October 25, 2009 - 12:05pm EST by
2009 2010
Price: 13.75 EPS -$0.96 -$0.21
Shares Out. (in M): 329 P/E N/A N/A
Market Cap (in $M): 4,523 P/FCF 9.6x 8.7x
Net Debt (in $M): 9,705 EBIT 236 560
TEV ($): 13,828 TEV/EBIT 59.0x 25.0x

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(Note that in the proforma for the VIC idea I have converted numbers where necessary from GBP to USD using spot rates.)

It is unusual to do a write up on a stock that has already gone up over three fold this year.  However in this case we think it is worth doing so. We would suggest that investors, even if they are value orientated, plan their entry point but in this case we think we have a company that is going through 'rehabilitation' and that, due to the complexity and size of the business, has several years further to deliver over.

Virgin Media was previously known as NTL Inc - and under that name has been written up twice in VIC on 15 Nov 2005 and 13 Sep 2004. It has historically been a 'value trap' that has had the potential but failed to deliver. It is worth dwelling for a moment on the issues the company has had. They can be summarised as (i) built by acquisition with poor integration (ii) poor focus on operational processes and controls (iii) management on the wrong side of the Atlantic (iv) an aggressive competitor in the form of BSkyB (v) overleverage and (vi) not enough investment in content, processes  and systems.

There are a number of UK specific issues that we believe non-UK investors have not fully grasped in the past that impacted the performance of NTL / Virgin Media:

(1)    Strong public sector broadcaster with high quality content free at point of access (ie the BBC)

(2)    Very aggressive pay tv satellite network (ie BSkyB)

(3)    Regulatory impact on BT forcing unbundled local loop at relatively low costs leading to a lot of broadband competition - and the focus on lowest price rather than fastest speed

We mentioned the tripling of the share price so far this year. This has been due to a number of issues:

(1)    Rebound in markets

(2)    Getting away some new debt issues - at one point this year investors were concerned that it would be hard for this company to refinance its debt

(3)    New CEO presenting well at investment conferences

(4)    The impact of high leverage on the equity valuation

(5)    Weakening of USD vs GBP

We believe that over the next 12-24 months there are a number of changes likely that could lead to a revaluation of the company and further upside.

(1)    End of integration process and hubris

a.       the company was built up by the acquisition of multiple cable networks across the UK (42 in total). The most significant was the merger of NTL and Telewest which was completed in 2006

b.      Frankly though NTL in particular acquired a lot of assets there was very poor integration

c.       the acquisition of Virgin Mobile (2006) which gave the company a mobile product and a new brand (hence the change of name to 'Virgin Media')

d.      The company did try to merge with ITV (2006) but failed when BSkyB bought a blocking stake. It is unlikely in the short term that the company will attempt to merge with ITV again (though ironically given the management vacuum at ITV currently and the fall in valuation now might be a good time)

e.      In 2006 there were rumours of a private equity bid from a number of private equity houses

(2)    Cost saving coming through

a.       As a parallel to the integration ending we believe that cost savings from the combined company is only now starting to come through

b.      The company will lose 2,200 jobs by 2012. Combined with a reduction in property and improving systems and processes means that 2010 is really the first year that cost savings will exceed the cost of restructuring

c.       By 2012 the company is aiming to save £120m per year.

(3)    Focus on delivery

a.       This was really started by Simon Duffy but I think that most investors had not appreciated exactly how bad both products and services were. The current CEO Neil Berkett is continuing this focus

b.      Part of the reason to drop the NTL and Telewest names was the reputation both brands had for bad service

c.       This is an extremely high fixed cost business. Improving churn, and attracting new customers is at a high incremental margin. I believe that the current management understands this. Furthermore it is clear reading the management discussions in recent results statements that the company is focussing more and more on high value (ie high ARPU customers).

(4)    Listing in the UK

a.       Historically the group has been listed in the US. I feel that this has made the group an orphan stock with US investors not really understanding the UK television / telecoms / media market and UK investors being suspicious of a US listed overleveraged entity with a management team in the US.

b.      The location of the management team changed with Simon Duffy.

c.       On 1st Oct 2009 the company obtained a secondary listing in London. Admittedly its primary listing continues to be on NASDAQ - however as a statement of intent and to interest its natural constituents (ie UK fund managers) I believe that this is very important.

d.      We would expect with time (many years) the UK listing's volumes will surpass those of the US.  This listing could also be important should the company seek future funding raisings or undertake acquisitions in the UK.

e.      The CEO said at a recent conference (GS - see reference to transcript below) that it is hard enough to manage a business under one jurisdiction, let alone two. I think this is a clear suggestion that the management and board is of the view that with time the company needs to come 'home' to the UK.

(5)    Growing importance of broadband

a.       In the UK we have had several years of intense competition between broadband providers with ever falling prices. The exit of Tiscali and AOL (both acquired by CarPhoneWarehouse) and the splitting of CarPhoneWarehouse will, we believe, lead to less intense pressure in the future

b.      The growing use of video downloads (both YouTube, but actually more important in the UK context is the BBC iPlayer) is leading consumers to look at unlimited high speed packages. By owning a fibre network that passes 50% of the population Virgin Media has a unique differentiation in this area. (For instance Virgin offers 50Mbps unlimited for £28 / month to customers who also have a Virgin phone line. I currently pay about the same to BT for an 8Mbps line. Interestingly the Virgin service also includes unlimited backups - I currently pay over $100 for two years for this facility alone with Mozy). (Note that technically Virgin's network is fibre to the node or street cabinet).

c.       Until BT upgrades its network for fibre to the home (starting shortly but will take a couple of years) or broadband operators build their own local fibre loops (unlikely in most areas) Virgin has a unique advantage in speed - especially as customer demands increase. (Virgin is using DOCSIS III)

d.      The regulator is going to allow BT effectively to have fibre to the home outside of the regulated infrastructure for a period of years - thus BT will not be forced to sell fibre at cheap prices to competing operators. I believe that this will mean that a number of broadband resellers will have to raise prices and find it difficult to compete against BT and Virgin

e.      In July there was a report by the regulator (Ofcom -see which showed that most broadband providers fail to deliver the speed that they promise consumers. ) Virgin was found to deliver the fastest speed. Interesting the report found that speed was a key issue for consumers.

(6)    Regulatory review of content

a.       Ofcom - the Office of Communications - is the regulator for both telecoms and television in the UK.

b.      It is current undertaking a review of charging for premium television content. This is going to report in Q1 2010. It is clear that it will seek to force BSkyB to reduce the prices it charges its competitors for premium content (currently BSkyB forces its competitors to pay, in some cases, more than retail for carriage of its content).

c.       There is no doubt that BSkyB will fight in the courts but the direction of regulation is clear - BskyB's monopoly on premium content is under pressure.

d.      We believe that this will be a key catalyst for Virgin Media but it will take time to pass legal challenges (if mounted)

(7)    Growing importance of video on demand

a.       Non linear viewing is becoming more prevalent. Only a limited number of companies can offer this as network infrastructure is required.  As the number of users increase the importance of infrastructure increases.

b.      VOD is a weak spot for BSkyB as it has set top boxes with hard disks in but not true VOD. It does offer some video over the internet but as volumes and quality (ie moving to high def., multiple video streams) increase it is likely that Virgin Media, BT and possibly Homechoice (owned by Tiscali and now TalkTalk (CarPhoneWarehouse)) will be in a better position.

(8)    Switching off of analogue

a.       Most investors will be aware that the UK is currently going through a switch off of analogue broadcast signals and a switch to digital broadcasting

b.      What may be less well known is that a lot of Virgin's cable network carries analogue signals. In a similar way to the broadcast market, as analogue signals on a cable network are replaced by digital signals available capacity increases. This will allow Virgin to offer more channels and also increase the broadband capacity to individual homes.

(9)    Replacement cost

a.       The estimates of the build cost of the Virgin network vary.  The write offs and write downs have been over £10bn. I think it unwise to estimate exactly what the replacement cost is since parts of the network have had to be upgraded and replaced. (Note that the write offs include investments in overseas operations and also in eg football teams - it is hard to identify the exact number relating to the network but the key point is it was an awful lot of money)

b.      Roughly Virgin Media passes about 12.5M homes. The cumulative build cost was about £12bn but the total tax loss carry forward is £16bn. (It is worth remembering that having multiple platforms in the different component companies, a variety of upgrades over the years and frankly being ahead of its time cost this company greatly)

c.       Note that for new build the company is estimating roughly £200 per home passed but it is worth remembering that this is marginal cost given it already has a significant amount of infrastructure. In many cases the new builds are 'fill-in' areas.

d.      BT estimates it will be able to pass 10M homes in the UK for £1.5Bn by the end of 2012. However it is important to note that BT has the advantage of already having a lot of infrastructure in the ground and having upgraded the connections to its exchanges. The greenfield cost for BT (or anyone else) would be far higher.

(10)Back-book impact

a.       A lot of existing customers were paying above market rates for products. Over the last year the company has repriced its products to market levels and is now starting to see anuplift in ARPU.

b.      ARPU grew 3.8% in Q2 and is now £43.27. Churn has fallen from 1.8% pcm to 1.2% pcm. We think that the market has not really modelled in rising ARPU potential going forward.

c.       The company has a penetration of 37.6% of the homes that it passes ie 4.7m homes. Competitive pricing and the drivers discussed above (eg improved customer service, competitive broadband etc) are likely to allow an increase in penetration.

Putting the numbers together the EV for the company is £8.426bn according to Bloomberg (comprising £2.77bn mkt cap, £5.898bn of debt and £246m of cash). The 2008 EBITDA was £1.279bn, and for the last 12 months it was £1.29bn. Current EV/EBITDA according to Bloomberg is 6.52. It is hard to know what comparator to use since the company operates in a unique environment and furthermore one needs to take a view on the value of its tax losses. Some analysts have put these as worth upto £16bn gross. Assuming a roughly 1/3 tax benefit and that due to discounting that one should halve it again the tax losses are worth roughly £2.5bn in current money (ie 1/3 x ½ x 16). (We appreciate that this is rough and ready but frankly it close enough for our purposes).

In the following table we layout consensus EBITDA forecasts from this week and from 300 days ago.

(A)   Consensus EBITDA from Bloomberg (£bn)

(B)   Consensus from 300 d ago

(A)                        (B)

2008  (a)               1.279    

2009 (e)                1.310                     1.317

2010 (e)                1.397                     1.374

2011 (e)                1.456                     1.436  (note this is 150d ago)

The point about the above table is that though there is an improving environment for Virgin for all the reasons discussed, and improving consumer confidence etc the consensus numbers for the company have hardly moved.

We believe that over the next 1-2 years consensus EBITDA numbers will increase as analysts and the market start to appreciate that the company is no longer in intensive care.  We believe that it is reasonable to assume that the company will gain 250k customers from now to 2012 (ie 80k or so per year for 2010 - 2012). Assuming that these customers come in at an ARPU of £50 pcm that will add £150m per year to the sales line. We estimate that the EBITDA margin on such incremental customers at 60% (in fact it could be much higher) thus adding £90m of EBITDA per year or 6% to 2011 numbers.

Capex is roughly £600m per year and net interest is £420m per year. This implies that 2009 FCF to equity will be around £290m. We expect capex to remain flat for the next few years and the net interest to fall by roughly £20-30m by 2012 as debt is paid down. It will be seen that even with consensus numbers this means that by 2011 FCF will rise to £461m (ie 1456 - 600 - 395). However if we then add in the £90 we have suggested attributable to new subs we will be at over £550m by 2011 - 2012 (depending on the exact timing of the new subs).

On the above numbers the FCF to equity is above 10% in 2009 and rising to about 20% by 2012. We believe that this implies significant upside even from current levels provided management delivers. Indeed if our numbers are correct we believe that by 2012 it is reasonable to assume a further double in the share price.

For those sceptical of this writeup we would highlight the transcript on Bloomberg of the CEO at a recent Goldman's conference (17 Sep 2009) where he appeared to suggest that a 2-3% subscriber growth (100k subs per year) could deliver 20% free cash flow growth.

(Note that for the above numbers we have used the company definition of free cash flow - see the company filings for the details but one interesting aspect is that it subtracts some intangibles so our estimates for FCF may be too low).







Discussed in text - summary (1) OFCOM regulatory changes (2) increasing importance of broadband (3) relisting in UK and increased following (4) analyst numbers to rise

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