Description

There have been several VIC reports detailing the consistency of QVC’s results, the loyalty of its customers (customer retentions of 85-90%), high margins/low capex etc.  We would encourage those unfamiliar to reread and to review the company’s investor presentations but we will not rehash these details.  That said, all of this history was called into question with sales weakness that started in June of last year and continued throughout the remainder of 2016 (Q3 and Q4 QVC US sales/EBITDA were down -6%/-8% and -7%/-10% respectively adjusted for corporate allocation changes discussed later).  As QVC had only experienced these types of declines during The Great Recession, the debate on QVC has centered around whether the US will turn or not.  While the LVNTA/QVCA announcement is clearly positive for LVNTA, we believe investors are underestimating how much this deal can benefit QVC.  As an asset-backed company with a tax advantage cash flow stream, the deal considerably improves the company’s risk/reward profile.  

It is impossible to ignore the carnage in retail over the past year.  QVC grew through these trends for years, but even the most ardent QVC bull has to admit that it is difficult to be fully confident of a US revival until one sees at least a couple quarters of growth.  That said, if the QVC model is completely broken, we find it difficult to explain why the international business has continued to post solid growth.   Historically, QVC has experienced periods of weakness in all its longer-standing international markets, (Japan, Germany, UK) with all markets eventually rebounding.   During this period of US sluggishness, the UK and Germany posted robust results while Japan showed improvement with all international markets showing positive constant currency growth in the third and fourth quarters of 2016.  During the fourth quarter, the international division posted EBITDA growth of 11% excluding QVC’s changed cost allocations, results hardly suggesting a business in decline.  While Zulily (ZU) targets a younger demographic and therefore there are comparability issues, its results have exceeded expectations since the merger with the company (2016 revenue/adjusted growth of 14%/58%) showing no signs of the weakness faced by QVC US.  

A lot has already been written about QVC’s super shoppers slowing spending, the problems with WEN hair care (be careful if you shampoo with that stuff) and stability of the sporadic QVC shopper – the one most likely to defect to Amazon – so we don’t rehash this discussion.  We would note that Mike George has recently discussed strength in apparel (the category that AMZN’s initial fashion show seemingly most likely to impact), improved results in beauty (ex-WEN) and new customer growth, including growth in electronics categories, suggesting positive trends in some of the previously weaker categories.  While jewelry has not turned (and shows no signs of doing so), QVC reduced inventory in 2016 and continues to dedicate less airtime to the category, thereby minimizing some of the negative impact.  These anecdotes, combined with the improving trends (albeit still negative) mentioned during the March conference circuit, seem encouraging.   QVC has aggressively reduced costs and sourced new products, which together has limited margin deterioration during this period of sales weakness (margins were only down 50 basis points during 2016 adjusted for corporate allocation changes).  But, until the US posts growth, the existential concerns will not die.

Buyback Stock With Tax Sheltered Cash Flow…Sell if Turnaround Fails to Take Hold

Two of the most widely respected capital allocators still own large quantities of QVC stock (John Malone and Greg Maffei own roughly $580 million and $200 million respectively).  Solid capital allocation requires changing strategies when facts change.  We think both individuals respect Mike George as an operator, believe his plan seems credible, think that election noise had some impact on retailing results during 2016, and are willing to give the turnaround time.    But, neither likely knows if Mike is right or if instead QVC has simply entered a secular decline.  And, therefore, while the movement towards an asset-backed security does allow index participation and expanded research coverage, it also makes a sale far easier if Mike’s plan doesn’t take hold.    But even in a failed turnaround scenario, QVC lack of store infrastructure/limited capital spending needs/strong ecommerce/mobile presence (~50% of sales are online with mobile accounting for 60% of these) will still allow substantial free cash flow generation, as Dr. Malone noted on QVC’s fourth quarter conference call.  This cash flow will be turbocharged by the exchangeable shield.  

We have always loved the optionality of the exchangeables and believed this was particularly valuable in Liberty’s hands.  While many sell-side models punished Liberty entities that owned these instruments with complexity discounts, their cash flow was a glorified interest free loan that was instrumental in the LBRDK investment.  While the reattribution of the exchangeables to QVC does increase leverage, it also allows cheaper financing at a time when QVC’s equity is at its weakest point since The Great Recession.   It should also be noted that QVC only faces $400 million of maturities before 2020 and roughly 60% of its non-exchangeable debt is due 2023 or later.  The transferred exchangeable maturities are between 2029-2031.   QVC will use the $330 million of cash payments from the exchangeable transfer to paydown its bank facility, thereby reducing senior leverage towards its promised 2.5x level.  Liberty will do its best to spin the deal as a deleveraging event (and maybe the rating agencies will only focus on senior level debt), but the reattribution clearly increases overall leverage.  But, as we will show, we think this debt will prove manageable while providing cheaper financing for share repurchases as additional sub-notes would have been costly.   Outside of the recent operational weakness, the biggest chink in QVC’s armor has been capital deployment.  QVC (old LINTA)’s historical returns would have looked far different had the company been able to aggressively repurchase shares in 2008-2010.  

We would further argue that QVC’s debt structure is more attractive than other retailers, whose lease adjusted leverage may prove more challenging to restructure as they rethink their real-estate footprint.  Furthermore, while QVC’s higher margin/lower capital expenditures have always allowed more robust free cash flow versus other retailers, QVC has always been a full tax payer.  This changes with the exchangeable reattribution, and in the short-to-intermediate time frame, the shield will almost exclusively be used for buybacks.  If QVC’s business turns, these buybacks will be wildly accretive.  But even in darker scenarios, we don’t think buybacks will prove value destructive, especially if our assumption about possible financial buyer interest proves accurate.  

So on to scenarios.  We will show 3 scenarios with varying assumptions on the US business while keeping our international/ZU assumptions constant.  QVC stopped disclosing sales/EBITDA data at the individual country level after 2014 and, therefore, our country level margin assumptions are a bit of guesswork.  We show (assuming flat exchange rates beyond 2017) 2017E-2020E EBITDA growth rates of 3-4% CAGR in Germany, 1-2% in UK, 6% in Japan and Italy/France EBITDA moving to $25mm/$1mm, respectively.  As previously mentioned, in 2016 QVC started allocating certain corporate expenses towards the market that benefited versus where the service was performed.  These changes benefited US EBITDA margins by 50 basis points and hurt international margins by 120 basis points.  For this reason, international trends have been stronger than the reported results would suggest.  Taken together, we assume total international EBITDA growth of 7-8% annually or 6-7% if you exclude Italy/France, with France currently generating losses.

On the tax side, we assume a 38% tax rate (and used the same rate in calculating the exchangeable shield) domestically and ~28% overseas.  2017 will be the last year heavy year (~$211 million) of non-deductible amortization from the QVC purchase.  We assume ZU’s purchase accounting amortization ($160-$180 million in 2017/2018) is not deductible for tax purposes.  We have used these assumptions historically, but we think our near term tax estimates could prove too high.

QVC’s Chinese operations are very difficult/impossible to value and therefore we assume no value.  As the QVC’s joint venture already has 1.4 million customers (with 121 million home passings) and ~$160mm of revenue, there could eventually be substantial value.  That said, the Joint Venture is still one of multiple competitors (currently ranked number 6-8 according to the latest investor presentation) and, unlike QVC’s other foreign markets, QVC is the minority investor since China National Radio owns 51%.  Clearly, success in China would be an enormous game changer and would offer considerable upside  

On the ZU side, we assume top-line growth of 12% in 2017, slowing to 7% by 2020 , an additional $30 million of synergies in 2017/2018 and margins expanding roughly 350 basis points to 10.7%.  An obvious criticism is that QVC US was the canary in the coal mine and international/ZU results will soon weaken as all of retail is eventually crushed.  If this is the case, it will be very difficult for this idea to work.  

Keeping these assumptions constant, we show three scenarios for QVC US:  

Base:  QVC’s  suffers -3% revenue decline in 2017 and 50 basis points of margin contraction followed by no growth in revenue/flat EBITDA margins

Bull:  QVC shows flat growth/margins in 2017 and then 3% top-line growth and 25 basis points of margin expansion annually   

Bear:  -5% annual revenue declines/100 basis points of margin declines translating to 10% EBITDA declines from 2017-2020

In all 3 scenarios, we show 100 percent of cash flow used to repurchase shares.  

Our base case depicts a broken (but stable) model and still essentially shows ~18-20% IRRs.  In the bear case, QVC US’s recent declines continue perpetually.  Certainly, the short-term won’t be fun but it still looks more difficult to lose substantial amounts of money over a multi-year period.  Of course, this would assume continued growth at ZU and internationally.  If Mike George is correct and the US issues prove temporary rather than secular, and a whopping 3% topline growth is possible, then QVC very well could have better return potential than any name within the Liberty family.  We suspect there would be some pushback on valuation as QVC has higher debt levels and therefore is not as attractive on an EV/EBITDA basis (depending on your assumption on the exchangeable tax liability).  We would argue that the better free cash flow conversion would certainly warrant a premium versus other retail names.  We would also note that if the business is viewed as stable/debt manageable, we would think the name could at least trade with a 10% free cash flow yield.

It seems nearly certain that QVC will repurchase large amounts of stock over the next 3 years, but there is considerable uncertainty at what price.  If John Malone were to go on CNBC today and say that of all the names in the Liberty family, the one he finds most compelling is QVC, the stock would certainly move higher.  But even in this scenario, we think the investors would still need to see several quarters of growth to carry the initial momentum.  That said, our base case scenario, in which QVC US never grows again, does assume share repurchases at 20% higher prices annually.  Given the deep unpopularity of anything retail related, it certainly seems possible QVC could repurchase shares far cheaper.  If instead of 20% annual share price increase we keep QVC’s share price flat, free cash flow per share would rise to $3.85 per share even assuming no US growth.  

We also show the credit metrics for each of the scenarios.  We would note that the exchangeable metrics overstate the true leverage as we simply use the raw undiscounted tax liability rather than a discounted value.  Our metrics also show the underlying exchangeable debt value on both a face value and market value basis, with the face value technically overstated, as there is some principal payment each year.    QVC does not own the underlying equities backing the exchangeables.  This is less of a risk for the S/CTL bonds given how far out of the money the underlying securities are but conceivably could be an issue with regard to MSI bond.  There is also a risk that one of the three companies could receive a cash offer and QVC would then have to pass through the cash proceeds to the exchangeable holders, with a cash deal for Motorola Solutions (2031 bonds) by far the biggest possible outflow.  LVNTA historically kept some dry powder for this possibility.

At the beginning of the year, there was considerable discussion that the exchangeables would have far less value if the corporate tax was lowered.  It is true that the actual shield would be smaller, but the discounted value of the tax liability would also be less and therefore, there is minimal effect on a net present value basis.  As noted, we currently use a 38% US tax rate for QVC (and roughly 28% internationally) and assume a similar rate for determining the amount of tax shield.  If we drop the corporate tax rate to 20%, this would result in lower shield savings for QVC – we show the amount would drop to $86mm, $94mm, $103mm in 2018, 2019 and 2020 respectively.  The question is whether this corporate tax rate change would also be accompanied by a border tax.  The tax (along with the non-deductibility of interest) would clearly be bad for QVC but it is difficult to quantify the damage given the lack of specifics regarding the proposal.  The odds of passing more dramatic tax reform may have declined (with the odds of a border tax perhaps dropping more) in the past couple of weeks, but there is a possibility that corporate tax rates get reduced without a border tax, a bullish scenario for QVC.     

Even in the bear scenario, QVC has more than sufficient capacity to service debt.  And as noted, we think a possible financial buyer would love the tax savings of the exchangeable bonds and be more than comfortable with an even more aggressive debt profile.  It is also conceivable that QVC ultimately finds a home with another buyer who has large NOLs that could ultimately shield the exchangeables’ future tax burden.  And while the hurdle rate for any acquisition will be enormous given the above repurchase IRRs, maybe QVC ultimately finds another ZU in the future.  While difficult to predict exact scenarios, we would simply submit that owning Liberty entities with optionality has historically been a profitable strategy.  

Risks are almost too numerous to list, but perhaps chief among them is that the past year of retail carnage has occurred during a period of economic expansion.  It stands to reason that results would turn far worse during a recession, and if this economic pullback occurs in the next 12-18 months, QVC would prove to be a poorly timed investment.  We have already discussed the risk of an international slowdown, but a stronger dollar would also hurt international results.  It is also possible that ZU hits a wall and its business eventually hits the same headwinds that have knocked QVC’s US business.  But, a lot of this is factored in QVC’s share price and the slightest hint of a turn could send shares materially higher.  

Risks:

• US Recession

• Secular decline in US business

• Slowdown in ZU growth

• Deterioration in International Results

• Change in Government Policy (Border tax or non-deductibility of interest)

• Substantial increase in interest rates

Catalyst

Higher share repurchase, inclusion in S&P 500, increased research coverage