Description

Following a multi-year rise, Liberty Global  (LGI[i] or the Company) shares have declined nearly 8% during 2016 and over 30% since its 2015 highs.  The sell-off was originally triggered by disappointment over no Vodafone (VOD) deal that was rumored for large parts of 2015.  The selling gained momentum following the complicated and unpopular acquisition of Cable and Wireless (CWC), as well as operational struggles in The Netherlands.  Finally, selling pressure further accelerated over macro concerns (Brexit/EU headlines/junk bond market), and the stock has now become a pariah. 

While the name has multiple moving pieces and admittedly faces challenges, we believe the above concerns are either overblown in some cases or manageable in others.  Additionally, we think the current price is ignoring the fundamental strength of LGI’s business and a couple of very favorable parts of the story:

1)      Less Content/Netflix/Regulatory Pressure and Possibility of Higher ARPUs

2)      Netherlands JV Mitigates Risk/Swiss Concerns are Real but Likely Manageable

3)      New Build/Cost Cuts Could Make “Liberty Go” Targets Achievable

4)      Fiber Still Better than Copper

5)      67% Stake in LILAC’s Interesting Growth Story

6)      Continued Leveraged Buyout and VOD Sale More Likely than Mobile Purchases

Most VIC readers are probably very familiar with the cable business so I’ll just give a quick overview of LGI and the differences between LGI and its US peers.  Liberty Global has transformed itself with a series of deals since the financial crisis that, along with organic growth, has taken total customers and Revenue Generating Units (RGU)[ii] from 12.6 million and 20.5 million in 2009 to 27.4 million and 57.0 million, respectively, by the end of 2015. 

While LGI has executed multiple deals, the furious growth has been primarily driven by a handful of larger acquisitions, including: 

·         2010:  Unitymedia (Germany) €3.5 billion – 7.4x 2010E EBITDA/6.6x 2010E post synergies

·         2011   KBW (Germany) €3.16 billion Euro KBW 10x LTM EBITDA/8.1x 2011E post synergies)

·         2013:  Virgin Media (UK) $23 billion 8.8x LTM EBITDA/7x 2013E EBITDA post synergies)

·         2014:   Ziggo (Netherlands) $13.7 billion (11.3x LTM EBITDA/9.3x 2014E EBITDA post synergies)

·         2015:  CWC (Latin America) £3.5 billion (12.3x LTM EBITDA/10.7x LTM EBITDA post synergies)

While US investor attention has been focused on the US cable industry consolidation and specifically Charter Communications (Charter) following John Malone’s famous comments that he wanted Charter to become a “horizontal acquisition machine,” Liberty Global has actually been executing this strategy since the financial crisis.  LGI’s five largest markets account for roughly 90% of total revenue.  Two of the five (Germany and the UK) did not exist in 2009 and a third (Netherlands) was significantly smaller.  While LGI is not the only acquisitive firm in Europe, its capital structure and shareholder base have provided far more leeway than its competitors to pursue such a strategy.  LGI pays no dividend, targets net leverage of 4-5x EBITDA, operates comfortably with a junk credit rating, utilizes net operating losses to avoid taxes and actively repurchases its own stock.  By contrast, many of its competitors (Vodafone, British Telecom, KPN, Deutsche Telekom) pay high dividends, target lower debt levels to maintain investment grade ratings, and possess shareholder bases that prioritize income and safety despite operating in an industry characterized by higher capital expenditures.  LGI’s capital structure and shareholder base have historically provided the company with an important long-term strategic advantage versus its competitors.  As we will note later in the write-up, the sheer volume of deals likely thwarted a full integration of the various assets, a situation that LGI is currently attempting to remedy. 

One of the criticisms of LGI has been the elevated acquisition multiples the company has paid during the past six years.  These acquisitions, however, have been financed with generational low interest rates as has been publicly discussed by John Malone when questioned about the higher multiples.    And the relationship is not limited to telecom.  As just one example, Warren Buffett noted at this year’s Berkshire annual meeting that the acquisition multiple for Precision Castparts was higher due to the lower cost of financing.    Despite the numerous deals, LGI’s fully swapped borrowing costs have fallen to 4.8% as of Q1 2016 versus 7.8% in Q1 2011.  Additionally, the average tenor of debt attributed to LGI was 7+ years, with only 15% due before 2021.  Despite the “Cowboy” reputation of the capital allocation team, Liberty has been religious about fixing interest costs and matching debt payments with its functional currency.  97% of LGI’s debt remained fixed at the end of 2015.  Furthermore, debt is generally crammed down to subsidiary levels, and therefore any problems would remain restricted to the subsidiary level (no cross collateralization).     

LGI’s total video and voice penetration rates tend to be higher than US peers[iii], but the exact penetration level varies by market. European cable companies have often been the incumbent video offering in many markets, partially explaining the higher video penetration levels.  But lower price points, more robust offerings and less developed OTT competition reduce the chances of mass cord cutting. The real opportunity for LGI comes from increasing broadband penetration levels, which trails US peers and substantially so in certain markets (Germany at 25% in 2015).   

Less Content/Netflix/Regulatory Pressure and Possibility of Higher ARPUs

While US and European businesses are attractive, there are some fundamental differences between LGI’s predominantly European cable business versus its US peers.  Generally speaking, customers typically view far fewer channels in Europe versus the United States, thereby freeing up substantial bandwidth.  For this reason, broadband speeds tend to be substantially faster in Europe versus the United States.  Additionally, content preference is often very specific to individual countries rather than across all markets, so content providers do not have nearly the same amount of leverage as providers do in the United States (i.e. ESPN cannot charge $6.00+ per subscriber per month).  As a percentage of revenue, LGI programming costs for LGI trend around 12-13% of total revenue versus 22-29% for many US cable companies.  While programming costs per video subscriber will continue rising, these are still a fraction of the costs of US cable companies.

Lower programming costs and generally more densely populated service areas allow higher EBITDA margins versus US cable companies. 

Despite higher margins, prices for LGI’s offerings are generally far cheaper than US peers, leading to far lower ARPU for LGI.[v] 

On the positive side, the lower prices generally do not provide the same incentives for over-the-top (OTT) offerings as are found in the US.  With a 100 Megabits per second (Mbps) triple-play offering costing €30-€40 , the need to cut the cord and subscribe to €9.99 Netflix offering is less appealing.[viii]  It should also be noted that Liberty Global’s video offering, includes its TV Anywhere product (Horizon) and its 7-day catch-up viewing features (available on multiple devices).   Additionally, LGI has launched its own Subscription Video On Demand product (My Prime) in the Netherlands, Ireland, and Switzerland, which is free for bundle subscribers and offers thousands of hours of video services.  My Prime can be viewed on set-top boxes or on other devices and its bundling with a moderately priced triple play bundle would appear to offer a formidable defense against Netflix’s advances.  While LGI’s video offering is likely more developed than US peers, the products have not been consistently rolled out across all markets and LGI finds itself trailing certain European competitors as we will detail later.

Lower prices also lessen the cacophony of customers complaining to regulators about cable market power.  A less developed OTT offering, fewer bandwidth constraints and overall lower pricing environment all contribute to the generally more favorable regulatory environment (versus the US) described by CEO Fries over the past couple of years (including most recently at the MoffettNathanson conference in May 2016).  Quite simply, European cable names do not face the same pressure over net neutrality or content pressure that dominates the regulatory debate within the US.  As concerns about heavy handed regulation (including possible rate regulation) are one of the primary threats to the US cable story, this regulatory advantage should not be overlooked.   

Netherlands JV Mitigates Risk/Swiss Concerns are Real but Likely Manageable

The Netherlands market has been one of the biggest headaches for LGI since the company closed the Ziggo merger in late 2014.  While the company has increased its synergy target to €250 million (from €160 million), The Netherlands’ operations have suffered from a poorly integrated acquisition that upset customers and made subsequent price increases more difficult.  At the same time, Ziggo faced more formidable competition from incumbent KPN, including an integrated quad-play offering.  While the Netherlands market was competitive prior to the Ziggo transaction (UPC Netherlands lost 26,000 RGUs in 2014), the problems increased post deal and the combined operations have suffered RGU declines for the past five quarters.  It should be noted that Ziggo has added broadband customers in four of the past five quarters, and LGI has added over 100,000 Horizon video customers for each of the past quarters.   Ziggo synergies allowed The Netherland operations to increase EBITDA 3% during the 2016 first quarter despite the RGU pressure.

During 2015, LGI blamed a good amount of Ziggo’s difficulties on irrational pricing from KPN.  Of LGI’s largest markets, only the Netherlands (30%) and Switzerland (37%) have meaningful fiber overbuilds[ix].  Unlike Switzerland, however, KPN offered its own discounted Telfort product at prices 30-50% lower than KPN’s own broadband offering.   LGI even suggested that KPN (a company not possessing the best of long-term shareholder track records) might sell itself and would behave differently under a new management team.  LGI did acknowledge integration challenges on its Q1 and Q2 2015 calls, but the company may have minimized the extent of the problems.   It is more challenging to hike prices by 5% when customers are complaining about black screens.  The issues were particularly unfortunate as the cable-to-cable UPC/Ziggo integration would normally have been considered fairly routine.   The integration challenges have been remedied, but the mistakes have allowed KPN to simultaneously raise prices and take market share.  

Recently, LGI has faced a more competitive Swiss market.  The second and largest mobile companies - Sunrise and Salt (formerly Orange Switzerland) – have increased discounted mobile offerings.  The companies can offer cable services by leasing Swisscom’s fiber and VDSL networks, offering packages targeted at lower-end customers.  During the 2016 first quarter, LGI’s Swiss operations lost over 50,000 RGUs. As a reference point, Switzerland/Austria comprise 12-13% of total 2016E LGI EBITDA.  The Switzerland operations will benefit from cost savings achieved from combining the Switzerland/Austria operations, with total synergies of roughly $100 million.  Despite the RGU attrition during the 2016 first quarter, total EBITDA actually rose 8%.                                              

LGI has also suffered from a dated video product relative to competition, and this problem has affected both the Netherlands and Swiss markets.  LGI will rollout its EOS cloud based set-top boxes in the UK later this year, and the box will be deployed across the LGI footprint sometime in 2017.  Currently, LGI has over 10 different entertainment platforms and more than 70 different set-top boxes in the field.  As if this weren’t troubling enough, Fries noted at the MoffettNathonson conference that LGI has something close to 20,000 vendors.  Again, part of the problem is that LGI has (to use CHTR language) been successful at identifying and achieving “transaction” synergies, but the company has yet to complete the operational synergies that can produce substantial cost savings by fully integrating the various markets.  In LGI’s defense, the number of deals may have prevented a truly integrated platform as LGI was racing for a land grab while the acquisition environment remained favorable.  With the takeover game in the latter innings, the time for full integration has arrived. 

One can also question whether a stronger operator might have been able to achieve a pan-European vision quicker than Fries and his team.  Despite Dr. Malone’s comments that Fries is one of the top CEO’s he has ever seen, we do not believe that Fries is the same caliber cable operator as Tom Rutledge.  We think that an objective listener to both Fries/Rutledge during the various investor circuits would conclude that Rutledge has a firmer grasp over the cable business than Fries.  We certainly do not want to diminish Fries’ accomplishments, as LGI’s stock has compounded 12.4% annually (nearly 500 basis points higher than the S&P 500 including recent LGI weakness) during his tenure and, despite the Ziggo difficulties, Fries should be given substantial credit for successfully integrating multiple acquisitions and transforming LGI into a dominant cable provider throughout Europe.  LGI benefited from a deal oriented CEO, and the pace of acquisitions might have prevented fuller integration.  In fairness, it is not clear that Rutledge would have as effective as Fries leading these rapid fire acquisitions.  But, the time for integration has arrived and we suspect total operational synergies might be far greater than LGI’s stated goal of keeping $5.5 billion of indirect costs flat over the coming years.  Fries has articulated some aggressive goals for the coming years, and LGI’s immediate success will now depend in large part on Fries’ integration skills.

In response to the Netherland difficulties, and perhaps to test a full blown merger, Liberty announced a 50/50 Netherlands joint venture with VOD earlier this year.  The JV includes VOD’s wireless assets (debt free) and LGI’s cable assets (with Ziggo debt) but neither VOD nor LGI tax assets were included.  The JV valued Ziggo at 11x EBITDA and VOD will pay €1 billion outside of the JV as a result of the valuation difference.  The JV has targeted leverage of 4.5-5x and the debt payments will be distributed to both parties with LGI’s Netherland tax assets shielding dividend payments.  The present value of the synergies is estimated at €280 million by year 5 (versus a combined 2015 revenue base of €4.4 billion) or €2.5 billion on a NPV basis (LGI’s calculation).  The deal is in the regulatory approval process and final approval is expected later this year. 

As a result of the JV, LGI will be forced to share some of the original Ziggo synergies as well as any benefits from a turn in market.  But, we think the large synergies, future integrated quad-play offering and the possible merger preview trump other concerns.  We would also note that the deal will free substantial cash flow for repurchases.  Assuming VOD’s cash flow is leveraged at 4.75x and taking into account the €1 billion payment, we believe LGI will receive roughly $2.7 billion in JV proceeds during 2017 separate from the rest of LGI’s business.  If LGI’s share price is anywhere near current levels, the company could consider a tender offer.  Sell-side models will likely not be adjusted for the JV until later this year. 

We also do not believe that KPN wants a price war and, in fact, recent KPN price increases suggest just the opposite.  There is risk, however, that LGI and VOD face integration issues and KPN takes further market share.  That said, we believe the JV will meaningfully strengthen Ziggo’s market position.

 Competitive changes in Switzerland are newer and will need to monitored.  LGI has long maintained that Swisscom is a tough but very rational competitor.  The competitive challenges facing LGI’s Swiss operations revolve around lower-end customers and, as opposed to The Netherlands, generally involve heightened mobile competition versus a quad-play assault.   Ziggo/VOD JV synergies and Swiss/Austria synergies will counteract competitive pressures and likely allow some EBITDA growth in both markets.  As previously mentioned, The Netherlands and Switzerland/Austria segments grew Q1 EBITDA 3% and 8% respectively.  While growth in Switzerland will surely slow, LGI likely needs to avoid EBITDA declines in Switzerland in order to achieve its targeted 7-9% rate.  While The Netherlands and Switzerland certainly face more competition, both markets are far from unhealthy and some perspective is warranted.  2015 EBITDA margins in Switzerland and The Netherlands were 59.2% and 55.3% respectively, or nearly 1400-1800 basis points ahead of Comcast’s 2015 margins.

New Build/Cost Cuts Could Make “Liberty Go” Targets Achievable

Liberty has announced a three-year restructuring/transformation program dubbed Liberty GO, whereby it believes that it can raise LGI’s compounded annual EBITDA growth rates to 7-9% from 2015-2018.[x]  The guidance is for constant currency and excludes Ziggo, Cable & Wireless and BASE.  LGI believes 60% of the growth step-up will come from faster revenue and the remainder from keeping $5.5 billion in indirect costs flat over the next several years.  On the revenue side, the faster growth is anticipated to come from: 1) pricing,  2) 7 million (could be increased to 10 million) new build rollouts with 4 million of these additions coming via Project Lightning in the UK, 3) further penetration of the Business to Business Market, and 4) continued growth in mobile. 

A larger percentage of LGI’s historical growth has come from customer additions, as opposed to price increases.  Given the consolidation in the European cable market and the continued penetration of broadband, it is likely that LGI will be more dependent on price increases for future growth.  LGI has successfully taken price in several of its markets, and the company has indicated that nearly 70% of future revenue growth will likely come from price increases.  Virgin and UK competitors have historically raised prices at mid-to-high-single-digit rates without a notable increase in churn.  Based upon competitor commentary, this appears sustainable.  Germany price increases have historically lagged other markets.  During 2015, LGI’s German operations did take 10% price increases on nearly 50% of its broadband customers in Germany after many of these customers hadn’t seen a price increase in nearly 10 years.  LGI also took a 7% increase in Switzerland during 2015.  LGI did see a negative impact on RGU trends  after the sizeable increase and therefore has vowed to take smaller, more consistent price increase of 2-4% going forward and to be conscious about giving customers perceived value for any increases (faster broadband speeds, Horizon/My Prime free access with bundles, etc).  Clearly, there is risk that other telecom incumbents will needlessly disrupt a perfectly working oligopoly and RGU additions relative to price increases will need to be monitored.  That said, with ARPUs significantly lagging behind US levels and most European telecom firms in need of pricing to support their business models, LGI would seem to have substantial room for additional increases. 

LGI has executed several greenfield rollouts previously, but Liberty GO’s new-build involves larger scale additions.  As noted, the largest component will be in the UK, via “Project Lightning,” Liberty also plans new rollouts in Germany, Switzerland and Central Europe.  Within the UK, Liberty plans to pass 4 million new homes between 2015-2020 at a total cost of £3 billion.  The initial number of homes passed has progressed slower than anticipated due to construction/zoning delays, but the product penetration and average ARPU are trending above the company’s initial guidance of 40% penetration and £45 ARPU (upside to £50).  Liberty has spoken generally about 1 million new homes in Germany and the balance primarily in Central and Eastern Europe but has been less specific about the exact timing/cost.  

Greenfield rollouts are amazingly difficult, and LGI is experiencing this again with the Lightning rollout.  LGI has emphasized that it would not attempt the in-fills if they were not nearly right on top of existing cable systems.  Within the UK, the additional passings are less than 50 meters from LGI’s existing network and two-thirds of these are actually less than 20 meters away.  LGI also believes it will be marketing to new homes stronger products than incumbent services with broadband speeds of 150Mbps or levels within the UK more than 2x faster than offerings from British Telecom, TalkTalk or Sky.  This would contrast with Verizon’s FIOS rollout where it was essentially marketing an identical product to cable competitors.  LGI’s return assumptions do not assume any contribution from mobile or business-to-business offerings, both of which could be material.   LGI has also noted that the modular construction of the project will allow it to stop building if penetrations/pricings do not meet assumptions

And finally, as LGI can obtain vendor financing for a large portion of the rollout and releverage new customer EBITDA, equity contributions are minimized, or conceivably close to zero depending on adaptation rates.  In total, LGI believes it can achieve unleveraged returns north of 30% on Project Lightning.  UK capital expenditures as a percentage of revenue are expected to peak at 25-28% of total revenue versus normalized levels probably closer to 16-18%.  We believe LGI’s assumptions appear reasonable, but capex spend could be higher in certain markets and customer penetration could take longer than anticipated as the incumbents respond to LGI’s offensive.  We model UK capex of 28-29% of revenue in 2018/2019, dropping to 20% in 2020 and assume it takes longer than 3 years to achieve the targeted 1.6 million additions. Obviously, any of these models involve assumption upon assumption but directionally, the project looks promising, especially as we view Virgin’s offering as superior to that of its competitors.

Both US and European cable companies have had success penetrating the small business market, and Liberty GO will be focused on the SOHO/SME markets.  While the timing of the exact penetration rates is open to question, it seems reasonable to believe that cable can continue taking market share.  We would note there is widespread skepticism about LGI’s ability to take meaningful share in the mobile market, and we will address the mobile issues later in this write-up.  As we previously stated, we think the opportunity on the expense side is extensive and we believe there are opportunities beyond keeping $5.5 billion of indirect costs flat over the coming years.  Fries has articulated some aggressive goals for the coming years, and LGI’s immediate success will now depend heavily on Fries' team successfully integrating past acquisitions.

We would finally note that LGI’s management compensation targets have been improved to better align equity compensation with the Liberty GO targets.  We would readily concede that Liberty company compensation plans are not the best proxies we’ve ever read.  And even the most ardent Liberty fans would have to acknowledge that the structure/appearance of Fries’ $80 million stock grants in 2014 (that had performance criteria for just nine months and then simply became time vested over 3 years) shortly prior to the CWC bid was far from ideal.  Under the new equity compensation plan, 2016 and 2017 equity compensation was combined into one 1.5 million[xi] grant with the total payout of 100% if LGI achieves 2015-2018 EBITDA growth of 6% and 200% if LGI achieves EBITDA growth of 8%.  Unfortunately, the minimum threshold was set at 3% EBITDA growth with 75% payout.  Certainly, we would have preferred a 7% target and higher minimum threshold, but we do believe the compensation plan does provide motivation to hit projected targets. 

Fiber Still Better than Copper

Multiple European telecom firms are in varying stages of rolling out newer copper technologies (VDSL/Vectoring/GFAST) that allow significantly enhanced copper speeds relative to current levels, albeit meaningfully behind cable’s fiber to the home.  The various iterations of the copper technology take download speeds from 20Mbps to speeds up to approximately 500Mbps when G-Fast is deployed.  Some research reports cite speeds clocked in the lab or show higher speeds if homes are close enough to the cabinet.  But, given average distances, the above speeds are probably more accurate.  By comparison, cable’s DOCSIS 3.0 offers speeds around 300Mbps now and DOCSIS 3.1 is expected to take speeds to roughly 10Gbps.   British Telecom (among others) is conducting various trials of the technology currently and hopes to roll out the G-Fast technology by 2020.  

Despite copper’s remarkably undistinguished record versus fiber over the years, several sell-side analysts seem captivated by the new technology, with some even predicting that it could reverse some of cable’s gains over the past several years.  It is possible…but we remain deeply skeptical.  At similar price points, we think customers will continue gravitating towards faster internet speeds and the need for faster speeds will continue to grow.  While 1Gbps+ download speeds might seem like overkill today, most people would have shared this exact sentiment regarding 100Mbps speeds 5 years ago.  LGI has repeatedly discussed how its fastest internet products have become some of its most popular offerings and that consumers who subscribed to these offerings, drastically increased their data consumption.  Furthermore, several telecom firms (including BT) introducing the faster copper products have publicly stated that the faster speeds will enable pricing power, not pricing discounts.  To us, this still looks like an oligopolistic market with rational pricing and we think LGI competes very well in such a scenario.   

67% Stake in Interesting LILAC Growth Story

LGI issued a tracking stock, LILAC, in July of 2015 to track the value of its cable systems in Chile and Puerto Rico. Following CWC’s acquisition of Columbus Media in March of 2015, many speculated that CWC would itself become a takeover target, especially as John Malone had been a significant shareholder in Columbus and then CWC. Despite LILAC’s struggling stock price, rumors of a possible CWC bid surfaced in October of 2015 and the deal terms were announced in November.  In a complicated deal (even by Liberty standards), LGI agreed to issue 109 million shares of its own shares along and nearly 13 million LILAC shares to CWC shareholders.  CWC was attributed to LILAC and LGI received a 67% interest in LILAC.  The acquisition nearly triples LILAC’s pro-forma revenue to $3.8 billion and expands operations into multiple new markets.  CWC has dominant market positions in Panama and throughout the Caribbean, with leading positions in 16/18 broadband markets and 10/16 mobile markets.  Like LILAC, CWC sports a complicated ownership structure with outside partners (often governments) owning 51% of its Panama operations, 51% of its Bahamas operation and 7% of its Caribbean operations.  In total, roughly 25% of CWC’s total EBITDA and 40% of LILAC’s Puerto Rican operations are actually claimed by outside parties.  As one can imagine, street models will report this pro-forma mess in a variety of different ways, but we suspect most will converge around management’s targeted double-digit EBITDA growth over the medium term along with some decline in capital intensity. 

To say the CWC deal was unpopular with many LGI shareholders would be among the understatements of the year.  LGI holders hated the CWC acquisition multiple, hated that the deal had obvious conflicts of interest given Dr. Malone’s ownership stake in CWC via Columbus and hated that LGI’s currency was issued (rather than repurchased) and used for what many believed to be a non-core asset.

Certainly, there are some legitimate questions regarding the deal and the acquisition multiple (10.7x with only CWC/Columbus synergies considered – the multiple is expected to decline once further LILAC/CWC synergies are announced) was certainly pricey considering the heavy slug of CWC wireless revenue.  LGI has said that the Columbus asset is particularly interesting, as the undersea cable reaches nearly 40 markets and therefore gives LILAC a tremendous advantage for future Latin American deals.  LGI noted that the situation is similar to Virgin, whereby the acquired assets actually proved beneficial outside of Virgin’s UK market.  But, this explanation begs the question as to why LGI was not more aggressive in trying to acquire Columbus originally. Perhaps, LGI was slow to recognize the synergy potential with Columbus, and this misread may have prevented LGI from making the deal at a more advantageous time.  LGI, however, does sound quite confident that further synergies will materialize and, given their experience with Virgin and Ziggo, we would take “the over” on the total amount realized.

Following past acquisitions, LGI used share price weakness to aggressively repurchase stock.  LGI is incredibly well positioned to take advantage of indiscriminate selling of its shares, and therefore longtime shareholders could benefit from highly accretive buybacks.  Some VIC members have noted that a problem of excel worksheets showing the magic of leveraged buyout math is that it works at any price.  We do wonder if certain LGI shareholders fall victim to this thinking.  That said, the same shareholders are convinced that the company is worth nearly $100 per share, and therefore they would much rather have the company continue to aggressively purchase shares at $45-$50 rather than pursue what they view as a periphery deal.  But, this deal provided a 67% share of an interesting growth asset while simultaneously allowing LGI to retire 15-20% of its share count below $40 by the end of 2017 if the stock sentiment remains horrible.  Now clearly, if CWC performs poorly, then LGI will have destroyed value with the CWC purchase.  But, we wonder if some of the concern is simply that many LGI shareholders (who often tend to own larger market cap companies) will not be able to hold the smaller LILAC stock and therefore will be unable to participate in LILAC’s potential upside.  Last week, LGI confirmed that it will distribute its 67% interest in LILAC to shareholders, and we suspect that many LGI shareholders will dump LILAC stock following the distribution. 

On the other end of the spectrum, many value investors have looked at the CWC deal and simply said, “Malone is signaling that LILAC is the asset to own.”   We will avoid a detailed discussion on the three alternatives presented to CWC shareholders in a mere 130 pages, but we will simply state that the degree of signaling was overstated in our opinion.  John Malone owns far more LGI than LILAC (even post the deal) and the idea of cutting off the nose to spite the face doesn’t seem to be the best recipe for becoming a multi-billionaire.  Furthermore, a difference of ~3% between the recommended offer and Alternative 1 was not a circa 1991 rights offering replay (we also reject that conspiracy theory but even more off topic).  And finally, we find it hard to reconcile Columbus’s choice of Alterative 2 (versus the first Alternative) without concluding that they thought LGI’s stock price would be higher when the CWC deal closed. 

We certainly believe LILAC is an interesting asset with substantial room to grow existing product penetration and acquire other assets, especially if the stock can maintain a higher currency value.  Additionally, the CWC deal significantly reduces the amount of total revenue exposed to the Chilean Peso, but currency exposure could change depending on future acquisitions.  On the downside, we think LILAC will likely be close to a full tax payer and this is a clear negative versus other cable companies.  The debatable question is whether the higher growth profile of LILAC outweighs its significantly higher tax burden.  As we will soon describe, the debate is complicated because the value of LGI’s tax assets could be much higher in the event of a deal with VOD.  We will not detail every assumption regarding LILAC, but we do assume faster growth than for LGI (low double digit EBITDA growth 2017/2018 and high single digit 2019/2020).  We also value the company at 9x EBITDA, but the implied price to free cash flow multiple is significantly higher due to the higher tax burden.  We do show meaningful upside in LILAC shares, and, as LGI investors will receive LILAC shares, LGI investors can participate in LILAC’s growth.    

Continued Leveraged Buyout and VOD sale More Likely than Mobile Purchases

While many investors are speculating about possible US cable mobile offerings in the next 1-3 years, LGI already offers mobile products in ten of its markets with 4.8 million total customers.  In most markets, LGI utilizes a Mobile Virtual Network Operator (MVNO) to provide wireless service.  A MVNO is essentially a wholesale wireless offering using another company’s infrastructure.  MVNO, however, allows LGI to control the customer relationship.  The MVNO model limits the initial investment required to offer mobile services, but the rental fees do limit the ultimate margin.  While LGI has not had problems with MVNO renewals, there is some risk that the contracts are not renewed on the same favorable terms. 

Majority controlled Telenet (Belgium) acquired wireless provider BASE Company NV earlier this year.  Fries claims that the BASE deal was a one-off opportunity, partially driven by the extraordinary price (

The EU’s rejection of a UK merger between CK Hutchison’s Three and Telefonica’s O2 has caused a wave of rumors about a possible acquisition of O2 by LGI’s Virgin Media.  Such a deal would reduce the primary benefits of combining VOD’s mobile assets with LGI’s Virgin cable business.  We think an acquisition of O2 is unlikely shorter-term but we acknowledge a deal is a possible risk.  Perhaps at a certain price, a transaction could be interesting but we believe LGI is fully aware of how many synergies exist in a VOD/LGI combination, and LGI would be hesitant to enter any deal that precludes a future sale.  Europe is clearly ahead of the US in terms of the move towards quad-play offerings, but, as noted, not all are offering integrated offerings and not all customers will be interested in a single product.  That said, LGI will likely start offering integrated quad-play offerings in in Belgium and The Netherlands following the BASE/JV integrations.  LGI has noted that quad-play customers in the UK and Belgium have 2/3 lower churn than the average customer in those markets and quad-play customers are among the highest value.  But, currently LGI does not have the customer relationship teams to handle quad play customers and therefore will need time post deal closings to offer a coordinated product.  Additionally, Liberty will likely see how efforts in Belgium and The Netherlands progress before acquiring other mobile assets or offering further integrated products in other markets. 

And then there is Vodafone.  More substantive rumors of a possible LGI/VOD merger began towards the end of 2014, and LGI shares rose nearly 30% over subsequent months as the companies confirmed discussions over possible asset swaps and/or a full blown merger.  Initially, it was believed that VOD might be the acquirer, given its size and still substantial liquidity following the sale of its share of the Verizon US wireless assets.  Subsequent press reports suggested LGI could conceivably be the buyer and/or that a deal would instead involve large scale asset swaps.  Multiple sell-side reports have almost encouraged VOD to pursue a deal as it would give the company compelling quad play offering in multiple markets and alleviate backhaul fiber concerns for its wireless business.  From what we understand, the 2015 talks were very real and may have involved a substantial premium to LGI’s then ~$50 share price.  LGI, however, held out, believing in could ultimately receive more should its growth reaccelerate.  We also believe that the deal proved elusive because of the substantial tax asset complications (more on this in a minute).   

As previously discussed, The Netherlands JV might be a preview of a full blown merger.  The announced €280 million savings amount to roughly 6-7% of combined operating expenses and capital expenditures. In prior deals, LGI has a history of achieving over 7% cost reductions so, as a starting point, if one takes 7% of the two companies’ combined UK and German operations, this would amount to ~$2.5 billion of synergies (These would ignore the obvious duplicative corporate cost savings).  One can certainly debate how to capitalize those savings at (8-10x or possibly tax affect and capitalize at 15x), but these operating and capital savings might amount to $20-$25 billion or 60-70% of LGI’s market capitalization.  These savings would also ignore revenue synergies.  While revenue benefits are normally severely discounted, the merger would establish the exact quad-play offering in multiple markets that most European telecom players are attempting to establish.

And then there are the tax assets.  LGI holds nearly $18 billion of tax loss carryforwards in the UK that can only be utilized for capital sales.  Currently, most of LGI’s $6.4 billion valuation allowance is likely reserved against $31 billion of tax loss carryforwards (listed as $6.6 billion of tax assets).  Additionally, as of March 31, 2015, CWC had $7.7 billion of unrecognized tax assets (including $5.5 billion of UK capital losses).  In the case of both assets, LGI has said it is unlikely the tax assets could be currently utilized, as the assets are restricted to capital gains.   This view does not contemplate a sale/asset swap which could unlock their value.  VOD meanwhile has large tax assets based in Luxemburg (nearly £64 billion on a gross basis or £19 billion on a net present value basis) that likely would be accelerated in a transaction.  The prospect of unlocking these assets might give VOD a strong incentive to attempt to solve the complexity headaches associated with a LGI merger, even if this requires a large headline multiple.  In summary, while VOD and LGI could not reach a deal in 2015, the odds of talks resurfacing are fairly high and history suggests a decided edge for LGI shareholders in such a negotiation. 

It seems clear that LGI can maximize value by selling to VOD, but this certainly doesn’t guarantee a deal.  VOD will face shareholder pressure if most of the deal’s benefits are seen accruing to LGI shareholders.  As noted, to fully maximize tax asset value, the deal would need to be mind-numbingly complex (even by Liberty standards) in order to preserve LGI tax assets in the UK and VOD tax assets in Germany.  Regulatory uncertainties (particularly in Germany), along with the two companies’ different perspectives on dividends/leverage ratios would also complicate a potential deal.

We show our assumptions for Liberty absent a deal in the space below.  We will concede that modeling LGI involves assumption upon assumption, and small tweaks in exchange rates, growth rates, EBITDA multiples, share repurchase prices, and so forth can drive meaningful changes in total value.  So we will try to provide a general overview of assumptions rather than discuss each market’s various assumptions.  We generally assume rising broadband penetration rates (with the biggest jumps in underpenetrated Germany), falling video penetration rates, and flat to slightly declining fixed line penetration.  We assume previously discussed synergies in The Netherlands JV and Switzerland (with some giveback because of competitive conditions), resulting in overall margin expansion excluding the VOD JV.  Our assumptions ultimately derive EBITDA growth rates slightly below LGI’s targeted 7-9% expansion.

We assume the full rollout of Project Lightning in the UK and further expansion in Germany and some in Central and Eastern Europe.   Primarily because of the Project Lightning rollout but also because of the set-top box rollout, we assume gross capex of 23-25%, reduced in given years by vendor financing.  LGI may rollout more aggressively in Germany and Central Europe than what we have assumed, and therefore capex could be higher (but presumably EBITDA as well).  We consolidate the VOD JV and subtract out the JV’s net debt, even though LGI will report its share of the dividend as equity income.  We assume no appreciation in Liberty’s content assets.  We assume all available cash flow is used to repurchase shares and that LGI maintains a leverage ratio of 4.5-5x.

Looking at a straight Enterprise Value/Forward EBITDA multiple is more challenging for LGI as investors must adjust for the value of content assets (we assume no increase in value) and make some assumption about the value of the company’s tax assets.  Valuing the deferred tax assets is a particularly challenging exercise.  Investors agree that paying limited taxes for the next five years is advantageous, but quantifying this benefit is more difficult, especially considering the option value of certain tax assets.  If we take LGI’s current tax assets adjusted for the valuation allowance and assume it takes 10 years to utilize, with minimal usage in years 1 and 2, and discount the savings at 10%, the net present value of the savings would be $2.5 billion or roughly $3.00 per share (~8% of LGI’s current market capitalization).  Our simplistic estimate is within the same zip code of a more elaborate independent valuation done at the time of the Virgin acquisition, which estimated the net present value of the tax assets at roughly $3 billion.

In our experience, discounting the value of tax assets for serial share repurchasers often understates the per share value of the tax asset, with the asset often worth more in a couple of years versus the assumed run-rate based on the discount today.  In LGI’s case, there is also the possibility that the $8B reserved tax assets could be unlocked via a sale.  If one assumes that the total tax asset base is actually $10.6 billion and it takes 12 years to utilize (with again minimal useable in years 1 and 2), the per share value would rise to ~$6.60 (obviously the number is even higher if LGI finds a way to use CWC’s UK assets).

We think it is highly unlikely that LGI will look to sell for less than 11x EBITDA given the various multiples paid for European cable assets.   If we’re in the ballpark on possible synergies, then VOD could negotiate a deal and still report a multiple of 10x or less after synergies.  LGI will almost certainly purchase an enormous amount of stock over the next 18 months.  If the company comes close to hitting its growth targets, there is reason to believe that LGI could receive something closer to $100 in a takeout scenario.  But, what happens if there is no deal and EBITDA grows at something closer to 3% and the multiple falls to 8x EBITDA?  Returns would be pedestrian, but it is more difficult to derive price targets meaningfully below current prices. 

We would also note that our valuation models actually show enterprise value (adjusted for content assets) per customer that are likely below replacement costs.  More densely populated European markets would theoretically have lower rollout costs per subscribers than US markets.  That said, LGI’s own Project Lightning is a fill-in rollout predominantly within 50 meters of existing properties and it is far from cheap.  Out of a total projected cost of £3,000, roughly £2,400 million would be spending on existing systems while £600 million would be for customer provided equipment (CPE).  While LGI describes its total spend as €600 per customer, this number is for homes actually passed (not subscribing customers) and does not take into account needed CPE spend.  When thinking about replacement costs, however, we would argue that it is more relevant to look at the total spend per customer actually acquired.  Verizon’s large-scale roll-out of its FIOS service throughout the northeast United States was estimated to cost nearly $4000 per subscriber (assuming only $23 billion was spent although some have suggested the cost is far higher when all indirect costs are allocated).  If LGI achieves its targeted 40% penetration rate, it would suggest a cost of over £1,800 per customer ($2,600 per subscriber at current exchange rates), and this rollout is practically on top of existing cable systems.  Recent US cable transactions suggest that companies find it cheaper to acquire customers rather than to attempt overbuilds, with Charter paying over $4,100 per customer for Brighthouse and $5,200 for Time Warner Cable.  Meanwhile, Altice’s acquisitions of Suddenlink and Cablevision were done at implied prices above $5,700 per customer.  While a lower interest rate environment has undoubtedly impacted acquisition multiples, we still believe it is quite possible that the replacement cost of LGI’s asset base is above the current enterprise value of the company.   

And what about the debt?  It is true that if growth is closer to 3%, then LGI might have to reduce its leverage ratio to closer to 4x and this hurts the equity case.  As previously noted, LGI’s funding costs have meaningfully dropped over the past several years and the company faces minimal maturities prior to 2021.  If an exogenous shock forced LGI to reduce leverage at the end of this year, we estimate that the company could deleverage quickly and reduce net debt ex-collars to near investment grade levels of 3.5x by the end of 2018 (clearly the stock trades lower in this scenario) and possibly even quicker if LGI could repurchase its debt at a discount.   Finally, as noted in our Liberty Broadband write-up, cable companies have proven to be among the most recession resistant and LGI was no exception.  We show LGI’s performance during the 2009-2010 performance below. 

And what about foreign exchange?  This is certainly an issue, and the stronger dollar has been a major factor in reduced forward EBITDA estimates.  Many investors are rightfully nervous about the pending Brexit vote (nearly 37% of LGI’s revenue is in Pounds) as an exit would almost certainly cause a substantial drop in the Pound and likely have spillover effects on the Euro.  Even if the UK stays, higher US rates and/or further European weakness could easily pressure the Euro.  As previously noted, however, LGI does match its debt with functional currency or will hedge the currency exposure in cases where it cannot be matched.  In theory, this should mean that the dollar value of LGI’s debt will also drop (along with an appreciation in currency derivatives) should the dollar appreciate.  While most sell-side models will have a toggle to adjust (lower) EBITDA in the event of currency fluctuations, the models will not reduce debt values even though the same models assume a multiple of EBITDA and subtract net debt in deriving LGI’s equity value.  But, clearly LGI likely trades lower if the dollar meaningfully appreciates and we understand the reluctance of many investors to purchase shares ahead of the Brexit vote.  We simply assume spot rates continue (our 2016 Pound assumption of 1.44 is roughly 5% weaker than 2015 so 2016 estimates reflect a 5% currency headwind) in forward years.

LGI is a convoluted story, with a mix of complexity, foreign exchange and leverage that make it untouchable for many investors.  When this complication is combined with headwinds in certain markets, it is not surprising that the stock is shunned.  But, in our opinion, cable remains an attractive business and while LGI’s stock price will be volatile, we ultimately think the risk/reward is asymmetric.  While LGI operates in a more mature market, we see substantial opportunity for the company to achieve modest growth, improve margins and ultimately sell itself of for at a substantial premium to current prices.  In some ways, the current negative sentiment in the stock could be particularly advantageous given the volume of pending share repurchases.  If headwinds in individual markets prove more challenging than anticipated, we think more modest returns are still possible and despite stock volatility, we think there is less intrinsic value downside even in lower growth/multiple contraction scenarios.      

Catalyst

Catalysts:

-Large share repurchases over the next 18 months, enhanced by proceeds from VOD JV

-Improved revenue/EBITDA growth as a result of Liberty GO Initiative

-Ultimate sale to VOD

Risks

-Continued/Increased problems in The Netherlands/Switzerland

-Foreign exchange volatility including possible Brexit vote

-VOD JV regulatory and/or integration problems

-Inability to hit Liberty GO growth targets

 -Forced deleveraging due to an exogenous shock or slower than anticipated growth