicated it is likely to be conservative, management is cognizant of the fact that QVC is an ideal platform for providing exposure for products targeting women, and QVC has played a key role in some recent success stories, including Bare Escentuals (BARE) and NutriSystem (NTRI), both of which were looking to sell equity just a couple of years ago, and both of which are now billion-dollar businesses that have showered their investors with riches.  Naturally, if QVC management spots a company like that looking for money among their suppliers today, they may be more inclined to at least consider buying a stake.

 

Liberty has also been slowly building a small e-commerce business through acquisition over the past couple of years, mostly around Provide Commerce (ProFlowers).  They have spent $630 million to date, and this business is projected by management to earn about $60 million in EBITDA in 2007, and grow at around 20% annually for the foreseeable future.  These figures would imply that the acquisitions have been a good use of cash – e-commerce companies have strong organic growth and limited capex requirements, and the businesses were acquired for around 11x 2007 EBITDA.  I would estimate that the e-commerce businesses are currently worth about 15x 2007 EBITDA ($900 million) at a minimum – publicly traded e-commerce comps (AMZN, NILE) trade at 25x 07 EBITDA and are growing at about the same rate.

 

Significant growth opportunity: QVC management has guided for high single-digit to low double-digit revenue growth and low double-digit EBITDA growth over the next three years.  Over the past four years, overall revenue growth has consistently been in the low double-digits, while EBITDA growth has consistently been in the high double-digits (see below). This is largely attributable to the international side of the business, which went from about $60 million in EBITDA in 2002 to over $400 million in 2006.  Over that time, the relatively mature domestic business has performed enviably as well, growing about 8% annually on the top line and 10% annually in terms of EBITDA.

         

 

Mathematically, QVC cannot grow faster than the economy forever, nor can operating expenses as a share of revenue shrink forever.  However, QVC still has a very strong competitive position, and if its loyal customers can continue to spend that same share of their income on QVC products as they have in the past, or even a little less, QVC will still grow at 3% - 5% per year, which would still be exceptional for a mature company not reinvesting in the business.  Meanwhile, the international business will be where the real growth is.  Operating margins in the UK and Germany are still 500 basis points below where they are in the US, and cable / satellite is not as ubiquitous overseas as it is here.  QVC is also eyeing China and India as markets for potential entry once cable takes off in those regions. 

 

Projecting growth far into the future is more art than science, but back-of-the envelope math tells us that 10% EBITDA growth over the next 5-10 years is quite reasonable. Take this scenario: if we can get 7% EBITDA growth out of the domestic business over the next decade (say, 5% to 6% revenue growth from inflation and customer maturity with the remainder being margin expansion) and 15% EBITDA growth out of the international business (maybe 10% revenue growth and the remainder being margin expansion), then we have 10% annual EBITDA growth over the next ten years.  These assumptions are well within what has been suggested by recent history as well as management guidance.  Beyond that, expansion into new markets may give yet another boost to growth. 

 

Finally, even once QVC finally matures, if we assume a terminal growth rate of 3% (inflation) and a WACC of 8% (implying equity returns greater than the inflation + 600 bps historically experienced by the market when it has traded at these levels in the past) we would get an EV/unlevered FCF of 20x, above where it trades today.  This is where the margin of safety lies; even if disaster strikes and some or all of this excess growth fails to come to pass, QVC is still priced to earn at least market returns.

 

 

Taxes on public holdings: Given Malone’s history of being able to avoid taxes at every turn, this seems to be an unlikely threat.  There are several ways to delay or avoid taxes on public holdings.  The first, and easiest, is to exchange the shares in question for a combination of operating assets and cash, as Liberty has done on the Capital side.  Since LINTA owns supervoting shares in both IACI and EXPE that give it control of both companies[2], it has ample leverage to achieve a favorable outcome in an exchange, probably at a premium to market prices.   This would appear to be a slam dunk in the case of IAC, which is just a hodgepodge of mostly unrelated assets anyway.   The most likely asset to be targeted from IAC is HSN, which QVC attempted to acquire in 1993, only to break it off so QVC could unsuccessfully pursue Paramount.  (A bit of trivia: QVC’s CEO at the time was none other than media titan and current IAC head Barry Diller.)  Selling HSN would allow IAC to rid itself of an underperforming, legacy asset, while QVC would remove the last vestiges of competition from the US home shopping market.  Other possibilities include Ticketmaster, another legacy business.  Least likely are any of IAC’s internet businesses, which it has sought to build its core around. 

 

This past quarter, neither IACI nor LINTA repurchased a material amount of stock (IACI repurchased none, while LINTA repurchased just a very little under a 10b5-1 plan), despite the fact that both have been aggressive repurchasers in the past.  IACI disclosed on their earnings call that the lack of repurchases was due to the fact they were considering a transaction “that they might revisit again in the future”.  Meanwhile, the Q&A during Liberty’s call included repeated discussions on the possible acquisition of HSN (to sum it up, management commented that they had considered it in the past, that they felt that HSN was worth significantly less than their stake in IAC, and that HSN might be difficult to turn around).  One could not blame a casual observer for concluding that IAC and LINTA had discussed a deal recently without coming to a successful conclusion, but that the talks would be revisited in the future.  This doesn’t necessarily mean a deal is coming any time soon – recall that the News Corp deal took nearly two years to conclude from when talks were first reported.

 

Achieving a favorable outcome is a bit more complicated in the case of Expedia. Expedia has no non-core subsidiaries it could exchange.  Furthermore, the parent companies of Expedia’s two largest rivals, Orbitz and Travelocity, have been taken private in the last year, increasing speculation that Expedia may consider doing the same.  But here, Liberty still has other options.  If a financial buyer does emerge, Liberty could simply negotiate to roll over its stake, much as they did with Comcast in buying QVC in 1995.  Or, Liberty could buy the remaining piece of Expedia outright, as they did with QVC in 2003.  Or, if the offer is rich enough, they could simply conclude that the benefit of the premium outweighs the tax hit, and sell.

 

In either case, it should be noted that the value of LINTA’s public holdings account for only a quarter of the current market cap, and thus even the worst possible tax hit would have a relatively minor impact – no more than $2  - $2.50 per share.

 

Technology: Technology is among the greatest risks for any franchise, and QVC is certainly no exception.  Digital cable is providing more choices for viewers, and so is the internet.  QVC has historically been able to use its favorable channel position to catch viewers flipping through channels, but with digital, everything is menu driven and no flipping is necessary.  E-commerce continues to grow and be a threat to retailers.

 

Not all is bleak, though.  Customer loyalty should be able to see QVC through these challenges, and besides, there are some positives on the technology front.  Interactive TV will allow customers to order with their remote control.  VOD will allow QVC customers to select what programs they want to watch, making it more likely they will find something they like.  And video over the internet might one day allow QVC to bypass the cable networks, and thus bypass the 5% of sales that the cable networks take in fees.

 

 

 

Increased leverage / continued repurchases: Eventually, aggressive returns of capital will attract recognition from investors, especially if the repurchases result in a rising stock price.  Even without attracting recognition, continued stock repurchases at a low price will result in exceptional returns. 

Tax-free disposal of public holdings. For the largest holding, IAC, a tax-free exchange seems to have been considered at various times in the past, and will almost certainly be considered in the future.  Though there isn’t as much urgency as there was in the News Corp. situation, an exchange would remove an overhanging issue for both companies.

 

Formal spin-off from Liberty. Almost certain to happen in the long term, but almost certain not to happen until the Capital side accumulates enough operating businesses to benefit from their NOLs without the help of QVC. 

 

 

As is probably clear from the preceding analysis, I believe the best way to think of this opportunity is that this is an investment that will return annually a minimum of the combination of its FCF yield and annual growth, which I believe to be around 15%-20% combined going forward, with the upside potential of multiple expansion.  Putting a fair price on this business, I would say that the QVC stub is worth around $30 per share on a DCF basis (implying that it is about 50% undervalued), using input assumptions in line with what I outlined previously.  (This translates to a 15x forward EBITDA multiple.) This would put the fair price of the stock at around $37 per share.  

 

Below I have outlined the backup for the pro forma earnings number. The revenue and EBITDA numbers my conservative estimates (9% annual revenue growth, relatively constant EBITDA margins), which are in line with analyst research estimates.  This comes in a bit below management guidance, and below recent historical growth numbers as well.  I did the pro forma adjustments myself, subtracting stock comp and the QVC Japan minority interest, and calculating interest expense based on current debt levels and adjusting for 40% taxes (approximately what they paid this year).

 

Finally, it might be noted that the stock is trading near recent highs.  However, backing out the public holdings, at LINTA’s all-time low of around $16.50 in July 2006, QVC was valued at implied NTM multiples of 13.5x P/E and 8.5x EBITDA.  Most of the appreciation since then has come from share repurchases, better than expected results, roll-forward of timeframe, and appreciation in IACI and EXPE; very little has come from multiple expansion.

 

 

 

Share Price as of 5/9/07:			$24.95
Less: Public Assets:
	Price	Shares	Value
IACI	$35.27	69.2	$2,441
EXPE	$24.67	69.2	$1,707
GSIC	$21.77	8.5	$185
Total Market Value:			$4,333
PF FD Shares Outstanding			655.6
Value of Public Assets Per Share			$6.61
Value of Full Stub (QVC + eCommerce)			$18.34
Less: Value of eCommerce		$900	$1.37
Value of QVC Stub			$16.97
P/E Multiples:
		Estimate
2006A		$0.90	18.8x
2007E		$1.04	16.3x
2008E		$1.17	14.5x
LTM (3/31/07)		$0.94	18.1x
NTM (3/31/08)		$1.07	15.9x
EV / PF EBITDA Multiples:
		Estimate
2006A		$1,519	11.0x
2007E		$1,661	10.0x
2008E		$1,818	9.2x
LTM (3/31/07)		$1,564	10.7x
NTM (3/31/08)		$1,695	9.8x
Leverage Multiples:
Total Debt / LTM EBITDA			3.9x
Net Debt / LTM EBITDA			3.3x
Value:
QVC Equity Value			$11,125
QVC Enterprise Value			$16,671

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