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In a turbulent market, the only thing better than a cheap stock is a cheap stock trading at a large discount to another cheap stock it owns! Liberty Entertainment (LMDIA) has all the hallmarks of an interesting opportunity: a misunderstood situation cause by a recent spin-off & confusing financials, large & increasing free cash flows, a large buyback, an owner-manager with a strong track record of shareholder-friendly value creation, a shareholder list full of value investors and most importantly it’s trading at a cheap price.
LMDIA is trading at a 20.5% discount to its net asset value (NAV) of $30.91; importantly, ~80% of this NAV is the current market value of its DirecTV (DTV) stake, only 20% has been estimated by my valuations. My intrinsic value estimate for LMDIA using my valuation of DTV is even higher, $39.43. In a display of market inefficiency, LMDIA is even trading at a discount to the DTV stake alone, valuing the other 20% of LMDIA’s assets at less than zero, creating a “negative stub” of -$3.83 per share, a beautiful sight for a value investor. These discounts are due to complicating factors that make LMDIA difficult to understand or value on a traditional book value, EPS, or DCF basis, including: dual-class A&B stock structure, tracking stock status (so limited standalone LMDIA info), a large misleading deferred tax liability booked against its DTV stake, investor neglect of its recent creation via a spin-off and its lack of a major operating business & standard financial statements.
I expect these complications to erode over 12-18 months as Liberty reduces complexity through a simplification of the LMDIA/DTV structure (once spin-off tax rules no longer preclude a transaction), which combined with appreciation in the intrinsic value of LMDIA’s DTV stake (and DTV trading up towards intrinsic value) and DTV’s $3BN stock buyback should boost LMDIA towards its intrinsic value of $39.43 (my NAV estimate with DTV at its intrinsic value of $35), offering a 60% return to investors. Essentially, I believe investors who today buy a tracking stock holding a minority interest in DTV will in 12-18 months own a far less complex non-tracking stock that has been separated from Liberty Media, operates DirecTV, cable networks and other assets and trades near its intrinsic value. Even if Liberty doesn’t simplify the LMDIA/DTV structure (they have strongly hinted they will), appreciation of DTV and LMDIA towards their intrinsic values offers multiple sources of value creation even if the restructuring doesn’t happen. Also LMDIA’s 20% discount to NAV and 38% discount to my calculation of intrinsic value provide an ample margin of safety.
LMDIA was created via a spin-off from Liberty Capital (LCAPA) and began trading on March 5, 2008. LMDIA “tracks” Liberty’s 48% stake in DirecTV, the Starz/Encore cable networks and several smaller media assets. There are 493MM LMDIA shares and Liberty Entertainment also has 23.7MM super-voting LMDIB shares, which don’t trade and are mainly held by Liberty Chairman John Malone (I include LMDIB whenever I refer to “LMDIA shares” below). LMDIA is one of three tracking stocks issued by Malone’s Liberty Media Corporation (the others are LCAPA, which “tracks” a variety of media assets, and Liberty Interactive (LINTA), which “tracks” the QVC network, equity stakes in IACI and EXPE, and some smaller assets).
For those unfamiliar with tracking stocks, Liberty Media is the single corporate entity that owns all the assets and is responsible for all the liabilities that are attributed to the three tracking stocks. Liberty Entertainment is not a separate legal entity and doesn’t technically own the assets which have been “assigned” to it by Liberty Media. This structure has been criticized as “gimmicky” and has been used to take advantage of tracking stock holders (by IPO-ing a hot dot-com subsidiary via a tracking stock at a high valuation and later buying it back after it crashes) and certainly carries drawbacks: financial disclosures are confusing, LMDIA shareholders lack some typical shareholder rights & are liable for the liabilities assigned to the other tracking stocks, and management can create conflicts of interests among the three tracking stocks. These drawbacks are partially responsible for LMDIA’s discount to NAV. I believe many of them are mitigated by John Malone’s large ownership of all three tracking stocks ($200MM of LCAPA, $460MM of LINTA and $650MM of LMDIA). Also I expect the tracking stock structure will be unwound when LMDIA is combined with DTV.
The LCAPA tracking stock historically traded around book value (Liberty provides an “attributed” balance sheet for each tracking stock); it appears the market now also values LMDIA at book value. For LCAPA this made sense since its assets were mainly equity stakes in other media companies. These stakes are marked-to-market and the associated capital gains tax liabilities are recorded as a deferred tax liability (DTL) and subtracted when calculating book value. Malone has boosted LCAPA’s book value & stock price through tax-free asset swaps, exchanging the equity stakes for operating assets and cash. These transactions reduce the DTL and increase book value. When the market values LCAPA at book it’s not giving credit for monetizing these stakes tax-free but instead assumes a liquidation scenario where all stocks are sold on the market and capital gains tax of 35% is paid. As a result the fully-taxed value at which LCAPA trades is typically 20-35% below the market value of its assets.
This might make sense for valuing LCAPA but it makes less sense to value LMDIA at book value. On that same attributed balance sheet from 3/31/08, LMDIA’s main asset is its $11.05BN of investments (mainly DTV) and it has a DTL of $1.75BN (also mainly DTV as LMDIA kept NWS’s tax basis in DTV). LMDIA’s book value is $12.8BN or $24.63/share (520MM diluted shares). Unlike LCAPA, whose business strategy involves monetizing its equity stakes, it’s unlikely LMDIA would ever sell its DTV stock and pay the huge $1.75BN DTL – Liberty loves the asset, believes it’s undervalued and intends to keep it. LMDIA is trading at its 3/31/08 book value despite DTV having appreciated 8.6% since then and the high likelihood the DTL will never be incurred.
Valuation & stub trade
Here’s my adjusted book value or sum-of-the-parts valuation of LMDIA (line-item details follow) based on 520MM diluted shares outstanding:
DirecTV stock (548.7MM shares @ current price of $26.92): $14,772MM or $28.41 per LMDIA share
Starz Entertainment: $2,300MM
Regional sports networks: $500MM
Gameshow Network (50% interest): $250MM
Fun Technologies: $200MM
Wildblue Communications (32% interest): $100MM
Total non-DirecTV assets: $3,350MM or $6.44 per share
Net debt: -$1,604MM or -$3.08 per share
Estimated DTV covered call liability: -$445MM or -$0.86 per share
Total NAV: $16,072MM or $30.91 per share
I’ve disregarded the DTL as it’s unlikely it will be incurred. I’m subtracting my estimate of LMDIA’s cost to settle some DTV call options they’ve written assuming they’re settled at my DTV intrinsic value of $35; in contrast to the DTL, this liability (while uncertain in amount and potentially smaller) will likely have to be paid. LMDIA’s NAV is based on DTV’s current market price; when I substitute my $35 DTV intrinsic value into the NAV calculation above, I get my intrinsic value for LMDIA: $39.43.
Clearly it’s difficult for investors to evaluate LMDIA; while sell-side research has analysis similar to mine, analysts & investors appear unable to grasp the large misvaluation. This misvaluation allows the creation of a “negative stub trade” where one buys a share of LMDIA, hedges out each LMDIA share’s interest in DTV by shorting 1.055 DTV shares (548.7MM DTV shares owned divided by 520MM LMDIA shares), get paid a credit of $3.83 cash and own the other net assets of the “LMDIA stub” that I value at $2.50/share for free. Since LMDIA bought 78.3MM more DTV shares on 4/3/08 (bringing the DTV/LMDIA ratio up to the current 1.055), the LMDIA stub has traded as low as -$4.00 and as high as -$0.05 (daily closing prices). If LMDIA appreciates just to the value of its DTV stake (LMDIA stub=$0), the stub trade returns 15.6% plus any DTV short rebate earned; if LMDIA appreciates to NAV, the stub trade returns 25.7%. The major risk to the stub trade is the unlikely event of LMDIA buying the rest of DTV at a premium; smaller risks include nothing happening for a while and/or the stub declining further. While the stub trade offers an attractive risk-return (very low risk, 16-26% expected return) and I recommend it to investors who aren’t bullish on DTV and can short DTV on attractive terms, I prefer the better risk-return of an unhedged long LMDIA position (exposed to DTV’s business & stock price risk, 60% expected return). One attractive way to hedge potential DTV weakness while retaining most of the upside is buying DTV put options or put spreads. The negative stub and LMDIA’s discount to NAV are clear signals of misvaluation that create a 20.5% margin of safety (buying $30.91 of NAV for $24.58 LMDIA price). Another way to look at it, assuming my valuation of LMDIA’s other net assets at $2.50/share is accurate, buying a share of LMDIA allows you to purchase already cheap DTV for $20.93 ($24.58 cost less $2.50 other assets equals $22.08 for 1.055 shares of DTV or $20.93 per share), a 25% discount to DTV’s price of $26.92.
Liberty acquired 470.4MM of its 548.7MM DTV shares on Feb. 27, 2008 in a tax-free asset swap with News Corp when it traded its block of NWS stock back to News in exchange for NWS’s 470.4MM shares of DTV (41% of DTV’s 1,146MM total shares), three regional sports cable networks and cash. Liberty decided to spin off its DTV stake and cable nets from the more complex LCAPA to reduce the discount to net asset value and create a vehicle for content acquisitions. They likely also had a combination of LMDIA and DTV in mind. Liberty bought the other 78.3MM DTV shares in open market purchases in early April.
A review of Liberty’s history lends credence to the theory that Malone will combine LMDIA with DTV in the near future. Malone has had a long, successful career as a media investor, building TCI into the nation’s largest cable network and acquiring & developing the content assets that comprise Liberty Media before selling to AT&T in 1998. Malone & Liberty regained independence via a split-off in 2001. Since then, Malone’s modus operandi has been to acquire attractive assets, use tax-free asset swaps & spin-offs to simplify the Liberty Media conglomerate and buy back his stock when it’s cheap. Some relevant transactions: in June 2004, Liberty spun off its international cable assets into Liberty Media International (LBTYA). In January 2005, in a situation virtually identical to the current LMDIA-DTV one, LBTYA combined with its 54%-owned subsidiary UnitedGlobalCom in a no-premium merger to form Liberty Global. Liberty Global has been an aggressive buyer of its stock. In June 2005, Liberty spun off its interests in Discovery Holdings (DISCA), which has simplified its structure post spin-off. In May 2006, Liberty reclassified its stock into the LCAPA and LINTA tracking stocks and has since aggressively leveraged LINTA and repurchased LINTA stock. Finally, Liberty closed the asset swap of NWS stock for DTV stock in February 2008, which set up the spin-off of LMDIA from LCAPA in March 2008. I expect this value-creating, shareholder-friendly behavior to continue & benefit LMDIA holders.
Rather than going into detail on DTV, I’ll point readers to a write-up posted to VIC by jriz1021 on 12/3/07. While my numbers vary I generally agree with that analysis. To summarize the investment case: DTV has been competing effectively, gaining subscribers, converting subs to more profitable advanced services (DVR and HD service), reducing operating costs, improving customer churn by getting strict on customer credit quality while locking in subs with 18-24 month contracts, and its Latin American operations are overlooked but are very attractive & growing rapidly. My DCF valuation uses a 9% discount rate, 2% terminal FCF growth, sales growth stepping down from 13.5% in 2008 to 8% in 2009 & 2010, 6% in 2011, 5% in 2012 and 3% thereafter, EBIT margin rising to 18% by 2010 on reduced costs and operating leverage and CAPEX declining from $2.7BN in 2007 to $2.2BN in 2008 and thereafter. These should combine to boost free cash flow from $950MM in 2007 to $1.6BN this year, $2.4BN in 2009 and $2.9BN in 2010. Importantly, FCF growth is based on realistic assumptions DTV management has outlined including set-top box cost declining from $450 to $250, reduced CAPEX as the HD and DVR rollout progresses (DTV estimates upgrades to HD/DVR offer a ~50% IRR) and higher ARPU (avg. revenue per user) as HD/DVR penetration increases. I arrive at a DCF valuation of $35 per share. Currently DTV is valued at 11.8x 2009 FCF for an 8.4% FCF yield. Even using more negative assumptions, both DTV and LMDIA remain substantially undervalued.
The next most meaningful asset is Starz Entertainment, which owns the Starz, Encore and Multiplex cable movie networks. Revenues ($1.1BN in ’07) have been growing slowly as the networks have already achieved large penetration. Programming costs have been declining as older, more expensive content contracts roll off; this is the main driver of recent increasing cash flow. EBITDA was $264MM in 2007 and I expect it to rise to $320MM in 2008 and over $400MM in 2009, driven mainly by cost declines, not subscriber or ARPU growth. My DCF valuation of Starz of $2.3BN implies 7.2x 2008E EBITDA, well within the ballpark for a cable network. Certainly one can debate the competitive threat of disintermediation of Starz by movie studios starting their own networks, video-on-demand via the internet, etc. But as long as Malone controls DTV and Starz there’s little chance any of the other major carriers drop the channel or drastically cut pricing; also at 7.2x EBITDA I think competitive threats are accounted for.
I value the three regional sports networks Liberty acquired in the NWS swap at $500MM. This is the book value implied in the asset swap and is about 11x their 2008 estimated EBITDA from a the sell-side analyst (can’t remember which). I value Fun Technologies, an internet gaming company, at $200MM based on the price Liberty paid recently to buy out the minority interest. LMDIA’s 50% interest in the Gameshow Network is valued at book value, as is its 32% interest in Wildblue Communications, a satellite broadband provider. I consider these valuations conservative, but appropriately so given the lack of information (importantly, these assets are growing somewhat and generating free cash flow).
Two important recent events deserve consideration. LMDIA’s April 2008 purchase of the 78.3MM additional DTV shares just 2 months after acquiring its initial stake illustrates how undervalued DTV seems to Liberty. The purchase was funded in a complex structured transaction with an investment bank. LMDIA entered into costless collars on 110MM of its original DTV shares by buying puts and selling calls (detailed in an 8K filed 4/14/08). This allowed LMDIA to pledge the 110MM shares (minimum value was locked in with the puts) to borrow the $1.98BN needed to buy the 78.3MM new DTV shares for $25.25 each. This $1.98BN loan is interest-free, as the value of the calls sold to the bank was greater than the puts purchased so this was effectively how the bank got paid. LMDIA is now short 110MM DTV call options with strikes from $28.33 to $33.25 expiring 12/30/09 through 8/29/12. The Black-Scholes value of these calls is -$513MM or -$0.99 per LMDIA share. Should DTV appreciate to $35, LMDIA would have to pay $445MM in cash to settle the calls, or $0.86 per LMDIA share (this is the liability used in my NAV). Hopefully LMDIA will pay to settle the options early before DTV rises that high. Also note that while a $445MM liability sounds large, LMDIA got a $2BN interest-free loan and if DTV rises to $35, the 78.3MM shares of DTV that LMDIA bought will have appreciated by $763MM so LMDIA is ahead. The written DTV calls also create a kind of negative convexity for the LMDIA stub trade – since 110MM/548.7MM or 20% of the DTV shares are covered by the calls, as DTV appreciates above the calls’ strike prices the stub trade relationship breaks down.
The other recent event was a voting standstill agreement LMDIA reached with DTV (8K filed 5/7/08). DTV has been an aggressive buyer of its stock, buying $3BN in 2006 and $2BN in 2007. Liberty’s April stock purchase lifted its DTV ownership to 47.9%. While DTV wanted to keep buying back stock, it didn’t want to push LMDIA over 50% and give away majority control. So Liberty signed a standstill agreement freezing its vote at 47.9% and allowing DTV management to execute its $3BN authorized buyback. This shows DTV management’s willingness to cooperate with LMDIA, allows DTV to resume an attractive buyback, and also allows LMDIA to get above 50% ownership of DTV, which could be important in combination negotiations. On 5/14/08 DTV raised $2.5BN in debt financing to facilitate the buyback on attractive terms ($1BN add-on to its bank deal at ~5% interest and a $1.5BN new bond paying 7.625%).
Combination with DTV
I believe Liberty management wants to combine LMDIA with DTV. They have spoken fairly openly on recent conference calls about the attractiveness of doing so. The benefits for Liberty include a simplified structure helping the combined company to trade at a higher valuation, creating a currency for acquisitions and access to DTV’s free cash flow & underleveraged balance sheet. The drawbacks are the potential loss of tax efficiencies through separation of LMDIA from Liberty Media, Malone may have to give up control (convert his super-voting LMDIB shares to LMDIA) and any premium to be paid to DTV holders. I think the positives well outweigh the negatives.
On 7/1/08, John Malone was interviewed on CNBC (the video is on CNBC’s website) and said: (1) a combination/Liberty taking control of DTV makes sense, (2) he knows exactly what he’d like to do but has to deal with tax issues first, (3) they are trying to get tax opinions/rulings to permit them to move sooner but might not be able to act for a year. This is the strongest evidence that Malone will move to gain control of/combine with DTV as quickly as possible. I am surprised no one picked up on this (both stocks declined in the next few days and the LMDIA stub has declined). The only questions that remain are how long it will take, the price and what structure will be used.
I believe that the most likely possibility for effecting a combination of LMDIA and DTV is a spin-and-merge transaction similar to the Liberty Interactive – UnitedGlobalCom transaction mentioned above. In this scenario, LMDIA is spun off from Liberty Media as a separate company and it merges with DirecTV. This can be accomplished tax-free using a Reverse Morris Trust structure as long as LMDIA has a greater market value than DTV (I believe the DTV shares held by LMDIA don’t count in this calculation as DTV market value). All of LMDIA’s actions point towards this structure (as does the UnitedGlobalCom precedent): LMDIA was spun off to create a stock with a smaller discount to NAV than LCAPA, LMDIA bought the 78.4MM additional DTV shares to boost LMDIA’s market value while reducing the DTV held by others, and LMDIA entered the standstill to allow DTV to buy back stock with debt, shrinking its market value. I believe these actions were done with an eye towards getting LMDIA’s market cap above the non-LMDIA held DTV market value to enable this transaction structure.
I further believe LMDIA will be able to convince DTV’s independent board members that a combination will simplify the corporate structure, increase all shareholders’ value and that no premium (or only a small one) is justified. The major impediment (besides time) is LMDIA’s current discount to NAV; Malone won’t want to combine LMDIA trading at $24.58 but actually currently worth $30.91 with DTV. Hopefully LMDIA’s discount to NAV will shrink or Liberty will figure out how to narrow the discount (buying back LMDIA shares and/or talking up their desire to do a DTV deal are possibilities) or structure a transaction that minimizes the problem.
I see two risks to owning LMDIA. One is deterioration in DTV’s business due to weakening U.S. consumer spending and/or competitive threats from cable companies. This is possible but I believe it’s unlikely and more than priced into DTV’s stock. I believe DTV’s business is more solid from a competitive standpoint than it’s given credit for (looking at the data the past few DTV quarterly results have been quite strong) and DTV’s recent initiatives to improve the credit quality of its customer base should insulate it somewhat from consumer weakness. Anyone worried by this risk can hedge the DTV exposure by shorting DTV or buying DTV put spreads. The other major risk is that Liberty switches priorities and decides to use LMDIA or DTV stock to make content acquisitions before combining LMDIA and DTV. I believe this is unlikely, but if it happened LMDIA’s stock price would suffer. If I’m wrong about a LMDIA/DTV transaction happening, it’s unlikely LMDIA will appreciate to its NAV, but the investment can still be profitable if the discount narrows and/or DTV appreciates.
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