Description

Quebecor Inc. (QRB) offers the opportunity to invest in a high cash flow yielding cable business with a nascent wireless offering and an event that should result in the elimination of a holding company discount over the next 12-18 months. QBR is worth $72 (all $ figures CDN) at an 8% 2014 FCF yield or 60% upside over the next 1.5 years.

Quebecor Inc. owns 75.4% of Quebecor Media (QMI), a Canadian media company with assets in cable, wireless, print and broadcasting. The other 24.6% of QMI is owned by Caisse de depot et placement du Quebec, a Quebec based investment manager for Canadian pensions. QMI owns 100% of Videotron, 100% of Sun Media, 51.5% economic (but 99.9% voting) rights in TVA and several other smaller media businesses.

QMI Business Segments

Videotron

Videotron is the dominant cable company in Quebec with a great brand name and 2.7m homes passed (90% of Quebec), 1.8m cable subscribers (1.4m of which are digital), 1.4m broadband subscribers and 1.3m fixed line telephone subscribers. Because they have a great brand, Videotron’s penetration levels are higher than most other cable companies in developed nations so we cannot expect significant growth in the cable business, longer term.

In 2008, Videotron participated in the government’s wireless spectrum auction for new entrants and acquired 40mhz of AWS spectrum across Quebec, 20mhz in eastern Ontario and 10mhz in Toronto for $554m. Since 2008, they have spent about $800m in opex/capex building out a wireless network across Quebec in order to offer customers a quadruple play. Videotron has about 400k wireless subscribers, growing at a run rate of about 100k/annually.

Videotron contributed 60% of QMI’s revenue, 87% of EBITDA and 81% of EBITDA-capex (105% excluding the wireless business cash burn) in 2012. 

News Media

Sun Media operates under QMI’s news media segment and is the largest press company in Canada with 43 daily newspapers and 250 weekly papers. They also operate a news reference agency, a printing/distribution business for third parties in Ontario/Quebec, a directories business and a portal, canoe.ca. As expected, pretty much all of the News Media revenue streams are in secular decline but the company has recently announced a $45m restructuring program to eliminate costs from the business.

News Media contributed 20% of QMI’s revenue, 8% of EBITDA and 15% of EBITDA-capex in 2012.

Broadcasting

TVA Group operates under QMI’s Broadcasting division. TVA has the largest French language television network in North America, a competitive advantage for Videotron’s Quebec centric cable business. TVA also publishes French language magazines in Quebec and distributes French films in Quebec.

Broadcasting contributed 10% of revenue, 3% of EBITDA and 2% of EBITDA-capex in 2012.

Leisure and Entertainment/Interactive Technologies

L&E operates the largest magazine publisher in Quebec, a retail music store, and an online/physical bookstore. Interactive Technologies operates an interactive communications business and a video game development business.

At 10% of revenue but 2% of EBITDA and 2% of EBITDA-capex, this segment is inconsequential to the investment thesis since it’s not going to 0 tomorrow.

Investment Merits

Value of Owning a Cable Business

John Malone recently doubled down on his cable investments with his recent purchases of stakes in Charter Communications (through Liberty Media Capital) and Time Warner Cable in the US as well as Virgin Media in the UK and Ziggo in the Netherlands (through Liberty Global). He also attempted but failed to buy out the rest of Telenet (Belgian cable company) that he didn’t already own. Arguably the best cable executive in history, having grown TCI from 100k subscribers in 1970 to a firm value of about $60bln when AT&T acquired the company in 1998 (which doesn’t include the value of Liberty Media and all the businesses spun out of it), Malone’s renewed interest in cable signifies the long term value of the assets, in my opinion. Given the high cost to build fiber to the home, it is barely economical at $2-4k/home passed even in cities/wealthy suburbs. DSL cannot handle growing bandwidth needs from streaming video, wireless has constraints based on spectrum capacity/tower buildouts and satellite broadband speeds are capped at 15-20mbps and only economical in rural areas. Cable can continue to handle broadband demand increases through DOCSIS software upgrades, some node splitting but overall limited incremental capex. Malone and many others in the business clearly see that cable in markets with limited government interference is the only way to deliver broadband to homes and will have significant pricing power/barriers to entry over the longer run.

In a recent earnings call, Telenet, the Belgian cable company which has one of the most advanced networks in the world has outlined a plan over the next several years to get to 1Gbps. No other physical distribution platform with infrastructure already built into the home can realize those speeds over a large footprint. The bottom line is that cable is a very good business which will grow subscribers as it takes share from DSL, has pricing power and high incremental margins with limited incremental capex. Quebecor is one of the cheapest cable assets in the world, has very limited fiber competition and no other cable overlap with its network. We can be very confident that the Videotron will continue to be a free cash flow machine over the longer run.

Financial Estimates for the Videotron Cable Business

• Videotron cable revenue (not including wireless) grew at 6.5% in 2012 due to a mix of pricing increases, conversion of analog television customers to digital, subscriber/pricing growth in broadband and slight growth in fixed telephony
• Going forward, based on a mix of growth in subscribers/ARPUs, I assume revenue grows at 2.5-3.5%/year
• Given higher growth in broadband where incremental margins are in the 80% range, I assume overall incremental EBITDA margins are 55%
• As per management’s guidance on future node splitting, I assume capex slightly increases vs. historical level

Wireless Quadruple Play Offering

As mentioned above, Videotron entered the wireless business through the purchase of new entrant spectrum in 2008. Wireless ARPUs/EBITDA are about 20% above the rest of the developed world in Canada. As such, the government began a push in 2008 to encourage new entrants to enter the market and compete down prices against the big three incumbents, Bell, Telus and Rogers. While most of the new entrants have floundered given the high capital costs of building out a wireless network across a country as large as Canada, Videotron has succeeded since they were able to use their cable cash flows to finance their build and also focused solely on Quebec where they already have a great brand name/distribution. This has allowed them to keep costs low (they have roaming agreements across Canada to fill in their coverage gaps) while also allowing them to focus on targeting their cable customers through their own distribution network.

A quad play offering significantly decreases churn which increases the life of a customer thereby increasing returns on the subsidy/overall cost to acquire a subscriber. Given how high customer acquisition costs are in subscriber oriented businesses, having a quad play helps make these sorts of businesses much more successful. 

Charlie Ergen highlighted the chart above in his investor presentation on the merits of a DISH/Sprint merger. This shows us that the monthly churn of a triple play customer halves when offering him/her a quad play which would double the customer’s life and returns on the customer acquisition cost. While it’s tough to quantify how much this will accrete to FCF for Videotron, I think we can view it as a free option on longer term profitability sustainability/margin improvement. In the chart below from a recent QBR presentation, they highlight how much lower quad play churn is vs. triple play, a decline from 0.6% to 0.2%.

Nearer term, QBR has guided to breakeven EBITDA in mid 2013 in the wireless business. This is a significant inflection point since wireless has been a large cash drain at $-175m in EBITDA-capex in 2012. Given that network costs are not increasing much (this is largely a fixed cost business), incremental EBITDA margins are high (I model 80% going forward) which means the high revenue growth should fall to the bottom line. On top of this, capex should begin to decline in 2013 as network build costs decline post LTE spend. The bottom line here is that the wireless business has been a significant cash drain over the last four years and it’s beginning to hit an inflection point which will reverse its losses and allow it to add to FCF for QMI rather than detracting from it. This is what is driving the large consolidated FCF growth in the business and what makes the stock look so cheap.

Financial Estimates for the Wireless Business

• I assume 105k wireless net adds in 2013-2016, spread evenly across the four quarters, slightly higher than the 112k net adds in 2012
• 75% incremental EBITDA margins as per the reasons discussed above
• Constant $41 in monthly ARPU as per company guidance that they will keep pricing flat to compete with the $55-60/month pricing at Bell/Telus for comparable plans

Capex declines to $80m in 2013 from an estimated $160m in 2012; this further declines to $65m in 2015/2016

Media Businesses

As per the business description above, the only media business that’s worth mentioning are the News Media and Broadcasting segments. News Media has been declining due to the same issues affecting traditional print media in all developed markets. In November 2012, QMI closed down two production facilities that they estimate will result in $45m in annual cost savings. Despite 15% annual revenue declines and 25% annual EBITDA declines, I believe the cost savings should result in stable EBITDA between 2012/2013 but then continued EBITDA declines of 20%/year going forward. I assume flat revenue/EBITDA in the broadcasting segment going forward.

I assume flat L&E/Interactive revenue going forward despite consensus expectations for growth.

Elimination of Holding Company Discount

Part of the reason QBR is currently misvalued is because they own only 75.36% of QMI (which also owns only 51.5% of TVA). The sell-side uses a 10-20% holdco discount when determining their price targets on QBR and many plain vanilla Canadian long only investors shy away from any complicated holdco structures. However, in October 2012, QBR purchased 20.64% of CDP’s stake in QMI for $1.5bln. This was a two part transaction. (1) They issued $1bln in senior notes at the QMI level to purchase/cancel 20.35m shares of QMI. (2) They also purchased an additional 10.18m shares of QMI for $500m through the issuance of a convert at the QBR level (thus, convertible into QBR CN publicly traded stock) at a rate of 4.125% and a strike price range of $38.50-48.125 over a 6 year term. Since the deal was done, the stock has rallied from $33 to $46.

Looking at the second transaction, QBR CN bought 10.18m shares or 9.86% of QMI for $500m, valuing QMI at $5.1bln or 16x 2012 FCF. While this is a premium to where QBR CN currently trades, the transaction was still accretive since it was debt financed at a lower rate and since QMI’s FCF is growing.

CDP has publicly acknowledged that they do not want to own any private illiquid assets going forward. Assuming a similar 16x 2013 FCF purchase price for final 24.64%, QBR would have to pay $1.64bln. If we assume this can be financed using QMI’s cash flow at a 5.7% interest rate, the transaction would be accretive to our 2014 FCF by $30m and 2015 FCF by $40m. This would also eliminate the holding company discount at QBR and attract many long only Canadian investors to the company. 

Catalyst