Description

Long - Liberty Starz Group (LSTZA)

12/18/09

Thesis:

Starz is a recent spin-off from Liberty Entertainment that is mispriced due to technical selling pressure from arbs that played the LMDIA/DTV merger. Starz trades at 11x free cash flow and 7.5x after backing out the excess cash and investments. This is too cheap for an entrenched business with predictable cash flows that come from multi-year contracts with their suppliers and customers, where zero capital is required to grow the business, and where EBITDA should grow 5-10% for the next few years. Starz should trade for more normal multiple of 12-15x FCF over the next twelve months as the street begins to learn about the premium channel business and pays more attention to Starz as a public company. This valuation would result in a $75-$85/share stock price or upside of 70%.

Background:

Starz is 1 of 3 companies in the premium TV channel business (PTV) along with HBO and Showtime. Starz offers through their affiliates (cable and satellite TV companies) several channels of ad-free programming under the Starz and Encore brands. The content is a combination of recent box office movies, older movies from studio libraries, and some original content. These are premium channels meaning that a consumer subscribes to the service on top of their basic cable package. Affiliates are motivated to sell the service because they collect a material % of the revenue generated by their subscribers opting for the premium packages which is incremental revenue for the affiliates without incremental cost.

PTV acts much like a wholesale distributor. PTV enters into deals with the studios for the rights to show their films after the box office and DVD windows (usually 12-18 months after the movie is released to the box office). PTV then enters into deals with the various affiliates (Comcast, Time Warner, Cablevision, DTV, Dish, Verizon, etc.) to distribute this programming to the end user in exchange for a fee. PTV are entrenched players in the system because affiliates cannot afford to pay as much as PTV can to the studios since affiliates only have a certain % of the total customers as subscribers whereas PTV can strike deals with all the affiliates and reach 100% of total end-users. Studios like PTV because deals include large upfront fees that help finance production of the movies. Contracts with the studios are 6-10 years and 1-5 years with the affiliates. Cash flows are much steadier than other media businesses due to lack of reliance on advertising spend and longer-term contracts with stakeholders. Starz EBITDA grew through the recession.

Pay TV has been around for decades and has momentum in consumer buying behavior. Starz was started by Liberty Media in early 90's vs. the mid 70's for HBO and Showtime. Starz has been able to compete and penetrate the market through an advantageous agreement with TCI which was then Liberty Media (then acquired by AT&T and then again by Comcast).

Bear Case & Variant View

Bear Case #1: Why should Starz exist? Why should I pay $12/month for Starz when I get hundreds of channels in my basic package? HBO is great for their original programming, maybe you can make a similar argument for Showtime, but what does Starz have? Do Starz subscribers actually get value from the channels or do they just get Starz as part being up-sold to a bundle that includes HBO which is what people really want?

Variant View: Starz and PTV in general is a great deal for consumers. Each month they offer hundreds of hours of recent and classic box office movies for less than the cost of going to the movie theater for a family. There is no question that Starz is a distant 3^rd in original programming but this is the biggest focus going forward for the company to the point where the new CEO will likely be from the content creation side. Crash has been successful and Spartacus has a lot of promise. Prime time Nielson ratings show that Starz #22 of all channels watched (including broadcast and basic cable channels) and is more watched per sub than Showtime. Through the recession subscribers have decreased less than 5% peak-to-trough. Meanwhile revenues continue to grow through higher pricing (mix shift to telecom subs which have higher price points than cable).

Bear Case #2: Management is the weakest of the 3 PTV companies. CEO is in transition.

Variant View: This might be a slight exaggeration, but it makes the point: the business can run itself. The important execution items are renewing deals with the affiliates and the studios which happen infrequently. The lack of creative leadership has hurt Starz original programming in the past but the company is now focused on this. Perhaps more importantly, you have John Malone and Greg Maffei on the board in charge of capital allocation which we view as a big positive given the amount of cash on the balance sheet and cash that will be generated over the coming years.

Bear Case #3: Big concentration risks with only 2 studios (Disney and Sony) supplying their box office movies and 4 affiliates representing 70% of the end users.

Variant View: Sony was recently renewed to 2016 and Disney runs through 2013. Bargaining power is definitely in the hands of the PTV industry vs. the studios given the change in PTV sentiment to original programming vs. blockbuster movie releases (i.e. Showtime pushback on MGM/Paramount/ Lion's Gate). Comcast (25% of users) was renewed in early 2009 at similar terms to their previous deal. Time Warner and Cox renewals (18% of users) are in 2010 and there is nothing to suspect that terms on their renewals would be different. Remember that the PTV business is very accretive for the affiliates unlike their contentious negotiations with Discovery or ESPN which is part of the basic package lineup and therefore a pure expense.

Bear Case #4: The content distribution business is going through a lot of change with new technologies disrupting certain market participants. The profitability of the movie business is decreasing. Movie studios are trying to compete with PTV with their own PTV service "Epix". Starz seems ripe to be negatively affected.

Variant View: New digital distribution mediums is a positive for PTV as it makes their distribution rights more valuable (Starz/Netflix deal). PTV will also be able to begin selling directly to the end-user (internet) which gives them more control over how their product is marketed. Our view is that new technology will hurt the affiliates through disintermediation and the studios through lower DVD sales. Showtime, to their credit, saw that the value of the pay TV window was decreasing due to the ability to see new releases earlier through new platforms and was not willing to re-up their distribution agreement with MGM/Paramount/Lion's Gate except at a 50% reduction in price. MGM et al recognized this as a significant threat to their profitability and started a 4^th PTV company (Epix) to compete/self-distribute their releases to the affiliates. Epix will be an important case study for understanding the competitive advantage of the incumbent PTV companies - 12 months into the effort they have not been able to strike significant distribution deals because the affiliates do not see demand from their subscriber base for a 4^th PTV service or the potential value-add that could come from one. Calls confirm the industry is pessimistic on its success. If Epix fails it will put the studios in a very difficult position on negotiating a deal for the pay TV window.

Bear Case #5: Corporate governance issues with a potential high-priced acquisition of Starz Media (still owned by Liberty Capital) or more inter-company loans (like the recent one with Liberty Interactive). Starz is a tracking stock which is foreign to most investors and makes them uncomfortable.

Variant View: While John Malone has a mixed reputation on governance, he has created enormous value for minority shareholders over time and has never done anything directly shareholder unfriendly (unless you call having to read several hundred pages of a registration statement "shareholder unfriendly"). Management has been clear that any acquisition of Starz Media would be on an arms-length basis using 3^rd party appraisers. The company is so sensitive to this issue that they are unlikely to do a deal until Starz Media begins producing more recurring cash flow so as to create less of a question over the ultimate valuation. Over time management has stated they intend to restructure and spin-off Starz into a separate public corporation which should relieve any tracking stock discount.

Why This Variant View Exists:

There are the normal spin-off dynamics such as forced selling and lack of historical transparency. As important, there are no pure-play public comps - investors are learning about the fundamentals of the premium channel business for the first time.

What Are We Playing For:

Starz currently trades at 7.5x EV/FCF and should trade to 12x-15x EV/FCF or ~70% upside over the next 12 months as the street gets more familiar with the story. In the meantime Starz is generating a 9% FCF yield and has stated they will buy back shares if the stock trades at an attractive price.

Risks / What Would Make Us Wrong:

• Change in industry structure that affects the incentives of the affiliates, allows the studios to disintermediate PTV, or otherwise affects PTV's competitive positioning and economics.
• Consumer behavior changes and/or opinion shifts on PTV value proposition.
• Starz Media is purchased for an absurd price or some other form of poor governance causes a panic.

Catalysts / Potential Event Timeline

• Next 6 months: Management walks the walk on share buybacks.
• Next 12 months: Normal dissipation of spin-off technicals. Company begins to meet 2010 guidance of 5-10% EBITDA growth - before the 11/19 conference call some sell-side analysts believed 2009 was peak earnings for Starz and going forward subscribers and pricing would decline while programming costs would increase.

Catalyst

Next 6 months: Management walks the walk on share buybacks.

Next 12 months: Normal dissipation of spin-off technicals. Company begins to meet 2010 guidance of 5-10% EBITDA growth - before the 11/19 conference call some sell-side analysts believed 2009 was peak earnings for Starz and going forward subscribers and pricing would decline while programming costs would increase.