Description

Liberty Media is well known to most value investors, so I expect that Liberty International (LBTYA) may be familiar to many of you. LBTYA was spun off from Liberty Media yesterday, and began trading as an independent company today.

LBTYA is nearly as complicated as Liberty, with numerous disparate assets and limited disclosure prior to the spin-off. Because of the complexity, because LBTYA is much smaller and is fundamentally different than Liberty Media, and because LBTYA plans a significant rights offering after the spin-off, I expect LBTYA to initially trade at a significant discount to its true value. While the discount may widen in the next few weeks, I expect it to narrow with time. Importantly, the underlying value should grow at a double-digit rate.

The discount should narrow as selling pressure from Liberty shareholders abates, and because the bulk of LBTYA’s value resides in two relatively easy-to-value businesses – a 53% stake in European cable provider UnitedGlobalCom (UCOMA, publicly traded) and a 45% stake in Japanese cable provider Jupiter Telecommunications (J-COM, privately held).

Both UCOMA and J-COM should grow EBITDA by roughly 25% this year and 15%+ in 2005. Given UCOMA’s growth, I think its current market valuation of 10x 2004 EBITDA is too low. I expect UCOMA shares to trade higher in the coming year as it delivers this growth, and as it receives more sell-side coverage after the LBTYA spin-off. Similarly, I expect investors to attribute more value to J-COM following the LBTYA spin-off, as LBTYA increases its disclosure about this business, and possibly sells a portion in an IPO.

In addition to UCOMA, J-COM, and a few other large assets, LBTYA includes a basket of smaller assets to which investors attribute little or no value. One or more of these could turn out to be worth a lot, and investors in LBTYA get these assets for free. I value most of these minor assets at zero in my analysis.

Valuing UCOMA and J-COM at 10x 2004 EBITDA, I estimate the value of LBTYA to be $45 per share. Valuing UCOMA and J-COM at 12x EBITDA yields a value of $53 per LBTYA share. Today’s closing price of $37.06 represents an 18% discount to the conservative $45 NAV and a 30% discount to the more-aggressive (but still very reasonable) $53 NAV.

Another way to look at the valuation is to consider that you are paying a very fair price for UCOMA, J-COM and LBTYA’s cash & investments (total $38 per share), and getting all of the other assets for free. Downside is limited.

One more note on valuation: I decided to post this today because I think it represents good value at the current price. I do expect it to trade lower in the next couple weeks. I have established a position and hope to add more at lower prices.

INVESTMENT POSITIVES
1. Rapid growth over next several years as a result of price increases, increased data and telephony penetration, and introduction of new digital cable services.
2. Strong competitive position in many cable markets, with little or no satellite TV competition.
3. Most cable systems upgraded and require little maintenance capital spending.
4. LBTYA’s major businesses are free cash flow positive, and should see strong growth in free cash flow in coming years.
5. Strong management team at corporate and each of the main operating businesses.
6. LBTYA’s discounted valuation and expected growth in NAV create a margin of safety that more than compensates for the risks.

RISKS AND CONCERNS
1. Difficult to truly understand the competitive landscape in foreign markets.
2. Incomplete information due to limited disclosure prior to spin-off.
3. Possibility of stupid acquisitions.

VALUATION SUMMARY (per LBTYA share)
UCOMA $22.50 50%
J-COM $9.00 20%
Jupiter Programming $3.00 7%
Latin America Businesses $3.00 7%
Other Assets $1.00 2%
Cash & Investments* $6.50 14%

NAV Per Share $45.00 100%

*Debt of subsidiaries included in individual business valuations.

UNITEDGLOBALCOM (UCOMA)
UCOMA is a publicly-traded company in which LBTYA owns a 53% economic interest and a 90% voting interest. LBTYA also elects the entire UCOMA board of directors.

UCOMA provides cable, high-speed data, and telephony services in a number of European markets and Chile. UCOMA’s geographic breakdown based on 2003 revenue is as follows: Netherlands 31%, Austria 14%, Other Western Europe 17%, Hungary 9%, Poland 5%, Other Central & Eastern Europe 6%, Chile 12%, and Other 6%.

While each of UCOMA’s markets is different, it is possible to draw general conclusions about its portfolio of businesses (to keep this write-up relatively brief, I have excluded discussion of each individual country). UCOMA is the #1 provider in most of its markets, and these markets are developing rapidly. In aggregate, UCOMA is expected to increase revenue and EBITDA at compound annual rates of 9% and 20%, respectively, over the next three years. Thanks to significant spending in recent years, UCOMA’s physical plant is very modern and ongoing maintenance capex should remain stable or decline. Free cash flow should increase from $59 million in 2003 to about $375 million in 2006.

The drivers of growth are: (1) large price increases this year and next in the Netherlands (largest market), (2) new high-speed data subscribers in Western Europe driven by rapid conversion from dial-up, (3) ongoing annual price increases in most markets, (4) new subscribers for all three services in Central and Eastern Europe as UCOMA upgrades those systems, and (5) higher revenue from new digital cable services. The first two of these will have the largest impact in the near term. Number four is a medium-term prospect. Digital cable could be huge for UCOMA, however it is years away and not something I am counting on.

Most of UCOMA’s markets are utility-like in nature. This is both bad and good. On the negative side, many customers view television as an entitlement and are resistant to paying for cable content (many opt for only a minimal level of service). On a positive note, there is little or no satellite TV competition, and there is an opportunity to sell consumers higher priced digital services in the future. The main barrier to digital services is the lack of quality local-language content. This problem should ease with time, and UCOMA will likely invest in content providers to speed the process.

With respect to high-speed data and telephony services, UCOMA typically competes against incumbent telephone providers, which provide DSL lines and traditional phone service. The incumbents in Western Europe generally are strong competitors with quality services and histories of good consumer relationships, while the incumbents in Central and Eastern Europe generally are not as well regarded by their customers. UCOMA’s competitive edge is its ability to bundle services. This provides customers with a single bill for cable, data, and telephone, and discounted prices if they purchase more than one service.

American cable companies trade in a range of 9-10x 2004 EBITDA. Taking into account UCOMA’s strong competitive position, upgraded physical plant, revenue growth potential and free cash flow generation, I think it deserves a higher multiple than the American companies. UCOMA’s current price of $7.74 implies a valuation of 10x 2004 EBITDA. Were UCOMA to trade at $9.50 (12x 2004 EBITDA and 10x 2005 EBITDA), this would add $5 to the LBTYA per share valuation.

JUPITER TELECOMMUNICATIONS (J-COM)
J-COM is the largest cable provider in Japan, and also offers high-speed data and telephony services. LBTYA owns 45.2% of J-COM, while Sumitomo Corporation (31.8%) and Microsoft (19.4%) own most of the balance. LBTYA and Sumitomo each appoint two executives that serve as directors and three non-executive directors (total of ten directors). There are also three independent directors on the board. The partners have rights of first refusal over each other’s shares, and Liberty has repeatedly said that an IPO of J-COM is possible in the next 12 months.

Television in Japan is dominated by free broadcast providers, which offer a limited number of channels but have some of the most popular content. Cable systems were initially created to provide these same channels to people whose broadcast signal was blocked. Such “retransmission-only” subscribers still represent the majority of Japan’s 15.4 million cable subs. There are roughly 4.9 million subscribers to multi-channel cable systems, and J-COM is the largest provider with about a third of these subs.

Japan has been a difficult market for commercial satellite broadcasters. Several have failed or been merged out of existence during the past decade. This is because of the strength of the free-TV broadcasters and the relative advantages of cable over satellite in Japan’s densely-populated cities. Sky Perfect Communications is the remaining major satellite provider, through its SkyPerfecTV1 and SkyPerfecTV2 platforms. SkyPerfecTV1 provides an extensive line-up (140 channels) to about 3.0 million subscribers, while SkyPerfecTV2 provides a smaller number of channels to a customer base of around 100k subs.

J-COM manages 19 majority-owned cable franchises, and also owns minority interests of 11-20% in four other franchises. Substantially all of J-COM’s homes are upgraded to 750MHz and are 2-way capable. Including the minority-owned franchises, J-COM passes 6.9 million homes, and has about 2.8 million retransmission-only subs, 1.6 million cable subs (23% penetration), 667k Internet subs (10% penetration), and 610k telephony subs (13% penetration of homes serviceable). J-COM offers high-speed data service in all 19 of its majority-owned franchises, and offers telephony in 16 of the 19.

J-COM introduced digital cable services in 2003, and currently has 26k digital cable subscribers (1.6% of cable subs). J-COM’s basic cable offering includes 43 channels. The digital offering includes the basic channels and 10 additional channels, as well as eight premium channels available for an extra fee. J-COM will launch pay-per-view services in some franchises in 2004.

J-COM faces strong competition in data and telephony from the incumbent telephony provider, Nippon Telegraph & Telephone, which was the country’s only provider until 1985.

Despite the competition in each of its businesses, J-COM has grown quickly. Revenue nearly doubled from $629 million in 2001 to $1.23 billion in 2003. EBITDA grew from $57 million in 2001 (9% margin) to $429 billion in 2003 (35% margin). Most importantly, J-COM achieved positive free cash flow of $55 million in 2003. 2004 guidance calls for mid-teen percent revenue growth, 20-25% EBITDA growth, and free cash flow of $185 million.

To value J-COM, I discount consolidated 2004 EBITDA by 20% to account for the minority interests in many of the majority-owned franchises. I then apply a 10x multiple, which I think is conservative given the company’s growth trajectory (company guidance is for mid-teen revenue growth and 20-25% EBITDA growth in 2004). Applying a 12x multiple would add $2.50 to the LBTYA per share valuation.

JUPITER PROGRAMMING (JPC)
JPC is a 50/50% joint venture between LBTYA and Sumitomo that develops television programming for distribution on cable and satellite systems. JPC operates four channels through wholly- or majority-owned subsidiaries, and also has investments of 11-50% in 11 other channels.

JPC owns 100% of Movie Plus, Golf Network, and LaLa TV (a women’s channel), and owns 70% of Shop Channel (the other 30% is owned by InterActiveCorp’s Home Shopping Network). The minority-owned channels include: a 29% interest in three sports channels jointly owned with News Corp, Sony, Fuji, and Softbank; a 50% interest in Discovery Channel Japan (JV with Discovery); a 33% interest in Animal Planet Japan (JV with Discovery and the BBC); and a 35% interest in AXN Japan (JV with Sony; an action and adventure channel).

Shop Channel accounted for 81% of JPC’s consolidated revenue in 2003, and therefore represents the bulk of the value of JPC. Revenue is derived from product sales, and the major expenses are cost of goods sold and distribution fees. Shop Channel pays cable and satellite distributors either a fixed fee per subscriber or the greater of a fixed fee or a percentage of revenue derived from the carriers’ subscribers.

Shop Channel has grown rapidly in recent years, with local-currency revenue growth of nearly 40% in both 2002 and 2003. Growth in 2002 came from a 30% increase in subscribers and an 8% increase in revenue per sub. Growth in 2003 came from roughly equal parts subscriber growth and revenue per sub growth.

Shop Channel now enjoys nearly full penetration, with distribution to 13 million homes (including 3.1 million DTH homes and many compensation systems). This leads me to believe that its growth in the future will have to come from maximizing revenue per subscriber, rather than from subscriber growth. While 40% annual revenue growth is not sustainable, growth should remain in the double-digits for the next several years.

According to LBTYA, most of JPC’s other channels are distributed to about 1.6 million homes. There appears to be plenty of room for additional subscriber growth for these channels.

To value JPC, I discount consolidated 2004 EBITDA by 25% to account for the minority interest in Shop Channel. I then apply a 15x multiple, which I think is fair given the company’s growth trajectory (company guidance is for 25% revenue growth and 45-60% EBITDA growth in 2004). This valuation captures Shop Channel and the three wholly-owned channels. It ignores several minority investments, which are small today, but could grow to become significant sources of value. These include: the three sports channels, Discovery Japan, Animal Planet Japan, and AXN Japan.

LATIN AMERICA BUSINESSES
LBTYA owns several small cable and programming businesses in Latin America. The two largest of these, and the only ones that are material to LBTYA’s valuation (each worth about $1 per LBTYA share), are Liberty Cablevision of Puerto Rico and Chilean cable provider Metropolis-Intercom. The smaller assets include wholly-owned Argentine programmer Pramer; a 10% interest in satellite TV provider Sky Latin America; a 40% interest in Argentine sports programmer Torneos y Competencias; and an 11% interest in programmer Fox Pan American Sports.

FINANCIAL ASSETS
LBTYA also inherited from Liberty several non-core financial assets, which are intended to provide liquidity following the spin-off. These include $50 million of cash; ABC Family Channel 9% preferred notes ($345 million face value; $413 million market value according to LBTYA); bonds of distressed UK cable provider Telewest ($281 million market value according to LBTYA); five million shares of News Corp ($170 million); and 21 million shares of The Wireless Group ($35 million). Collectively, these assets are worth about $6.50 per LBTYA share.

RIGHTS OFFERING
LBTYA expects to raise $500 million (and maybe up to $1 billion) through a rights offering shortly after the spin-off. The primary purpose is to raise capital without diluting existing shareholders. I suspect it is also intended to temporarily depress the LBTYA share price. For shareholders not inclined to own LBTYA, the rights offering should provide incentive to sell very quickly after the spin-off so that they don’t get diluted. This should provide John Malone and those of us who want to own LBTYA the opportunity to buy at cheap prices, both in the market and through the rights offering.

MANAGEMENT AND BOARD
Liberty Chairman John Malone will serve as chairman and CEO of LBTYA. According to Liberty CEO Dob Bennett at Liberty’s investor day in May, Malone “very actively and specifically wanted to run” LBTYA. It appears that Malone will take a more active role at LBTYA than he has at Liberty over the past few years. Malone’s only compensation will be roughly 1.5 million options to be issued just prior to the spin-off. These will have an exercise price equal to 110% of LBTYA’s fair market value, as determined by the board (not clear how they will determine this).

Miranda Curtis is the president of LBTYA, and Graham Hollis is the CFO. Both have extensive experience in international cable and programming, particularly in Japan where they have been building J-COM and JPC for ten years. I know them from when they ran these businesses for TCI International prior to 1999, and they are solid managers.

The board consists of seven members, six of which are also directors of Liberty. Unless these directors purchase shares of LBTYA, they will all own more Liberty than LBTYA. Since Liberty will not retain any ownership of LBTYA, the likelihood of conflict of interest in minimal. However, if a conflict does arise, it is likely that the board would favor Liberty.

DISCUSSION OF RISKS
The major risk I see is our inability to truly understand the competitive landscape in LBTYA’s foreign markets. I am reasonably comfortable with the competitive situation for cable television in most of LBTYA’s markets. It is Internet and telephony competition that is more concerning because the fields are more crowded and there are strong incumbents. For example, just how competitive is the Dutch market for high-speed data? The Japanese market for telephony services? It’s difficult to know, and even more difficult to track any changes in these markets. The best protection against this risk is to purchase LBTYA at a valuation that provides a significant margin of safety.

The second risk relates to Liberty’s limited disclosure prior to the spin-off. UCOMA is relatively easy to research because it is publicly traded, but it is much more difficult to find information on the rest of the assets (J-COM and JPC in particular). LBTYA’s Form 10 provides basic information, but very little depth. In addition, LBTYA management has essentially been unavailable to answer questions. I expect this to change after the spin-off.

A third risk is the possibility that LBTYA makes stupid acquisitions. Liberty has been very clear that LBTYA will be an active acquiror of international cable and programming assets. It is possible LBTYA could buy poor assets or overpay, but I’m not too worried about this. Despite some stumbles in the past few years, John Malone has a very good track record of creating value.

Catalyst

CATALYSTS
1. Passage of time from the spin-off and rights offering as LBTYA shares fall into stable hands.
2. Appreciation of UCOMA share price as a result of significant expected growth, and also as the LBTYA spin-out prompts sell-side analysts to initiate coverage (UCOMA currently receives very little coverage).
3. IR efforts to promote the Japanese businesses, which are relatively unknown to investors.
4. M&A activity – There has been discussion of both an acquisition of the remainder of UCOMA and an IPO of J-COM. It makes no sense that LBTYA would buy-in one business and sell a piece of the other, but Malone is very savvy and I trust that any deal he would do would either create value or highlight the value of LBTYA’s assets.