Description

LILAK:

LILAK has underperformed peers by ~21% over the past two months as the result of a ~117.4M share distribution related to the recent acquisition of CWC LN. This technical pressure has created an attractive entry point into a compelling long term consolidation story in the Caribbean Cable market, investing alongside one of the greatest capital allocators and cable pioneers of all time in John Malone.

Background

LILAK is a tracking stock spun out of LBTYA last June to track the economic performance of Liberty Global’s Latin American Assets and serve as a platform for consolidation in Latin America to duplicate LBTYA’s success in Europe (as well as Malone’s success in the U.S. more broadly). In November LBTYA  announced the ~$7.4B acquisition of the Cable & Wireless acquisition in a complicated structure (even for the Liberty complex) by which CWC LN holders were compensated in LBTYA/K and LILA/K equity as well as a special dividend. The acquisition was formally completed on 5/16/16 and on 6/2/16 LBTYA announced the BOD had approved the distribution of 117.4M LiLAC Group ordinary shares (35.2M LILA, 1.3M LILAB, and 80.9M LILAK) that represent the current inter-group interest to Liberty Global s/h on a pro rate basis. This 67.2% inter-group interest resulted from the use of LBTYA equity in conjunction with the CWC LN transaction. This has been a significant overhang on the stock as the 117.4M shares represented ~107% of LiLAC groups shares outstanding. Since announcement date LILAK has traded ~83M shares and has underperformed peers by ~20% as the market had to a) price in the impact of the distribution and b) hedge fund were cognizant of this and began short selling applying incremental pressure on the stock and c)  long only holders of LBTYA did not have interest in a smid cap cable Latin American cable asset. The distribution took place at the close of trading on 7/1 which means we’ve now had a month for the long only community who received LILAK or LILA to sell their position. Given the relative size differential of the two companies, the different geographic footprints, and the fact that LILAK is a tracking stock, it’s not unreasonable to assume ~2/3-3/4 of that distribution would need to turn over and we’ve now reached that point. Management noted that LBTYA was used as consideration not only for enhanced liquidity and the higher trading multiple but also because CWC LN holders were largely UK institutions and the BOD was UK dominated which could suggest incremental supply. Ultimately we feel that the bulk of the technical headwind is behind us and with LBTYA earnings 8/4 management will have their first opportunity to focus the investment community on the pro forma entity and provide synergy guidance for the first time.  

LILAK

Despite the share price volatility I think one month post distribution we are now at an attractive time as any to revisit the story and potential upside 3-5 years out in LILAK. As a reminder prior to the CWC LN acquisition LILAK was the largest cable operator in their respective Latin America markets (Puerto Rico & Chile) in terms of number of subscribers, and a leading provider of broadband internet and fixed-line telephony services in those markets. Their Chilean operations are provided through their wholly-owned subsidiaries VTR GlobalCom SpA (VTR GlobalCom) and VTR Wireless SpA (VTR Wireless and VTR GlobalCom and their respective subsidiaries, VTR). These systems pass through nearly all of the 3M multi channel households in Chile.  While they conduct business in Puerto Rico through their 60%-owned subsidiary Liberty Cablevision of Puerto Rico LLC (Liberty Puerto Rico), where their systems pass through ~1.1M homes or ~90% of the island’s multi channel homes.

When the tracking stock was initially separated Liberty management indicated the willingness to create a “pure-play” equity focused on Latin America & the Caribbean in an attempt to create value not only through organic growth & appropriate capital structure management but through M&A. LBTYA has a strong track record of value enhancing M&A in the region, and the highly fragmented market is ripe for consolidation with the low broadband and Pay TV penetration representing significant growth opportunity. The market had anticipated LILAK would do an acquisition with CWC LN and Megacable the best pure play publicly traded companies along with a slew of other private entities or divisions of large multi nationals. The market did not have to wait long and they went after the largest target in CWC LN. LILAK was able to do this given their ability to leverage LBTYA equity as part of consideration which is a competitive advantage no other operator possesses.

LILAK’s networks are essentially all digital (~100% in Puerto Rico & ~90% in Chile) supporting superior speeds & channel offerings vs. competitors, who are often Telcos that rely on copper DSL technologies, or satellite companies that do not have the ability to bundle their services. Approximately ~1/2 of LILAK’s bandwidth was built out at 1GHz which requires little incremental investment which should result in a decline of the capital intensity of the business on a go froward.  

CWC:

CWC is leading full service communication provider across 18 countries in the Caribbean and Latin America. Through their various brands CWC provides a residential mix of cable (HFC

is ~50% of the plant, and FTTH/FTTC is ~20%), copper telephony (~30% of the

plant), mobile quad-play services, and B2B and B2G services in those 18 countries. Some high level stats on their various business lines:

•       Mobile- the leader in 10 of the 16 mobile markets in which they operate with ~4.11M customers.

•       Broadband business- the leader in 16 of the 18 markets they serve and have ~690K broadband customers. 

•       Fixed Voice- the leading provider in 17 of their 18 markets with 1.13M fixed line customers.

•       Video- the leading provider in 7 of 10 markets with 474K customers

In May of 2014 Cable & Wireless unveiled its new operating plan entitled “Project Marlin” through which they intended to invest more than $1B in its fixed & mobile networks over the subsequent three years, resulting in an increase in CapEx by 30%, adding ~$250M to its standard level. The strategy targets top line growth with investment in new networks & services such as 4G & LTE as well as WiFi hotspots, TV services, and B2B solutions. Prior to this initiative CWC LN had historically operated mostly incumbent copper telephony & wireless infrastructure. As a result of this build out CWC LN CapEx should peak in ~2017 and revert to more normalized levels ~2018.  

Pro Forma Thesis

The transaction easily created the leading consumer and B2B communication provider in Latin America, while creating a platform that has the ability to capitalize on further M&A opportunities as the company generates low double-digit OCF growth for the foreseeable future, while also adding management depth. The LiLAC Group operates in over 20 countries in Latin America and the Caribbean under the consumer brands VTR, Flow, Liberty, Mas Movil and BTC. In addition, the LiLAC Group operates a submarine fiber network throughout the region in over 30 markets.  The pro forma company had ~10M video, broadband, fixed and mobile telephony subscription services. There are both organic growth opportunities from further penetration in pay-TV, high speed Internet, wireless, and B2B supported by the increased scale, as well as incremental upside optionality from further consolidation with the ability to exploit the fragmented pay TV and telecom landscape.

Liberty Global CEO Mike Fries has referred to the transaction as a “game-changer” for this part of the world noting that they look at their business over a 5-year time horizon and stating this transaction clearly creates value over that time. Prior to the transaction they were growing top line at high single digits and EBITDA at double digit rates but both the Chilean assets and the Puerto Rican assets were subscale. The penetration rates in those regions are ~30-50% of wheat the U.S. level is. The CWC LN asset they purchased are number one fixed or broadband provider in 7 of the 18 countries in which they operate and they have a massive subsea cable business that feeds those markets. While management has avoided given granular guidance hiding behind U.K. Takeover Panel rules they have publicly acknowledged they intend on growing EBITDA at a double digit rate going forward. While CWC LN had guided to $125M in synergies associated with their Columbus Networks acquisition (of which ~$98M had yet to be realized according to the proxy) the companies were unable to provide synergy guidance around this transaction although it is likely to be at least at those levels. At various conferences since the deal was announced both Fries and Rick Western have alluded to “great synergy potential” which they were preclude from discussing but intended to discuss post deal closure.  Areas of opportunity include savings related to elimination of public company expenses, further corporate and administrative rationalization of existing LiLAC Group operations with those of CWC, leveraging the combined scale in areas such as content, procurement, and product development, and capitalizing on CWC’s terrestrial and submarine network assets and B2B expertise and product portfolio to benefit LiLAC Group’s operations. There are also very likely revenue synergies from product & service development in several regions along with cross selling.

Management has clearly indicated they intend to take a page from the LBTYA playbook around driving best in class organic growth, coupled with smart M&A, and a focus on balance sheet optionality to drive equity returns over the long term. There are a number of interesting opportunities they could look at over the intermediate term including Megacablle, a pure play Mexican cable operator, Millicom International Celluar, and Grupo Televisa. On Grupo Televise I think it’s worth noting that Mike Fries, David Zalav, and Joe Feltheimer are all on the BOD, all of whom have ties to John Malone, which could lead to a partnership or acquisition. Outside of the public opportunities there are numerous private entities or divisions of multi nationals that would be ripe targets for LILAK at the right price.

Finally CWC LN had a strong history of B2B which intrigued LILK. Management notes that everywhere that bandwidth is required on B2b or B2G they are the preferred provider. This not only provides LILAk with a complementary business line (that has only recently started in Puerto Rico & Chile) but yet another platform by which they can look to grow through M&A.

I think it’s important to keep in mind that in making this acquisition they decided to use some LBTYA stock as currency for a multitude of reasons but noted one of them was they did not like the price at current LILAK levels as they thought it was too cheap (the stock was trading ~$38/sh at the time and traded at a ~2x multiple discount to LBTYA).  

Management Team

I’d be remiss not to mention the management team here which will be best in class for any cable asset globally and even more so with a focus solely on the Caribbean region. LBTYA CEO Michael Friess is a 30 year cable veteran that launched the company’s international expansion over 20 years ago. The President & COO of the Latin American assets is Betzalel Keingsztein, who has over 25 years of experience in the industry.  He joined Liberty Global in 2004 as the Chief Technology Officer for Liberty Global’s operations in the Netherlands where he led a crucial phase of product innovation. In 2009, Liberty Global appointed Kenigsztein to the position of Managing Director of Liberty Global’s Hungarian operations. Then, in 2013, he was promoted to Managing Director for the Central and Eastern Europe region of Liberty Global, which encompassed over eight million RGUs across five countries. Prior to joining Liberty Global, Mr. Kenigsztein held a range of senior management positions with Tevel Israel International Communications Ltd.  Betzalel and CFO Chris Noyes will report directly to Friess.

 As part of the transaction John Malone elected the First Dual Share Alternative for consideration (which increased his economic exposure to LILAK).

 Secular Thesis

The Latin American and Caribbean region is currently under penetrated and underserved, while its growing faster than North America and Europe, and consolidation is celery needed. The penetration rate is ~30-50% of what the U.S. level is. That said if you look at demand for bandwidth whether its mobile data or fixed data its off the charts in terms of growth and its extremely fragmented.  

If you look at households in various Latin American countries that receive multichannel cable it pales in comparison to the U.S. or Europe. In Brazil for instance ~32% of households have multi-channel cable, Chile 45%, Colombia 42%, Costa Rica ~47%, the Dominican Republic ~29%, El Salvador, Guatamela, Honduras, and Nicaragua are all <30%. This despite growing populations and GDP growth outpacing most of the developed world.

 Financials

As Liberty enjoys doing they have made the process of analyzing the pro forma company difficult by not providing granularity around synergies or updated CWC LN numbers since their last interim report. On my numbers I have LILAK trading at a 6.8% unlevered FCF yield on ’17E and an 7.5% unlevered FCF Yield on ‘18E along with ~7.0x ’17E EV/EBITDA and 6.1x ‘18E EV/EBITDA vs peers in the 3 % / 4% range and 6.5x / 6.0x respectively. Ultimately I think LILAK will warrant a premium multiple as a result of the consolidation thesis and the scarcity value of a being the only Caribbean cable asset listed in the U.S.

 n deriving a ’17 PT I built out a DCF for the pro forma company without baking in any future acquisitions (which I believe is very unlikely). In this scenario using an 8.5% WACC and 1% perpetual growth rate I derived a ‘17E FV of ~$48/sh or ~36% upside from current levels.

Risks

Stale Financials/Legacy CWC Growth Assumptions: Since we have not had updated financials in CWC since February there is concern about growth assumptions for some of the legacy assets. The mobile side of the business continues to be competitive with new players and there has been a slow down in both the Caribbean and Panama.

FX- A lot of the pushback on the story has been FX risk as it relates to the Chilean Peso. The CWC LN transaction did a lot to assuage those concerns as ~70% of pro forma

Chilean Regulatory Environment- The Chilean rate regulations are governed by the Consumer’s Rights Protection Law (CRPL) and interpreted by the National Consumer Service (Sernac). VTR is  allowed to increase its rates 2x/  year based on inflation for its cable triple-play products.

Natural Disasters- This has been well socialized by management and the investment community but given the geographic location tropical storms & hurricane can affect the Caribbean based plant which could cause business interruptions. That said they have done a good job to ensure the bulk of the infrastructure is hung (not dug) for this reason.

Catalyst

LBTYA and LILA/K earnings on 8/4 will refocus investors on the pro forma story & allow management to provide pro forma guidance for the first time.