Description

Lodgenet Interactive Corporation (LNET) provides cable and other broadband service to the hospitality industry.   The stock trades at incredibly cheap free cash flow yield (arguably over 40%) and valuation multiple (4x TEV / EBITDA).   The market clearly believes these cash flows are not sustainable due to lower travel spending in a recession and technology risk (travelers will increasingly watch movies on their own laptop or other device as opposed to ordering a film on the hotel TV).  No doubt  the slowdown in consumer spending is definitely happening and new technologies may erode LNET’s business in the medium to long-term (not much evidence so far of a major impact).  But the market ignores many of LNET’s considerable strength.   It is effectively a monopoly and it has many levers to reduce costs.  While not without risk, LNET offers investors the potential to make multiples on their money and has less risk than most investors fear.     

 

For years, the company was locked into a bitter price war with Liberty Media controlled On Command. Last year, LNET finally bit the bullet and bought On Command.  The market initially reacted very favorably to the merger and sent the shares to over $30 a share. This year however is a different market and a different story.   As many industry participants and observers can attest, On Command was a very aggressive competitor more interested in market share than profits.   As part of a much larger organization, it had the luxury of pursuing such a strategy.   On Command frequently including free services in its bids to hotels.    By eliminating somewhat of an “irrational” competitor, LNET can realize higher prices and better margins.   For example, the Company projects margins to increase  from 10.7% in 2007 (proforma for the merger) to almost 19.1% on the sale of basic and premium television to customer.  This dramatic increase is due to LNET renegotiating a legacy contract of On Command that provide such services to a major customer for free.   Increased market clout and better pricing will go a long way toward offsetting the impact of weak travel market. 

 

At current levels the stock has a free cash flow yield of close to half the current stock price and trades at just 4.3x EBITDA.  LNET  paid down close to a dollar per share in debt in the last quarter alone. They should be well within their debt covenants and small changes in the markets perception of the stock can yield large returns.  Using the midpoint of the company’s guidance of $155mm, here is a matrix of potential returns:

 

EBITDA	155	155	155	155
Multiple	4	5	6	7
EV	620	775	930	1085
Net Debt	(600)	(600)	(600)	(600)
Equity Value	20	175	330	485
Per Share Val.	.90	7.84	14.80	21.75

 

So why are we getting such a bargain? A year ago the company could do no wrong. A duopoly with fierce pricing wars over the long term hotel contracts was to give way to a monopoly with pricing power and steady cash flow.  Investors were upset that any precious equity was issued to pay for the deal. Today, LNET is exactly what the market doesn’t like.  With a $65mm market capitalization it is a micro cap in a market that hates small cap stocks.  At just under 4x debt to EBITDA, LNET is too levered even though that is a fairly standard and serviceable LBO debt amount.  LNET is tied to the travel industry which is in fact slowing. LNET has technology risk as more and more people view DVDs and movies on alternative devices.  The company was never doing as well as $30 a share implied but down here it is a cheap option on a business that is being unfairly punished. LNET still gets a release window ahead of DVDs and pay cable, which drives demand. On the adult entertainment side, there are many companies that will not allow or actively block adult websites for their employees. So LNET offers the main way to view that content on the road.  In addition, LNET has started to charge for services like support and service calls that used to be free when On Command was around. They are also generating incremental cash flow by charging some hotels for basic cable service that On Command never used to charge for. In addition, LNET has started to penetrate new markets like hospitals. In short over time, less and less of their cash flow will be from movies and more and more will be from providing cable and broadband services. In short, the company will resemble a cable company more and more.

Catalyst

Deleveraging is one catalyst. If you take $155mm in EBITDA Less interest expense of $43mm, Capital Spending of $75mm and working capital changes of 3mm, you get $34mm of free cash flow over a equity capitalization of just $65mm, The yield is therefore 52.5%. If EBITDA is off by $10mm (possible but not likely), the yield is still 36%. If the company were to trade to 6x EBITDA which is lower than it has historically traded, you would get a value of $14.80 per share or 5x your money. Yes there are risks of travel, debt, and technology. But many of these have existed for a long time. In many ways the business is better now since there is only one player, yet the market has never hated the stock so much. They are within their covenants, they are executing against a business plan that makes sense and yet the market is treating this like a worthless option. To make a nice return from here, all LNET has to do is execute do numbers at the low end or even below its business plan. It is also worth noting that insiders have bought shares this year at much higher levels and the company bought shares back in Q1 at around $10. In retrospect those buys look badly timed, but it would not take much for the stock to get back to those levels and higher.