Description

Executive summary:

• Dominant video/streaming retailing business ran into issues in 2022 following fire at a key fulfillment center
• Other macro headwinds led to higher costs, worse performance, and accelerating customer losses
• Last two quarters customer losses have improved, business grew OIBDA +35% y/y
• Aggressively buying back bonds to deleverage the balance sheet
• Equity is a cheap call option, trading around 100% leveraged FCF yield with business performance inflecting positively
• Other opportunities in the capital structure, including double-digit yielding first lien debt, and subs trading at attractive prices
• Fears about secular decline are overblown; QRTEA is the market leader in a secularly growing industry

It’s the holiday season, which means it’s time for VIC to tune into its favorite video shopping channel and hunt for bargains. In this piece, I argue that Qurate Retail Inc. (NADAQ: QRTEA) is trading at an extremely cheap valuation with catalysts for near-term appreciation. The myriad issues that plagued the company over the last two years were idiosyncratic as opposed to terminal, and the company is in the midst of a positive inflection point. There are attractive buying opportunities up and down the company’s capital structure, including the common stock.

Qurate has been written up four times on VIC. The past write-ups provide more than enough background and overview of the company and its business model. In brief, Qurate is a holding company which owns various subsidiaries in the video and e-commerce industries. Qurate’s principal businesses and assets include consolidated subsidiary QVC Inc. and Cornerstone Brands International (“CBI”), plus other equity method accounting investments. Below is a snapshot of the company’s capital structure per its 11/9/23 investory day presentation (available here, recommend looking through the whole thing):

And my own cap table with some estimates for YE23 and FY2024 numbers:

 The QVC Inc. subsidiary includes QxH (QVC US and HSN) and QVC International, and generates most of the consolidated company’s revenues and earnings (the company uses adjusted OIBDA, or Operating Income Before Depreciation and Amortization as one of its primary performance metrics; I will use OIBDA and EBITDA interchangeably here because they are basically the same thing). Over the last twelve months, Qurate Retail has generated $11.3 billion in revenues and $931 million OIBDA. In terms of segment breakdowns, QxH generated 63% of revenues and 73% of OIBDA; QVC International 22% of revenues and 35% of OIBDA; CBI 11% of revenues and 3.5% of OIBDA. Corporate and other was 5% of revenues and -11% of OIBDA. It should be noted that Corporate and other historically included results from its money-losing Zulily asset, which the company divested in May of this year.

As of yesterday’s close, the stock was trading at 88c, a deep discount to where it was trading the last time it was written up. In fairness, no one could have anticipated the devastating fire the company suffered in late 2021 which near-destroyed its Rocky Mount Inc. fulfillment center in North Carolina. Rocky Mount was the second largest fulfillment center for QxH and QVC’s primary return center for hard goods.

Much of what was previously written about Qurate remains true today. Following a public LBO of the company in August 2020 (nicely laid out by Mustang here), Qurate became a darling in the value investing community, with a stable and very profitable business that produced lots of cash and could therefore support its heavy debt load. It aggressively returned capital to shareholders via repurchases and dividends. Its programming reaches 213m households worldwide, and its customers are extremely loyal. In the latest quarter, the company reported a 95% retention rate (89% repeat customers i.e. had purchased something in the last twelve months, 6% reactivated customers i.e. had purchased before but not within the last twelve months). They are known for having incredible data analytics and effectively catering to their loyal customers. Not only is the company an effective merchandiser and product curator, but its studio production creates a compelling, immersive and engaging customer experience. thecoyelf wrote about the concept of super users in a previous write up here – super users account for approximately 70% of QxH’s annual revenues. There are about 1.8m of them (99% retention rate) and they spent on average $3,800 on 75 units over the last twelve months. The super users create a stable, recurring income stream that grows at a 5% CAGR.

Unfortunately, the company ran into myriad problems in 2022. Supply chain bottlenecks, inflation, and a Rocky Mount fire wreaked havoc on the company’s operations. The loss of property (including $95m of inventory) raised costs and made it difficult for the company to fulfill customer orders, leading to abnormally high levels of customer losses. However, in the last two quarters Qurate has shown considerable progress in repositioning its supply chain (the Rocky Mount property was closed and subsequently sold) and cutting costs through its Project Athens initiative:

These efforts helped substantially improve cash flow year-on-year:

OIBDA is on track to reach about $1 billion for FY2023 and the company has generated $585 million of free cash flow over the last twelve months. For 2024 I’m assuming they’ll generate $1.1 billion of OIBDA and $300 to $400 million of free cash flow.

It's rare to find a stock trading at a 100% (levered) free cash flow yield, and even rarer for that company to have just reported 35% year-on-year EBITDA (OIBDA) growth. Qurate has both going for it. Additionally, the Liberty Media team know how to manage leveraged capital structures, and they aggressively bought back bonds in the second quarter of this year ($177m of the QVC 24s and $15m QVC 25s at big discounts to par). On the latest call, they indicated they would be able to mature the 24s and 25s with balance sheet cash and revolver draw; they have about $3bn of total liquidity, consisting of $1.1bn of cash and $2bn available on the RCF. They indicated they would look to use all their FCF to buy back bonds, although wouldn’t disclose which ones (I suspect they are buying the QVC 2027s and/or 2028s).

Assuming $400 million of FCF in 2024 and all of it going to bond buybacks at an average price of 80c on the dollar, Qurate will reduce the face value of its debt by $500 million to $4.5 billion in 2024. Assuming $1.1 billion OIBDA puts net leverage at 4.1x. The preferred is another $1.3 billion so net leverage through the preferred would be 5.3x. Assuming another turn through the equity implies a TEV / EBITDA of 6.3x (vs. 6.6x today) and a stock price of $2.65, about 3x today’s price.

A quick note on technicals: while most analysts and investors seek out opportunities in companies who are buying back stock, in my experience a company that is buying back bonds at substantial discounts to par is an even more powerful tailwind for a stock. Not only do such repurchases create equity value for the shareholders, but there is a tendency for bondholders who may be long the bonds and short the stock to cover their stock short as the bonds rally, creating a virtuous cycle as the company’s debt exits distressed territory. It’s also rare to see a company’s debt recover quickly and the stock lag the way QRTEA has. See below – both the bonds (QVC 2027s) and stock of Qurate took a dive in March of this year, with the former bottoming around 40 and now completely recovered to where they were at the beginning of this year. Meanwhile, the stock is still down about 50% YTD:

These situations usually present an attractive entry point for the stock. One last point: my firm has been (somewhat) successful shorting stocks with deteriorating credit fundamentals over the years, and one of our risk management rules has been to stay away from anything with a market cap that is less than 10% of the company’s TEV. It’s just too dangerous to short a stock with that much potential torque, especially if there is no imminent risk of filing. QRTEA’s market cap is currently around 5% of its TEV, so would be on our “do not short” list. Perhaps buying a stock simply because it’s too risky to be short is insufficient reasoning on its own, but it certainly doesn’t hurt.

For those who are not inclined to “take a yo” on a distressed equity (whether due to personal preference or firm mandate), here are some thoughts on the other parts of the company’s capital structure:

QVC Inc. (Bloomberg ticker = QVCN, all first lien, pari passu with revolver)

2024s/2025s: low-risk way to lock-in 10% YTM, company will use cash and RCF capacity to mature

2027s/2028s: only risk is if company can’t extend its revolver, however given cash generation and deleveraging I think these bonds are cheap given 2.3x create, first lien position and 14% YTM; believe company is buying them back which doesn’t hurt

2034s/2043s/2067s/2068s: not as compelling to me, if you’re going to take that much duration risk, may as well go junior

Liberty Interactive LLC (Bloomberg ticker = LINTA)

Probably my favorite security in the capital structure aside from the stock is the Sr debentures due 2029. The bonds have nice carry with 8.5% coupon, current yield around 20% and 32% YTM, created at 3.9x. What makes this especially compelling is the relative value: the Qurate Retail Inc. Series A cumulative redeemable preferred stock, 8% of which is owned by John Malone and Greg Maffei, sits beneath the bonds and is trading around $37.50. They have a mandatory redemption date of 3/15/2031, so the effective YTM is 29% vs. 32% for the 2029s, despite the 2029s being more senior in the capital structure. The rest of the bonds in the LINTA credit box are also senior to the preferred and relatively cheap, but I like the 2029s in particular because they have the highest carry with the shortest maturity. Additionally, if the company were to run into further problems, it can turn off the $100 million annual preferred dividend to save cash; they can’t do that with the bonds or else they’ll be in default. In a restructuring the bonds would (theoretically) have to recover 100c on the dollar before the preferred gets any recovery. The preferreds offer the worst relative value in the structure in my opinion.

Although they are somewhat related, there are two main risks with this investment. First is balance sheet/capital structure. The company can handle its near-term maturities with cash and revolver, but the revolver matures in 2026, and the company will have to refinance that. They have picked the “low hanging fruits” with sale leasebacks to generate liquidity, and any additional unencumbered assets the company can pledge would be only incremental.

However, on its latest investor presentation, the company indicated a commitment to 2.5x LT net leverage, which if achieved will bode well for refinancing the revolver. To accomplish that, they’ll have to continue to perform on the business front and use excess free cash to buy back bonds and deleverage, which they’re doing. Additionally, the bottoming of the company’s OIBDA and FCF generation gives me confidence they’ll mature the 2024s and 2025s with no problem. If one thinks of the stock as a call option, the time to expiration just got extended and that alone justifies a higher valuation, which I believe is likely to be realized over the next year.

The bigger issue is terminal risk. It’s true that streaming is taking over bundled cable packages and that has caused disruption in the video retailing industry. Earlier this year, the company was losing mid-teen percentage of total customers, and it can’t survive long term if it loses customers every year.

A few counters to this argument. First, reiterating the point from earlier that the high customer losses were predominantly due to performance issues related to the fire, which the company has addressed. Second, recall the point about super users: they are extremely loyal and account for 70% of the company’s core revenues. Warren Buffett recommends investing in things that don’t change. If there’s one thing that doesn’t change, it’s older people’s TV viewing habits. And there’s a reason for this loyal devotion: Qurate’s programming is centered around creating an immersive, community-like experience. The viewers feel as though the talent is speaking directly to them, and they enjoy this sense of belonging. Frankly, it’s almost cult-like. Spending growth by this cohort grows at a roughly 5% CAGR. With QxH’s customer loss rate slowing, the growth in spend implies a flattish next couple years for the company’s topline. Third, streaming should be considered as an opportunity to grow and take share. Qurate is “the original influencer company” as they put it in the recent investor day presentation, and has the cheapest cost of studio production for video/streaming retail content. They will meet their customers wherever they are. The digital revolution has meant more content consumption, not less. Fourth, their target demographic is women entering the 2H of their life; this is a secularly growing category, as America’s population is getting older, not younger. Qurate is skating to where the puck is going. With Project Athens already bearing fruit to stabilize the business, they indicated they will share plans in the coming quarters about their next growth initiative in 2025.

Catalyst

Continued OIBDA growth and deleveraging through cash generation and bond buybacks in 2024