Description

INTRODUCTION:

I would like to present an investment idea that certainly does not meet the traditional Graham definitions of a “value” stock (low P/E, low price/book, etc.) and has operations exclusively outside of the United States (the Company, however, is U.S. headquartered, is a full U.S. filer, and follows U.S. accounting standards). So why am I bringing it to the attention of a group of value investors that prefers to focus on companies with U.S. operations? Good question. No, seriously, I am presenting for your consideration UnitedGlobalCom, Inc. (UCOMA on Nasdaq) because I believe that it offers a very intriguing investment given the potential value of its assets as well as the “special” situation created by current events (courtesy of John Malone).

[Note: UCOMA is a complex company involved in a complex situation. In this write-up, I will endeavor to rise above the minutia to more clearly convey the investment thesis. Hopefully, I will succeed without oversimplifying or leaving out important details. Nonetheless, this write-up is lengthy, and I appreciate your indulgence.]

QUICK SUMMARY

UCOMA, approximately 73% owned by John Malone’s Liberty Media, is a holding company whose principal operating subsidiary, United Pan-Europe Communications (UPCOY on Nasdaq), is currently going through a balance sheet restructuring. UCOMA owns securities throughout UPCOY’s capital structure, so UCOMA is positioned to control the restructuring process as well as benefit under virtually all restructuring scenarios. UCOMA closed today at $5.56 while very conservative assumptions yield a post-restructuring value of more than $7.00. More bullish assumptions result in values well north of $20.00.

COMPANY DESCRIPTION:

UCOMA is the largest international broadband communications provider of video (i.e., cable television), voice, and data services, with operations in 26 countries. UCOMA's networks reached, in aggregate, 19.0 million homes, and served over 11.2 million video customers, as of December 31, 2001. In addition, the Company's telephony business had approximately 877,000 telephony subscribers, its high-speed internet access business had 786,000 subscribers, and its programming business had approximately 48.2 million subscribers.

The Company is organized as a holding company with ownership stakes in three primary operating companies:

(1) United Pan-Europe Communications (UPCOY on Nasdaq) – 53% owned by UCOMA. UCOMA also owns roughly $1.7 billion in face value of UPCOY subordinated debt (approximately 37% of the outstanding subordinated debt) and approximately $900 million in face value of an UPCOY convertible instrument (100% of the convertible issue). UPCOY is one of the leading broadband communications companies in Europe, providing its customers with cable television, internet, and telephony services. Furthermore, UPCOY delivers interactive and transactional television services and pay TV channels to its own and other cable and satellite networks.
(2) VTR – 100% owned by UCOMA. The largest broadband communications provider in Chile. UCOMA also owns some other smaller Latin American assets, but for the purpose of this write-up they will be ignored.
(3) Austar – 81% owned by UCOMA. A provider of satellite, cable television, and telecommunications in Australia and New Zealand.

UCOMA also has approximately $200 million in cash and no meaningful liabilities.

OWNERSHIP:

As a result of a series of transactions between John Malone’s Liberty Media and UCOMA, Liberty now owns an approximately 73% economic interest in UCOMA. In the transaction that closed at the end of January 2002, Liberty increased its ownership stake in UCOMA from approximately 10% to the current roughly 73% in return for $200 million in cash, $1.7 billion in face value of UPCOY subordinated debt, and $900 million in face value of an UPCOY convertible instrument. Interestingly, at the end of February 2002, Liberty bought an incremental 1.7 million shares (approximately 400 million outstanding) of UCOMA in the open market at just below $4 per share and in the first half of March Liberty bought a further 650,000 shares between $4.30 and $5.00. The founders of UCOMA own a bit more than 2% of the equity and the public owns almost all of the remainder. It should be noted that Liberty’s shares carry super voting power.

THE “SPECIAL” SITUATION:

Quick background – UCOMA and UPCOY were once internet bubble high fliers, with UCOMA’s stock reaching roughly $100 and UPCOY’s stock peaking near $80. Money was easy to come by, and, based on over-optimistic assumptions, UPCOY raised and spent lots and lots of it building out and upgrading its broadband network. Not surprisingly, this easily available capital has dried up, and now UPCOY must face the music as its capital structure is much too leveraged (similar to its UK peers, NTL and Telewest).

It should be clearly noted, however, that unlike many other internet bubble businesses that simply never made sense nor will ever make sense, UPCOY’s business and financial model makes clear sense. In its most summary description, it is the same as that of Comcast, Charter, Cox, or the old TCI – providing cable television and other broadband services (e.g., internet access, telephony, interactive television) to its customers. Just like these U.S. cable companies, UPCOY controls the valuable “last mile.”

On February 1, 2002, UPCOY announced a restructuring plan to deal with its over-leveraged capital structure. According to the press release, it is UPCOY’s intention to convert all of its subordinated debt, all of its convertible debt, and all of its preferred shares into common stock. UPCOY intends to leave its bank debt outstanding. UPCOY’s bank lenders have provided UPCOY with a waiver until June 3rd to work out the details of the restructuring. The waiver was needed because UPCOY chose not to pay EUR 113 million due on its public debt on February 1st. Given UPCOY’s meaningful cash position (approximately EUR 900 million as of September 30, 2001), the decision not to make the interest payment was intentional and done because of the ongoing discussions regarding the equity swap with the debt holders.

As a reminder, UPCOY securities ($900 million in face value of a convertible instrument, $1.7 billion in face value of subordinated notes, and 53% of the common shares) are UCOMA’s main assets. Thus, the UPCOY restructuring process (and the associated conversion of UCOMA’s various stakes in UPCOY securities into new UPCOY equity) provides the key to unlocking value for UCOMA.

Generally, I would be wary of wading into a stock prior to a restructuring due to fear and uncertainty as to what the post restructuring value of the equity would be. Therefore, let me attempt to explain why I see this situation as different from the norm:
(1) Most importantly, I am suggesting a purchase of UCOMA shares, while it is UPCOY that is being restructured. To be honest, I think there is a good chance that the current UPCOY equity winds up being nearly worthless, but the UCOMA equity is another story.
(2) The restructuring process will largely be controlled by UCOMA given UCOMA’s stakes in UPCOY throughout the capital structure – 100% of the convertible instrument (this instrument is senior to the subordinated debt), 37% of the subordinated debt, and 53% of the common equity.
(3) The legendary master of the complex deal, John Malone, is on UCOMA’s side of the negotiating table. Given Liberty’s recently acquired 73% stake in UCOMA, Malone and his lieutenants are meaningfully incentivized to create value for the UCOMA common shares.

VALUATION:

Like most things involving UCOMA, valuation is a bit complicated as we can look at it at least three ways: (1) prior to the restructuring on an asset value basis, (2) following the restructuring on an asset value basis, and (3) following the restructuring on a cash flow basis.

[Note: In the analyses below, I sometimes refer to values per subscriber as well as ARPU’s. All of my calculations count one customer as one subscriber regardless of to how many services he or she subscribes. In UCOMA’s and UPCOY’s press releases they typically speak and calculate in terms of RGUs (revenue generating units). One RGU equals a subscriber to one service, so a single customer that subscribes to cable + telephone + internet access is counted as three RGUs. I prefer to analyze in terms of customers rather than RGUs because to my mind doing so is more true to the concept of increasing ARPUs through bundling and it is also more consistent with the methodologies used by U.S. cable companies. Keep in mind, however, that because of this my number of subscribers is lower than UCOMA’s/UPCOY’s number of RGUs while my ARPU is correspondingly higher.]

(1) Prior to the restructuring on an asset value basis

UCOMA has the following assets – (a) 81% ownership of Austar (worth $0 for all practical purposes), (b) 100% ownership of VTR (conservatively worth $400 million based on $1,250 per subscriber (vs. $3,000 to $4,000 for a typical U.S. subscriber), which is quite low considering these are high quality, high ARPU (>$30) customers and that VTR is the premier cable company in Chile and making strong inroads in telephony and internet access; some would argue VTR is worth $2.00-$3.00 per UCOMA share), (c) $200 million in cash (d), $900 million in face value of the UPCOY convertible instrument (valued at par given its position in the capital structure), (e) $1.7 billion in face value of UPCOY subordinated debt (valued at $300 million, slightly less than Liberty paid for it, but a round number), and (f) 53% of the UPCOY common shares (conservatively valued at $0). UCOMA has no meaningful liabilities. Adding it all up ($400 million for VTR + $200 million in cash + $900 million in the convertible + $300 million for the subordinated debt, all divided by roughly 400 million shares) we get a floor value of approximately $4.50. It should be noted that using comparable assumptions to those above, Liberty paid a weighted average of $5.00 per share when it increased its stake in UCOMA from about 10% to 73% at the end of January 2002. In a sense, I view this $4.50 value as a kind of security value floor. “Extra” discounting the convertible instrument and the subordinated debt yields an “extra” conservative pre-restructuring value of $4.00.

(2) Following the restructuring on an asset value basis

Post restructuring much will change for UCOMA – its $900 million of UPCOY convertibles, $1.7 billion of UPCOY subordinated debt, and 53% of UPCOY common will all be converted into equity of the “New” UPCOY. So, following the restructuring UCOMA will be left with (a) 81% ownership of Austar, (b) 100% ownership of VTR, (c) $200 million in cash, and (d) equity in the “New” UPCOY. What is it all worth? In (1) just above I gave my explanations of why (a) + (b) + (c) conservatively amount to $1.50 per UCOMA share. Now, let’s look at (d), the equity in “New” UPCOY. First of all, how much of the “New” UPCOY will UCOMA own? Management has quoted figures in the 80% range based primarily on the senior position of the convertible (of which UCOMA owns 100%) vs. the subordinated debt (37% owned by UCOMA), preferred, and common (53% owned by UCOMA). I have created a model in which I have run through all sorts of restructuring scenarios (i.e., how many cents on the dollar for each part of the capital structure), and, given UCOMA’s hedged position throughout UPCOY’s capital structure, the lowest post-restructuring ownership stake I come up with is 65%. So, let’s use this figure and consider any stake above 65% gravy (keep in mind that UCOMA/Liberty has a very powerful seat at this negotiating table, so upside is quite likely).

So, UCOMA will own at least 65% of what? Well, UPCOY will have its core cable business (including telephony and internet access) plus ownership stakes in many other assets (e.g., DTH satellite operations, UPC Media – a programming business, Chello – a broadband ISP, Priority Telecom – a CLEC focused on business customers, stakes in several public companies, significant tax loss carry forwards, and roughly $800 million in cash (as of September 30, 2001)). For this analysis I will value them all, other than the core cable business, at $0. Admittedly, this is an unrealistic assumption because some have valued these assets collectively at more than $2 billion (excluding the cash), or $3.25 per UCOMA share assuming 65% ownership of the “New” UPOCY. However, I like to be conservative. As just previously noted, I have also valued UPCOY’s $800 million in cash at $0. Why? One, to be conservative, and, two, because UPCOY will need to use that cash to implement its business plan.

Seemingly, I’m valuing everything inside UPCOY at $0, so is there anything else left to add to the $1.50 in value from UCOMA’s cash and its VTR stake? Absolutely – UPCOY’s core cable franchise. This business has approximately 7.2 million subscribers. In the U.S. a subscriber is worth $3,000 to $4,000. UPCOY’s subscribers are not as valuable as those in the U.S. because the amount they pay per month is far less than subscribers pay in the U.S. – UPCOY’s current average monthly ARPU is approximately $13 while many U.S. subs are paying more than $40 per month. UPCOY, however, has been slowly but steadily increasing its average ARPU through a combination of raising rates, providing higher tier options, and signing subscribers up for service beyond basic cable television (e.g., internet access, telephony, and digital cable). You will have to draw your own conclusion about the average value of one of UPCOY’s subscribers. Your conclusion will depend most particularly on how high you believe UPCOY can drive ARPU and how profitable that ARPU will be. I personally believe UPCOY can easily get to ARPUs north of $20 in just a few years and earn typical cable industry margins (40% EBITDA margins) on those revenues. My confidence is based on the steady progress they have been making, the tremendous demand from customers for broadband internet access as well as alternatives to their incumbent, generally state-run, phone carriers, UPCOY’s own profit margins in its base analog cable business, and the margins generated by UPCOY’s cable company peers. No matter how you cut it, UPCOY is sitting on top of what John Malone and others consider to be highly prized real estate – the “last mile.” I believe UPCOY will monetize that real estate. Given my expectations, UPCOY’s average subscriber can be conservatively valued at $1,000. With this assumption in hand, UPCOY’s core cable business is worth $7.2 billion (7.2 million subs x $1,000). Take out the bank debt that will be remaining post restructuring of approximately $3.7 billion (very conservative estimate; compares to approximately $3 billion indicated in press releases and research reports, but provides “extra” leeway for any other “pockets of debt”) and you have $3.5 billion of UPCOY equity value. 65% of this equity value will be owned by UCOMA and results in an UPCOY contribution to UCOMA’s per share value of $5.70. Add in the $0.50 for the cash and $1.00 for VTR and you have a $7.20 UCOMA stock price.

As a quick recap, the major assumption on which that $7.20 value is based is that an UPCOY subscriber on average is worth $1,000 (keeping in mind a U.S. sub is worth $3,000 to $4,000). At $2,000 per UPCOY subscriber, UCOMA shares would be worth about $19; at $750 per subscriber the value for a UCOMA share would fall to $4.25. In order to make an investment in UCOMA at current prices, you need to get yourself comfortable that an UPCOY sub is worth a minimum of approximately $850. If you can do that, you’ve eliminated the downside and baked in all sorts of meaningful upsides to the UCOMA share price – (a) each and every extra $100 of value per subscriber is worth approximately $1.15 per UCOMA share, (b) UCOMA’s ownership of UPCOY post restructuring may turn out to be more than 65%, (c) there is reasonably up to an extra $2.00 in value from VTR, (d) post restructuring debt outstanding at UPCOY may turn out to be more than $500 million less than the $3.7 billion figure in the calculations above resulting in an additional $0.80, (e) there is potentially more than $3.00 in other asset value inside of UPCOY, (f) the tax loss carryforwards have value, etc., etc. My point is this – don’t get bogged down in the details, if you can get comfortable with an approximately $850 value per UPCOY subscriber then you will win here, the only question is just how big. It is clear where Malone is betting.

(3) Following the restructuring on a cash flow basis

This write-up is already far too long, and, in my opinion, this is really more of an “asset value” investment than a current or near-future cash flow investment, so I will try to be brief and to the point in this section. In 2001 and before, UPCOY generated negative EBITDA as UPCOY spent heavily starting up and marketing its new services. It should be noted that in 2001 and years before UPCOY’s base analog cable business produced positive EBITDA; it was, however, masked by the start-up losses in internet access, telephony, programming, etc. In 2002 UPCOY is projected to turn EBITDA positive and from there forward quickly ramp to more meaningful positive EBITDA as it adds new services, new customers, and increases prices while its costs are relatively fixed. UPCOY should generate $200 million in EBITDA in 2002, $450 million in 2003, $700 million in 2004, and continue growing in the years beyond. Based on this 2003 EBITDA (and given the conservative assumptions run through above regarding the restructuring), today’s UCOMA price implies a 2003 EBITDA multiple of approximately 14x for UPCOY; this figure drops to about 9x if you use the 2004 numbers. Most U.S. cable companies are trading in the range of 11x-14x 2003 EBITDA. UPCOY is arguably more risky than the average U.S. cable company, but its EBITDA growth prospects are substantially better. Also, keep in mind that these implied multiples of UPCOY EBITDA would be meaningfully lower if some of the UCOMA/UPCOY “upsides” discussed above materialize (e.g., greater than 65% ownership of UPCOY by UCOMA, more than $1.00 in value to UCOMA from VTR, less debt outstanding post-restructuring at UPCOY than used in the above analysis, greater than $0 in value to UCOMA from UPCOY’s other assets, etc.).

KEY RISKS:

(1) Timing and outcome of the UPCOY restructuring: While at various points in this write-up I have provided my opinion regarding the likely timing and outcome, it ain’t over until its over. That being noted, UCOMA’s positioning throughout UPCOY’s capital structure should enable an efficient and constructive process. Also, the conservativeness of my assumptions regarding the outcome of the restructuring makes disappointment unlikely. All this being noted, if a consensual negotiated restructuring agreement cannot be reached, it may get ugly for holders of all the securities.

(2) Value of an UPCOY subscriber: This issue has already been addressed in the Valuation section above. Nonetheless, it is worth reiterating that in order to get really comfortable with UCOMA an investor needs to get comfortable with the value of an UPCOY subscriber.

(3) Future funding requirements: Following the restructuring and the elimination of meaningful interest expense, UPCOY’s business plan should be largely funded. Remember, I have given no credit to the $800 million cash balance in any of the analyses above (and I have also baked in an “extra” $500 million of debt). It is always possible, however, that the cash needs could turn out to be greater than expected requiring UPCOY to raise additional capital in the future through transactions that could be harmful to UCOMA’s stake in the equity of UPCOY.

Catalyst

Conclusion of the current UPCOY restructuring negotiations is the major catalyst that will drive UCOMA’s stock price northward. According to management and some debt holders, the negotiations and restructuring should be completed by June 3rd at the latest (when the current waivers expire). Following the restructuring, two key factors that have kept buyers away will be eliminated – uncertainty and excessive leverage (although enough leverage will remain to provide some juice for the equity jam). A further catalyst will come on the financial performance side – in 2002 the UPCOY will finally turn EBITDA positive, and, based on my research, will exceed expectations. Finally, Liberty/John Malone will be by far and away the most meaningful stakeholder in both UCOMA and, through UCOMA, in UPCOY, and it would not surprise me to see further Malone value-creating moves down the road (e.g., folding UPCOY fully back in to UCOMA, taking the Chilean assets public, merging UPCOY and/or UCOMA with one or more other European cable properties, etc., etc.)