Liberty Starz Group LSTZA
January 29, 2011 - 6:56pm EST by
flyer
2011 2012
Price: 65.01 EPS $4.04 $3.98
Shares Out. (in M): 52 P/E 0.0x 0.0x
Market Cap (in $M): 3,391 P/FCF 0.0x 0.0x
Net Debt (in $M): -536 EBIT 331 336
TEV ($): 2,855 TEV/EBIT 0.0x 0.0x

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  • Media
  • Malone

Description

PLEASE SEE ROTIN'S LSTZA WRITE-UP FROM 12/18/09.  I FOUND IT VERY HELPFUL IN MY RESEARCH PROCESS.
 

•      I.        THESIS

Liberty Starz Group ("LSTZA", "Liberty Starz" or the "Company"), one of Liberty Media Corporation's ("Liberty Media") three tracking stocks, includes the Starz/Encore premium cable movie networks ("Starz Entertainment") and a small collection of theatre and home video distribution and production businesses ("Starz Media"); Starz Media does not have a material impact on LSTZA's financial results.  Liberty Starz is set to be split-off from Liberty Media later this year alongside a second Liberty Media tracking stock, Liberty Capital Group ("LCAPA").  The LSTZA and LCAPA "splitco's" will still be tracking stocks, housed inside the same parent company. 

 The current LSTZA was formed on 9/20/09 when Liberty Media spun off its former Liberty Entertainment ("LEI") business, which then owned a 41% equity stake in DirecTV ("DTV").  LEI subsequently merged with DTV, leaving the LSTZA assets behind with Liberty Media as an independent tracking stock.  While the natural selling pressure related to arbitrageurs of the LEI/DTV merger shorting LSTZA stock has dissipated, owning the common equity has now become significantly more attractive as the split-off will enable management to pursue its plans to return balance sheet cash to shareholders and assume a modest amount of debt appropriate for such a cash-rich, stable business.  If management allocates $500 MM of the current $635 MM cash balance to buybacks and optimizes the balance sheet with 2.5x turns of leverage using proceeds to repurchase stock, fair value is $97/share, upside of 50%, assuming the pro forma equity is valued at 15x 2010 earnings.  If LSTZA re-signs its Netflix ("NFLX") agreement at market rates, in combination with the aforementioned recapitalization and buybacks, at 15x pro forma earnings, fair value for LSTZA stock is over $180/share, upside of 180%

 In addition, consider two very plausible call options: 1) Chris Albrecht, the former head of HBO and creator of its original series successes, is now the CEO of Starz Entertainment and recently completed his first full year with LSTZA, and; 2) LSTZA has discussed the potential for a PTV consortium that distributes the digital streaming content for the three industry participants, which would improve the Company's financial performance and prospects while also alleviating the negative investor sentiment that questions how Starz will survive the major competitive landscape changes facing the digital video streaming business.

•    II.        BACKGROUND / COMPANY OVERVIEW

Starz, a premium TV channel business ("PTV"), provides a multiplex of channels that play commercial free programming under its Starz and Encore banners through its cable and satellite television affiliates.  Starz content includes a combination of recent box office movies, older movies from studio libraries and original content. As a PTV channel, Starz makes money when cable and satellite TV consumers subscribe to the Company's channels in addition to a basic cable package.  The cable and satellite affiliates are incentivized to sell the Starz package as the affiliates collect a significant portion of the subscription revenue.

Starz is ultimately a distributor, entering agreements with film studios for the rights to show such films over the Starz and Encore channels following the box office release and subsequent expiry of the DVD sales window (DVD sales are generally the golden goose for the film studios, and the studios permit Starz and other PTV channels to show films only after the DVD has been available for sale for 60 to 90 days.  This time frame is also generally between 12 and 18 months post box office release). Starz must then sell its product, thereby entering agreements with various affiliates or MSO's such as Comcast, DTV, Dish, Cablevision, Time Warner Cable, Verizon, etc. to distribute the Starz service to consumers in exchange for a monthly fee.  For cable affiliates, this is an additional fee on top of a basic cable package. 

While Starz on the surface may not appear to own a meaningful piece of the value chain as a wholesaler, the Company in fact enjoys a nice competitive moat vis-à-vis the inability of affiliates to afford studio content given that each affiliate can only access a finite number of the country's subscriber base, whereas LSTZA can distribute to all of the MSOs and penetrate a critical portion of the country's subscriber base.  Furthermore, the studios are fighting to protect their share of the film business's economics, and PTVs such as Starz provide the studios with large, upfront payments that facilitate the production of movies. Studio contracts generally last 6 to 10 years while affiliate contracts generally last 15 years.

The competitive forces for video distribution are rapidly changing with the proliferation of alternative video consumption models such as Netflix (which currently has a contract to distribute Starz content), as physical video stores are declining, and speculation runs rampant over the upcoming changes to digital video distribution with the likes of Hulu and Amazon, while Apple, Google and Microsoft are largely regarded as potential acquirers or entrants into the business.  However, it is important to remember amongst all of the change (and perceived potential for additional change) that PTV has existed for decades and has maintained consumer purchasing momentum, particularly as competing PTV service HBO has bolstered its in-house content offerings with shows such as the Sopranos, Curb Your Enthusiasm, etc.  Note that Liberty Media launched Starz in the early 1990's whereas the Company's two competitors, HBO and Showtime, launched in the 1970's.  Despite its late start, Starz has penetrated the PTV market, and with the recent addition of HBO's former original series star, Chris Albrecht, as Starz's CEO the Company is poised to offer even stronger competition for HBO and Showtime in the future.

•   III.        CATALYSTS

  • 1. Share buybacks - the Company has stated its intention to use cash on the balance sheet and excess free cash flow for such purposes, particularly in light of the currently undervalued share price. The key strength of this business is John Malone's capital allocation decisions. He acts very similarly to Warren Buffet, always pursuing the highest risk-adjusted return on capital and thereby focusing heavily on valuation when making buyback decisions.

 

  • 2. Post split-off, a levered recapitalization to enhance shareholder returns without jeopardizing LSTZA's ability to run its operations and acquire/produce original series content. Clearing up the transparency of LSTZA's balance sheet stands as a key motivator for Liberty Media's planned split-off of the Company.

 

  • 3. LSTZA renegotiates its NFLX agreement at current market rates in-line with NFLX's recent agreement to pay Epix $1 BN over 5 years ($200 MM/year) for streaming rights to the Epix film library. The Company currently receives about $20 MM/year from NFLX, or 1/10th of what NFLX pays Epix. Similar terms for LSTZA would translate into levered free cash flow increasing 65%, while after-tax earnings would increase over 50% to more than $6.10/share. Note that any contract pricing increase goes directly to LSTZA's earnings and cash flow lines as the Company incurs no marginal costs with the re-pricing. This is a call option of sorts and not critical to the valuation analysis of this write-up.

 

  • 4. Chris Albrecht's pipeline for Starz original series programming creates a superior product offering and thereby increased subscriber base over the coming years, similar to his success transforming HBO into a powerhouse of in-house content with series such as the Sopranos, Entourage, Curb Your Enthusiasm, etc.

 

  • 5. Similar to Epix's strategy of forming a consortium for film studios, Starz forms a consortium with the other two PTV players to distribute digital streaming content. While not likely a near term event, the value proposition and economics of a consortium would have a multiplicatively positive impact on the Company's financial prospects and perception amongst investors. LSTZA management has openly discussed this as an ongoing consideration.

  

•   IV.        VALUATION

Intrinsic Value: Net of the $10.28/share of balance sheet cash, investors receive the Starz business for 13.5x 2010 earnings.  Despite the current negative sentiment, which creates the opportunity to buy the stock today at such an attractive price, LSTZA is a good business that not only grew EBITDA during the coinciding economic downturn and proliferation of HBO's original series content but that also requires virtually no capital investments and generates operating margins of almost 28% and a pre-tax ROIC of almost 14%.  The upside resides in capital allocation and balance sheet efficiency, which is exactly what the pending split-off transaction is designed to produce - the ability to return balance sheet cash to shareholders and capitalize the business with a reasonable level of debt.  If management allocates $500 MM of the current $635 MM cash balance to buybacks at the current share price, the stock is worth $71 should it be valued conservatively at 15x 2010 earnings.  Second, assuming the Company optimizes the balance sheet with 2.5x turns of leverage and uses the proceeds to repurchase stock, at 15x EPS, fair value is $97/share, upside of 50%.  Then consider shareholders have very real upside potential in the form of re-signing LSTZA's contract with NFLX to market rates.  Using NFLX's recent agreement with Epix as a benchmark, if Starz received a similar $200 MM/year from NFLX, revenues would increase by $180 MM/year.  Assuming no marginal cost, earnings would thereby increase by a similar amount.  In conjunction with the aforementioned recapitalization and buybacks, at 15x pro forma earnings, fair value for LSTZA stock is over $180/share, upside of 180%.  

Lastly, consider two very plausible call options: 1) Chris Albrecht, the former head of HBO and creator of its original series successes, is now the CEO of Starz Entertainment.  He has recently completed his first full year with LSTZA and has spent his time almost exclusively focused on creating original series content for Starz.  While his efforts are still in the production stages, this content should begin to materialize over the coming years.  This is obviously difficult to quantify, and while not included as part of this valuation analysis, a management change as significant as this acts as a true catalyst for the success and growth of the business and its financial performance; 2) LSTZA has discussed the potential for a PTV consortium that distributes the digital streaming content for the three industry players.  Again, this cannot be currently quantified, and while not critical to this analysis, such a consortium would not only enhance Starz's digital streaming penetration and financial performance, but it would alleviate the negative investor sentiment that questions how Starz will survive the major competitive landscape change that the digital video streaming business is facing (a la Netflix, Hulu, Amazon, Microsoft, Google, Apple, etc.).

Relative Value: Given that LSTZA has only two direct comps, both of which are subsidiaries of large, diversified media and entertainment companies (Time Warner owns HBO, and CBS Corporation owns Showtime), no relevant publicly traded peers exist.  However, according to the Company's most recent investor presentation that incorporates analysis provided by external analysts, HBO is currently valued at 11x forward EBITDA, and Showtime is valued at 8x.  While Starz may be the #3 player, at less than 8x EBITDA, LSTZA is by no means overvalued, especially when considering its prospects with Chris Albrecht as CEO in the beginning stages of creating an original series business and Starz's contract with NFLX is currently priced far below market rates.  It's also important to note that Starz/Encore has almost 50 MM subscribers, while HBO and Showtime only have about 42 MM and 37 MM subscribers, respectively.

 

•    V.        CAPITAL STRUCTURE

 

LSTZA has just $99 MM of debt outstanding with balance sheet cash of $635 MM, for net cash of $536 MM, or more than $10.25/share.  Part of the reason for the proposed split-off of LSTZA is to provide a clean balance sheet for the Company.  Should LSTZA assume a moderate leverage ratio of 2.5x, the Company could pay out over $780 MM to the common equity holders.  Combined with the balance sheet cash, this implies potential current cash to equity holders of $1.3 BN, which represents approximately 40% of the current market capitalization without assigning any value to the actual business.

 

•   VI.        VALUE ADDED RESEARCH

This is a summary of the value-added research conducted for LSTZA.  Below is the list of key sources with an overview of the findings and relevance for each source.  This research generally CONFIRMS a long position in LSTZA at $65/share or less

KEY SOURCES

Entertainment Talent Agent (Los Angeles):  A contact who is a L.A. based talent agent for one of the leading agencies frequently participates in discussions with film studios.  This agent has confirmed the deteriorating leverage of the film studios and concerns they have regarding disintermediation as alternative venues for digital video consumption emerge, thereby reducing the most profitable element for the film studios, DVD sales.  Therefore, the studios are becoming increasingly friendly with PTVs to maintain the current system and economics in tact as the massive change in digital consumption continues.  Furthermore, film studios strongly fear a similar fate to the music industry where Apple has monopolized music distribution with its iTunes service which has taken away the music industry's (former) golden goose, CD sales, and given Apple leverage over the music labels in determining the allocation of industry economics.  Therefore, the film studios continue to work with PTVs to ensure the current system remains intact.

DTV S-4:  Given the lack of publicly traded peers for Starz, the DTV S-4 provides supporting valuation analysis for LSTZA as the filing includes the valuation process for legacy LEI's cable channel business, the Game Show Network.  Unfortunately, the S-4 does not include any precedent transactions; the sole valuation methodology employed is a discounted cash flow analysis.   While this analysis does not include a discounted cash flow model in light of the inherent false precision related to financial projections and the wide ranging assumptions for terminal valuation, the Game Show Network analysis provides a supporting data point in that the terminal value is based upon an EBITDA multiple of 7x.  The Starz/Encore business is vastly superior to the Game Show Network business as Starz not only has far superior product with a much larger and more loyal subscriber base and thereby demand from consumers and affiliates, but it has established distribution via the largest digital streaming business, Netflix.  Furthermore, Starz's prospects prove significantly greater given its management change and hiring of Chris Albrecht as well as potential to re-sign its agreement with Netflix at much higher market rates and possibly create a PTV digital distribution consortium.  Therefore, if the Game Show Network has been valued at 7x EBITDA, LSTZA should certainly be worth far more than its current valuation of 7.6x.

 

• VII.        REASONS FOR OPPORTUNITY / VARIANT VIEWS

  • 1. Bear Case #1: Starz should not exist. HBO offers superior in-house content, and consumers only purchase a Starz package as an up-sale for an HBO package. Furthermore, basic cable offers hundreds of other channels with adequate content.

Variant View:  Starz provides good value, showing hundreds of hours of box office movies for approximately $12/month. While Starz sits well behind HBO and Showtime in original programming, the Company has hired the HBO original programming star, Chris Albrecht, to make this the key priority for the business.  Furthermore, note that Nielson has Starz ranked #22 for all channels viewed, including broadcast and basic cable channels, and Starz is viewed more per subscriber than Showtime.  Also, note that through the current downturn, subscribers have declined less than 5% from the peak as pricing has increased due to customer mix shifting towards telecom affiliates (i.e., Verizon and AT&T) which generate higher rates than cable affiliates, resulting in overall revenue growth over this time frame.  Lastly, John Malone now owns over 50% of DTV, one of LSTZA's top three customers, and I imagine Mr. Malone would not limit DTV's PTV offerings or allow DTV to drop Starz and cause a company he controls to deteriorate as a result.

  • 2. Bear Case #2: Starz is the clear #3 player behind HBO and Showtime in a three player industry, largely as a result of having the weakest management team. Therefore, Starz's sub count has peaked.

Variant View:  Management is actually a positive event-driven catalyst that makes this company and stock compelling.  Starz changed management in December 2009, hiring as its new CEO, Chris Albrecht, the former HBO executive who turned that business into an original series powerhouse with the likes of the Sopranos, Curb Your Enthusiasm, Entourage, etc.  Having just over a year of experience with Starz, Mr. Albrecht has had the requisite time to start launching his initial original series into production, providing substantial future upside for content quality and therefore subscriber growth and subsequent loyalty.  As an example of one early achievement for Mr. Albrecht, he arranged and completed a transaction with the Weinstein Company, which acquired a 25% stake in Starz Media. This transaction is effectively a minority stake in the Anchor Bay subsidiary, which will now distribute Weinstein Company films.

Additionally, note how well this business has performed throughout the downturn and without Chris Albrecht as CEO.  This illustrates the power of the Starz business and its ability to ultimately run itself.

  • 3. Bear Case #3: Starz assumes significant vendor risk with only two film studios, Sony and Disney, providing the Company with its content, while customer risk is also high given that four affiliates distribute to 70% of Starz consumers.

Variant View:  As it relates to vendor risk, film studios rely on the PTVs to monetize their libraries, and PTV is therefore becoming increasingly relevant to the studios as DVD sales wane in light of the consumer transition to digital streaming content.  Furthermore, PTV companies have actually come to possess meaningful negotiating leverage with the film studios given the outsized shift in consumer demand for original series content, as exhibited by Showtime's recent re-signing of its agreement with MGM/Paramount/ Lion's Gate at a 50% haircut to the previous contract. 

In terms of consumer concentration risk, Comcast, which represents 25% of Starz consumers, renewed its contract with LSTZA on terms similar to the prior agreement.  Additionally, in 2010, Time Warner and Cox, which represent approximately 18% of Starz consumers, also renewed their respective contracts with Starz on terms similar to the previous deals.  Furthermore, the affiliates very much like the PTV business not only because consumers are demanding ever increasing amounts of original series content, but because PTV requires no capital or marginal expenditures from the affiliates.  The agreements include a revenue split for the affiliate, which proves to be nothing but accretive.

  • 4. Bear Case #4: The video distribution model is undergoing substantial changes as digital streaming emerges as a new form of consumption while new distribution technologies emerge (i.e., Hulu, Netflix digital streaming, Amazon digital streaming, Redbox digital streaming). Furthermore, even greater industry change looms from the likes of large technology companies with outsized cash balances seeking out acquisitions and potentially penetrating the digital video streaming business (i.e., Google, Apple, Microsoft, etc.). Additionally, film studios have begun to compete with PTV via Epix, a consortium formed by a handful of studios that recently signed a digital streaming agreement with Netflix. How will Starz survive this increasingly competitive environment?

Variant View:  Digital streaming is a positive for Starz and the PTV industry.  Digital streaming growth increases the value of distribution rights, and Starz is already carried by the top digital streaming participant, Netflix.  As evidence, note the most recent digital streaming transaction, signed between Netflix and Epix, which set a record price of $1 BN over five years.  Second, LSTZA has openly discussed forming a PTV consortium with HBO and Showtime to digitally stream content over the Internet.  The victim of this change is most likely the affiliates who risk disintermediation as the Internet becomes the standard medium of digital streaming, as well as the studios who risk deterioration of their golden goose, DVD sales.  

To its credit, Showtime has realized the shifting value within the ecosystem, namely that the exclusivity PTV has on the "new release window" continues to erode as consumers have found alternative digital viewing platforms.  As such, Showtime refused to re-sign its distribution agreement with MGM/Paramount/Lion's Gate at its previous rate and demanded a 50% price reduction.  This proved the catalyst that caused these studios to form the Epix consortium designed to disintermediate PTV.  While Epix signed a valuable digital distribution deal with Netflix, Epix has proved unable to arrange any significant distribution agreements with the affiliates who fail to find the need for a 4th PTV service.

•VIII.        RISKS

  • 1. Management fails to follow through with its stated capital structure and share repurchase plans for LSTZA.
  • 2. The video consumption transition to digital streaming and related industry changes disintermediate PTV participants such as Starz.

Catalyst

  • 1. Share buybacks - the Company has stated its intention to use cash on the balance sheet and excess free cash flow for such purposes, particularly in light of the currently undervalued share price. The key strength of this business is John Malone's capital allocation decisions. He acts very similarly to Warren Buffet, always pursuing the highest risk-adjusted return on capital and thereby focusing heavily on valuation when making buyback decisions.

 

  • 2. Post split-off, a levered recapitalization to enhance shareholder returns without jeopardizing LSTZA's ability to run its operations and acquire/produce original series content. Clearing up the transparency of LSTZA's balance sheet stands as a key motivator for Liberty Media's planned split-off of the Company.

 

  • 3. LSTZA renegotiates its NFLX agreement at current market rates in-line with NFLX's recent agreement to pay Epix $1 BN over 5 years ($200 MM/year) for streaming rights to the Epix film library. The Company currently receives about $20 MM/year from NFLX, or 1/10th of what NFLX pays Epix. Similar terms for LSTZA would translate into levered free cash flow increasing 65%, while after-tax earnings would increase over 50% to more than $6.10/share. Note that any contract pricing increase goes directly to LSTZA's earnings and cash flow lines as the Company incurs no marginal costs with the re-pricing. This is a call option of sorts and not critical to the valuation analysis of this write-up.

 

  • 4. Chris Albrecht's pipeline for Starz original series programming creates a superior product offering and thereby increased subscriber base over the coming years, similar to his success transforming HBO into a powerhouse of in-house content with series such as the Sopranos, Entourage, Curb Your Enthusiasm, etc.

 

  • 5. Similar to Epix's strategy of forming a consortium for film studios, Starz forms a consortium with the other two PTV players to distribute digital streaming content. While not likely a near term event, the value proposition and economics of a consortium would have a multiplicatively positive impact on the Company's financial prospects and perception amongst investors. LSTZA management has openly discussed this as an ongoing consideration.
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