The Case for Liberty Global

Posted on 22/02/2011

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Liberty Global Chairman John Malone

Liberty Global (“LGI”) is a telecommunications network operator, providing television, telephone and broadband internet services to 17.7m households across 14 different countries. LGI’s key markets are Germany (17% of EBITDA), The Netherlands (15%) and Switzerland (15%), though the company operates across much of Europe and also owns assets in Australia (AUSTAR) and Chile (VTR), as well as content-producer Chellomedia.  In the first nine months of 2010 LGI generated revenue of $6.6bn and EBITDA of $3.0bn.

Competitive Positioning

  • Potential competitors face significant barriers to entry in the form of huge capital investments (LGI has net fixed assets of over $11bn) and likely operating losses following any start-up.  The oligolpolistic nature of the markets in which LGI operates usually allows the company and all its competitors to earn returns which exceed the cost of capital.
  • Customers face switching costs, meaning that LGI is able to charge higher prices than might otherwise be the case without experiencing a loss of custom.  Clients are usually locked-into 12-month contracts, face “shoe-leather” costs if they shop-around for a new provider and also face the risk of annoying (and potentially costly) technical problems if they attempt to change service providers.
  • LGI has a unique product in the firm of high-speed broadband, offering maximum speeds of around 100Mbps to almost all its customers, which also allows LGI to offer advanced video-on-demand services.  This compares to competitors who – at best – are limited to the 30-40Mbps that can be delivered over traditional fixed-line telephone networks (usings ADSL2+ and VDSL type technologies).  LGI’s broadband service does not suffer from distance degradation (where homes further from the telephone exchange receive slower speeds) or competition for bandwidth (where more users on the network means slower speeds for all).
  • Because the customer base is made up of millions of separate households, no customer (or group of customers) holds any significant bargaining leverage over LGI (or any other operators in the market).
  • Unlike in the United States, where content providers wield significant market power, charging ever-higher prices for cable companies to carry their channels, in Europe the strong positions of national public service broadcasters, many different languages and contents rights that are negotiated on a state-by-state basis means that Liberty Global is able to secure content on reasonable terms.
  • Incumbent telecommunications operators across Europe are regulated as utilities given that national governments and the European Union see their natural monopolies. Consequently, such operators are usually required to provide open access to any other companies wishing to deliver services over their networks, severely limiting their returns on capital employed. As a result of this, and the uncertainty surrounding exactly how investments in high-speed networks will be regulated, many incumbents have delayed investments, allowing cable television operators to steal a march on them.
  • LGI, like other cable operators, benefits from a capex cost advantage vs traditional fixed-line telecoms operators when it comes to upgrading its network.  LGI can use Docsis 3.0 technology at the cost of roughly $15-20 per home to upgrade its network, and this can be done incrementally as customers require greater speeds and bandwidth.  Fixed-line telecoms operators are unable to utilise Docsis3.0 and so must rely upon FTTx-based technologies.  Although these deliver higher speeds than Docsis3.0, the speeds are well-beyond the needs of customers and the roll-out is very costly, at $600-700 per home.  Consequently, the returns on capital don’t make sense for incumbent telecoms operators, who are mainly focusing on upgrading their networks to ADSL2+ and VDSL-type services.

Capital Structure

Liberty Global operates with a leveraged balance sheet, with management targeting to maintain net debt/EBITDA within the 4-5x range. Using LQA (last quarter annualised) EBITDA, net leverage is currently 4.2x. Note that much of the debt is at the subsidiary level and non-recourse to the parent, while some of the cash balances are also trapped at the subsidiaries. In addition, much of Liberty Global’s indebtedness is covenanted and on a secured basis, allowing the lenders significant control over the business in the event that covenants are breached (creating a downside risk to shareholders if something was to go wrong).  LGI moved aggressively to term-out its debt maturity profile during the credit crisis, meaning that the next material maturity (read: maturity that will most likely need to be refinanced rather than being repaid out of free cash generation) is not until December 2016.  In addition, given that LGI managed to term-out its debt during some of the darkest days of the credit crisis, we have a high degree of confidence that the company should be able to continue doing so.

The equity portion of LGI’s capital structure is split in to segments with varying economic and voting rights. There are three lines of stock: A, B and C. A has one vote per share, B has ten votes per share and C has no voting rights. Given the current mix of shares outstanding, A shareholders have 49% of the economic interest and 56% of the voting rights, B shareholders have 4% of the economic interest but 44% of the voting rights and C shareholders have 47% of the economic interest.

Financial Forecasts

I expect LGI will benefit from a number of positive trends that will drive the revenue line. Firstly, existing customers are likely to continue adding extra services. At present the average LGI customer has 1.55 services (usually television and perhaps one other), though this will increase as many more add telephone and/or broadband to their package. Secondly, I expect customers to trade-up over time: from analogue to digital TV; from standard definition to high definition; to begin downloading pay-per-view on-demand content; and to increase the speed of their broadband package. Not only are these services higher-revenue, but also higher margin. Thirdly, I expect to see LGI taking market share by adding new customers. All these trends are currently under way, rather than simply something I see in a crystal ball. I think they are powerful structural trends in the market and not factors likely to change in the short-run.  These positive trends are partially offset by customers who are disconnecting their analogue TV service and gradually declining ARPUs for telephone and broadband services.  Consequently, I expect revenue growth in the low-to-mid single digits.

The marginal cost for LGI to serve an additional customer is relatively low, as gross margins on television, telephone and broadband services are relatively high (LGI doesn’t disclose its own gross margins but comparable firms typically earn 60%+ on these services). With selling, general & administrative expenses fixed in the short-term, LGI should see the benefits of operating leverage as revenues increase, leading to medium-term EBITDA growth of in the mid-to-high single digits.

LGI has recently invested very heavily in upgrading the bulk of its network to deliver broadband speeds of 100Mbps and digital/HD television services. This provides the company with a significant advantage over competitors but also means that less investment will be required in the future. While capex in absolute terms will remain high (mainly due to spending on set-top boxes for new customers), I expect it to gradually decline as a percentage of revenue. The combined effects of rapid EBITDA growth and negligible capex growth should lead to a rapid expansion in free cash flow, which I believe could be in the region of 15-20% per annum over the course of the next three years.

Valuation

LGI currently trades at 6.6x LQA EBITDA, which compares to 7.0x for Virgin Media, 8.2x for Kabel Deutschland (a direct comparable to – but not competitor to – LGI’s German subsidiary Unity Media) and 8.0x for Telenet, LGI’s 50.3%-owned Belgian subsidiary. Therefore, LGI is trading at a discount to all its closest comparables. Based on a sum-of-the-parts valuation model which uses KDG’s public valuation for Unity Media and the current market value of Telenet, the market is valuing the remainder of the business at only 5.7x EBITDA.

Based upon last quarter annualised EBITDA of $4.3bn, my estimates for FY10 capex of $1.7bn (excluding acquisitions), interest of $1.0bn and cash tax payments of $0.3bn, my estimate of free cash flow is $1.3bn, which is equivalent to an equity free cash flow yield of 12.3%. Given my expectations for free cash flow to increase over rapidly over the next few years, this looks like a very attractive valuation. In addition, I would expect additional indebtedness to make a positive contribution to free cash flow. LGI management operate the company with a stable level of net debt/EBITDA, so as EBITDA increases we would expect proceeds from debt issuance to be a positive contributor to free cash flow. Because the company has a clear focus on shareholder value, I would also expect such free cash flow to be used to finance acquisitions and/or share repurchases (most likely both).  Note that Liberty Global is believed to have made a bid for Kabel Baden-Wuerttemberg, which may sell for $3.4bn.

Risks

  • John C. Malone beneficially owned outstanding shares of the common stock representing 38.5% of the aggregate voting power as of February 19, 2010.  The segmentation of the voting rights between the triple-class share structure creates a risk that Malone could sell his B shares at a premium, transferring effective board control to a new owner, without the acquirer being required to pay for any A or C shares, potentially leaving shareholders with a new operational and financial strategy that is not in their interests.
  • The company has a number of poison pills in place to thwart a potential takeover.  I have written in the past on how such devices tend to signal poor investment returns.  LGI has staggered board elections, has the ability to issue “blank cheque” preferred stock, has 75% and 80% voting thresholds for certain resolutions, and has limitations on who may call shareholder meetings and how shareholders may submit proposals for directors and other resolutions.
  • Given that LGI operates with a leveraged balance sheet, the company’s stock price is sensitive to changes in credit market conditions. This is exemplified by the significant share price decline in the second half of 2008 as it became apparent that the company may have to refinance at penal interest rates. At present this trend is working in favour of the company, with interest rates available in the leveraged finance market close to record lows. UPC Broadband, LGI’s main subsidiary recently issued $1bn of secured notes due 2020 at a cost of only 6.375% per annum.
  • Although fixed-line operators in Europe are obliged by regulators to allow competitors to provide services over their networks, the same rules do not apply to cable operators such as LGI, who have exclusive use of their own networks.  Consequently, their is a risk that regulators may determine that LGI has significant market power and should therefore provide open access to competitors.  Such a ruling would likely have the effect of significantly driving-down returns on capital.  However, given that cable operators still have smaller market shares than traditional telecom operators in the broadband market (plenty of room for growth); that regulatory changes tend to have a long legislative gestation period; and that national and EU regulators need to co-ordinate their policies, any changes – if they happen – are likely to be many years away.

Summary

In conclusion, Liberty Global is a company with a very strong competitive position, is diversified across a number of markets, is benefiting from structural trends which are driving revenue growth, is likely to see rapid free cash flow growth as EBITDA expansion exceeds that of capex, is valued at a discount to its direct comparables, and is generating a very high free cash flow yield of 12.3%.  Consequently, I take the view that the attractions of Liberty Global outweigh the risks relating to the leveraged balance sheet, John Malone’s dominance of the board and potential regulatory changes.

Note: Liberty Global reports its FY10 results after the market close on 24th February 2011.

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Posted in: Investment Ideas