Description

Qurate Retail Group:

Summary

QVC has been written up twice in the last couple of years and covers both the background (tdylan409) and the 2020 transaction (Mustang), I won’t rehash here.

The market thinks QVC is a melting ice cube due to their current reliance on the bundle, but the business has some unique characteristics that reduce this reliance.  The focus on certain headline metrics such as total customers and headline debt lead to a misunderstood business and security:

1.  ~70% of QxH revenue comes from ~1.8 million “super users”.  Total customer count, while relevant over the long-term isn’t the metric that determines performance, it’s the health and stability of the super user. 

2.  The business model holds real value.  Other retailers have tried and failed to set up similar type businesses, but it is difficult to replicate given the time it takes to build up super users.

3.  The leverage is well managed and management has a good track record of effectively running highly levered cash flow generators.

4.  Management continues to throw capital back to shareholders and will continue to do so through special dividends and share repurchases.

Thesis

1. Super users

QxH has ~11.1 million customers (as of September 30, 2021), but the real driving force behind their operating performance is “super users”. These users are defined by customers who have purchased 20+ items within the last 12 months. There are ~1.8 million of these customers in the U.S. I’ve listed some of their key 2021 stats below (from investor day):

• Spend ~$3.4k a year

• Purchase ~70 items a year

• Visit QVC related websites daily

• Tune into QVC 18 times per month

• Have a retention ratio of 99% and

• Make up ~70% of QxH’s sales

70% of QxH’s revenue is ~$6 billion. Assuming a similar make up for QVC International, we get ~$8 billion of QVC’s revenue from ~2.5 million customers. QVC hasn’t given much info on international super user stats, so there’s some guesswork, but the point stands, super users drive QVC’s operating performance (QxH and QVC International make up >90% of OIBDA).

And this isn’t a bad group. Super users love what QVC offers and keep coming back year after year. A habit this strong isn’t something that stops because a super user decides to cut cable. It’s likely these customers will either keep cable, specifically for QVC, or will make sure their new streaming method/device includes it.  An obsessive golfer doesn’t just give up golf because he’s moved to a different city, he may have to go out his way to find a club or people to play with, but he’ll do it given his passion for the game. QVC’s super users are the female shopping equivalent.

The key question for QVC is can they get new customers into their funnel and can they keep turning them into super users, whatever their preferred platform. Historically, they’ve turned ~2% of new U.S. customers into super users in year 1 and ~2.5% by year 3 (purchased 20+ items in any of years 1-3). The scenario below shows an estimate of the number of new customers QxH needs to keep super users roughly stable:

• Current super users at QxH = 1.8 million

• Super user conversion ratio = 2.25%; mid-point of 1 and 3-year conversion ratio.  There's a good chance this can be improved with performance marketing now bringing ~30% of customers (more targeted ads).

• Retention ratio = 97%; adjusted down from their investor presentation number (99%) to account for increased friction from switching platforms and a mortality rate I don’t believe is included in the ratio they present (mortality rate of a 65-year woman is ~1%...).  This number could temporarily drop lower as normalization occurs post pandemic.

• Super users lost per year= ~$55k

• Solve for new customers needed $55k/2.25% = ~2.4 million new customers per year

In QVC’s 3Q presentation the # of new customers for the quarter was ~450k, a 33% drop YoY and down ~15% from 2019.  This numbers spooked the market.  However, just like the juiced-up numbers from the pandemic need to be normalized, the same needs to be done here. 

Supply chain issues have made for a very tough quarter.  Getting product has been extremely difficult and put pressure on what QVC can offer their customers (shipping delays have been 2 weeks in some cases).  The categories most impacted by supply chain bottlenecks are also over-indexed to occasional and new customers (electronics and home).  In this environment, focusing attention on keeping current customers happy is more important than trying to attract new ones.  QVC is also buying products from multiple different vendors and locations, making logistics complicated.  Finally, a slowdown from elevated pandemic demand was inevitable.  People have been itching to get back out and, given QVC customers tend to be active in their communities, seeing her get back out is not a surprise or indicative of a long-term trend.  Bottom line, looking at just 3Q numbers isn’t a reasonable way to look at customer count moving forward.  Using pre-pandemic 2019 customers numbers or a 2-year stack (2020 and 2021) would give a better picture.

2. Business model value

QVC’s business model adds value for both customers and sellers, allowing for a more authentic selling experience.  Rather than having an influencer add a post on their Instagram and read a script “I use x product, it’s great, use promo code xxx21 at checkout”, the selling is less in your face and feels more collaborative. The host, while paid by QVC and has an incentive to promote the products, doesn’t (as obviously) directly benefit from selling the product to the audience, and is therefore viewed as a trusted adviser by the customer.  The host is almost seen as a guide, showing customers items of interest in an educational way, rather than the high pressure sales tactics seen elsewhere.  The vendor benefits by gaining access to QVC’s customer base who are willing and eager to spend.  The live demos also help promote higher quality products as vendors are forced to show their product in a live environment. 

This is the reason other retailers have attempted to create a QVC type experience over the years (e.g. Amazon Style Code which was shut down in 2017).  These attempts haven’t really got off the ground due how the business model works; it requires a base of customers that make up most of the revenue.  Building this base takes time as new to best customer conversion rates are low (~2% for QVC).  Therefore, operating at a loss for an extended period is required.  Not many businesses are going to accept this, and a better option would be to be to just buy the customer base (especially when its trading ~5x FCF).  There’s almost an argument that if the new to best customer conversion ratio gets too high, say 10%, it would lower QVC’s structural advantage, as others could then build the required base quicker (all things equal).

3. Leverage

QVC operates with a significant amount of net debt, ~$8 billion (includes the preferred, offset by ~$300 million in cash post special dividend).  However, the debt structure makes the headline numbers misleading.

QVC has four outstanding convertible debentures, currently valued at ~$2 billion, that can be settled in either payment of principal at the maturity date (ranges from 2029-2046) or for the stock of certain companies (Charter, Motorola Solutions, T-Mobile, and Lumen Technologies). These are carried on the balance sheet as a current liability as they can be exchanged at the holder’s option and they don’t currently hold the stock.  Management does not expect these options to be exercised until closer to the maturity dates (“never convert a convert”). 

The Lumen and T Mobile bonds (~$860 million principal) are way out the money and can be viewed as debt due in 2030, with a ~4% interest rate.  The Charter bonds have an indemnification attached to them, so they’re carried at fair value, ~$715 million, but Qurate will be reimbursed for any payments above the principal (principal is currently ~$330 million).  The MSI bonds (~$210 million principal) are “in the money” and management announced they will call these bonds in December and fund the redemption with their newly refinanced line of credit. Total expected cost to redeem the MSI bonds is ~$420 million (including $105 million increase in tax liability).

What this effectively means is they have ~$6.7 billion of debt maturing by 2030 (including converts and preferred) but none before 2023.  The maturities are reasonably spread out but it’s likely the debt markets are going to be tough on Qurate, given their extreme capital return policy over the last 18 months (they’ve returned ~$3.5 billion to common equity since August 2020).  However, Mr. Maffei and the team have proven themselves more than capable of navigating debt markets and I believe they can do so again.    

A note on the bonds maturing in maturing in the 2060s with a ~6.3% interest rate (issued in 2018 and 2019).  The common equity is yielding ~20%, capital is being returned consistently, management has a good reputation for acting in shareholders’ best interests, and the market sees the business as a melting ice cube.  If someone has a good bull case for this debt over the common (it trades slightly above par), I’d be genuinely interested to hear it.

4. Continued capital returns

Management’s statements about the continued return of capital are credible and are set to continue.  While true the previous buybacks did not add value (the acquisitions haven't worked out great either), the special dividends show management is willing to adapt.  The current low multiple also allows for Mr. Maffei to get creative in how capital is returned (likely a mixture of buybacks and special dividends - $1.25 per share special dividend was paid November 22). This was on full display with the 2020 transaction as it gave shareholders a choice of how they wanted to participate in QVC going forward. It allowed the bulls to double down and keep a levered equity, while those who wanted to reduce exposure got capital back through a dividend and a preferred security (rather than having to sell the common equity at a very low multiple).  Mr. Maffei's comments at the investor day hint at heavy buybacks through the rest of the year.

On the operations side, Mike George retiring is a loss, but this was known for a while and an orderly transition has taken place.  David Rawlinson II took over on Oct 1 and, despite the tough quarter, came across well during his first conference call and the investor day.  His previous experience, focusing on customer behavior, looks a great fit for QVC.  The current cash flow number is also lower (both quarter and YTD) due to a readjustment of working capital and increased capital spending in the current year (TV distribution rights).  Inventory is now higher and ready for year-end demand (~30% of sales occur in 4Q), which should translate to solid cash flow.  Cash flow will look a lot better in 4Q.

Valuation

There has been a bit of volatility in FCF due to some working capital movements in the business but OIBDA has been stable at ~$2 billion over the last few years.  The business currently trades at ~5.5x EV/OIBDA and assuming no multiple expansion, a stable business, ~$800 million annual FCF with ~80% returned to shareholders, we end up with a business still valued roughly the same (~$3.3 billion) with ~$3.2 billion returned to shareholders (~$800 million debt paydown and the rest refinanced).   

The bet is the business can stabilize and we trust the management to return capital.  If these two things happen, Quarate will do just fine.

Risks

• Super user numbers drop, and the pandemic proves to be a band aid over a structurally declining core business (super users cut the cord and don't continue watching on their streaming device). If super users decline significantly over a short period (outside of post-pandemic normalization), this thesis will have been proven incorrect.

• Missteps in managing their heavy debt load or credit markets tightening would mean more free cash flow has to be allocated to debt repayment, or new debt on unfavorable terms.

• Even if their core business is difficult to replicate, substitutes, such as influencers selling directly over social media, eat into QVC’s customer base and reduces the value add of their curation and full studio production. I consider this unlikely given QVC’s ability to pivot to what their customers want and the quality of their production. Watching QVC has a significantly different feel than being pitched a product by an influencer on Instagram or even Amazon Live.  

• Supply chain issues persist and freight rates stay elevated over the long-term, resulting in reduced free cash flow and forcing QVC to increase prices to a level where QVC’s customers start to look around for cheaper options. This is a macro risk but may have a larger impact on QVC, given they don’t primarily compete on price.

Catalyst

• The business rebounds from 3Q numbers and the market begins to believe QVC has a terminal value.

• Super user numbers hold steady or even begin to grow modestly, showing the market the long-term viability of the business model in the digital world.

• Potential sale, on QVC’s terms, to a retailer looking to buy their high-quality customer base.

• Value is recognized due to aggressive capital return policy.