Special situation opportunity: Liberty Ventures

Thesis: Liberty Ventures stock may be undervalued when it starts trading due to its complexity and misleading balance sheet.  Ventures has a stated book value of -$1,9871M.  After adjusting for the market prices of its investments and its anticipated cash balance, Ventures would have an adjusted book value of around $570M.  Making adjustments for its deferred tax liabilities will add a few (to several) million dollars on top of that.

The tracking stock proposal and history of prior tracking stocks

Liberty Interactive (LINTA/LINTB) is going to split into two tracking stocks: Liberty Ventures and Liberty Interactive.  This is a classic John Malone situation:

A- Tax efficient.  Ventures will generate significant tax deductions and it can apply these deductions to Interactive’s tax return in exchange for cash.  If Ventures was separated as a spinoff (instead of a tracking stock), this would not be possible.

B- Using complexity as a weapon against institutional investors so that they might sell stock for less than what it is worth.

When the predecessor Liberty company was split out of TCI as a tracking stock in 1995, institutional investors stayed away from Liberty due to its unusually high share price (from an intentional reverse share split), its reported book value (close to 0), and sheer complexity.  In Mark Robichaux’s biography on Malone “Cable Cowboy”, it is noted that even TCI’s founder (Bob Magness) did not understand the deal.  But those who invested in Liberty would have seen their money grow several times.  The financial aspects of the deal are discussed in Joel Greenblatt’s book on special situations investing “You Can Be a Stock Market Genius”.

In 2006, Liberty split into two tracking stocks: Liberty Capital and Liberty Interactive.  It was Liberty Capital that was very complicated and difficult to understand.  Originally, Interactive’s current exchangeable debentures were attributed to Liberty Capital.  Prior to Interactive and Capital splitting up in a spin off (breaking the tracking stock structure), Interactive and Capital did a swap so that Interactive was given the exchangeable debentures.  This is because the debentures generate significant tax deductions and Interactive generates far more taxable income than Capital does.  You have to wonder why these debentures were attributed to Capital in the first place.

Liberty management talks about giving investors “choice”.  I believe that this will create an opportunity for investors to put their money disproportionately into the more expensive/less undervalued tracking stock of the pair.

Liberty’s exchangeable debentures

1- Liberty’s exchangeable debentures can be thought of as two parts: debt and an associated call option.  The debentures mature in 2023, 2029, 2030, and 2031.  Liberty has effectively sold call options that expire in those years.

When the debt was issued, Liberty owned stocks that Malone felt was overvalued.  As these stocks had a very low cost basis, selling them would require Liberty to pay substantial taxes.  To sell call options and buy put options on these stocks would effectively sell the stock through derivatives.  Doing so would avoid triggering gains on the stock sale as the common stock hasn’t actually been sold.

Liberty essentially sold call options on the stocks through the exchangeable debentures.  It also likely bought short-term put options on the same stocks to hedge against losses.  (These put options were likely settled in cash to avoid triggering capital gains on the stocks.)  This is one of the ways in which the debentures defer taxes.

2- The second method in which the debentures have favorable/funky tax characteristics has to do interest deductions.  Liberty gets tax deductions based on the “comparable yield” of its debentures, as if it issued fixed-rate debt with similar terms.  The comparable yield is significantly higher than the cash interest that Liberty pays.  From the YE2008 10-K:

From the date Liberty issued its exchangeable debentures through 2007, Liberty claimed interest deductions on such exchangeable debentures for federal income tax purposes based on the “comparable yield” at which it could have issued a fixed-rate debenture with similar terms and conditions. In all instances, this policy resulted in Liberty claiming interest deductions significantly in excess of the cash interest currently paid on its exchangeable debentures. In this regard, Liberty deducted $2,847 million in cumulative interest expense associated with the exchangeable debentures since the Company’s 2001 split off from AT&T Corp. (“AT&T”). Of that amount, $844 million represents cash interest payments. Interest deducted in prior years on its exchangeable debentures contributed to net operating losses (“NOLs”) or offset taxable income earned in prior taxable years.

In effect, every year Liberty receives interest-free loans from the US government that may last until 2023-2031.  If you have $1.00 due in 19 years and discount that to the present at a rate of 3%, then the present value would be $0.57.  The liability recorded on the balance sheet likely overstates the present value of these liabilities significantly.

However, it is uncertain when these tax liabilities will be due.

2a- The debentures are essentially putable (and callable).  The holders have an option exchange the debentures for the underlying reference shares.  Holders of 3.125% Time Warner (TWX/TWC/AOL) debentures can do so in March 30 2013 and 2018.  Holders of the other debentures can do so anytime.  The 10-K states that management believes that the chance of the other debentures being redeemed early is “remote”.  This is because these other debentures are linked to shares that have gone down significantly since the debentures were issued.  Holders can hold the debt until maturity and receive the face value of the debt  The amount due upon maturity is significantly higher than the value they would receive if they were to exchange the debt now (and re-invest the proceeds).  There is also potential additional upside in the call option that they own.

2b- Historically, Liberty has voluntarily bought back its exchangeable debentures (all series).  Sometimes the debentures trade at around a quarter of their original issue price.  I would expect management may try to buy some back when they are cheap if the overall after-tax return of repurchasing debt is attractive (or if they can replace these debentures with other debt that is more attractive).

3- Liquidity Issues
If a party were to buy the reference shares associated with the debentures in cash (but not stock), then Liberty would be required to make a cash distribution to the holders shortly after the deal closes.  This is currently happening for a second time with the 3.5% Motorola debentures as Google is buying Motorola Mobility (MMI).  This could potentially be problematic if Liberty has not hedged its position as it has to distribute a very large sum of cash.  One way to hedge this liquidity risk would be to own the reference shares.  However, Liberty has disposed of its MMI shares (as well as those for the Sprint debentures).
It is unclear what Liberty is doing to manage its risks.  Simply not hedging its position is not necessarily a bad idea.  However, Liberty needs to be able to quickly come up with sufficient cash and this could limit how Liberty invests its money (e.g. it must have a credit facility or invest a portion of all its assets in cash equivalents).  Liberty could also potentially hedge its position by buying call options on the shares.

4- Tax law issues
There may be tax disputes with the IRS over Liberty’s various tax schemes.  Liberty has had to settle with the IRS in the past over these debentures.  From the YE2008 10-K:

In connection with the IRS’ examination of Liberty’s 2003 through 2007 tax returns, the IRS notified Liberty during the third quarter of 2007 that it believed the interest expense on Liberty’s exchangeable debentures was not deductible for the period following Liberty’s split-off from AT&T. In February 2008, Liberty reached a settlement with the IRS, which stipulates that interest deductions claimed on a portion of the exchangeable debentures were disallowed and instead will reduce Liberty’s gain on the future redemption or other retirement of such debt. The cumulative amount of interest deductions disallowed through December 31, 2007 under the settlement is $546 million. As a result, a portion of Liberty’s NOLs were eliminated and Liberty had net taxable income in 2006 and 2007 on its amended tax returns. Consequently, Liberty expects to remit federal income tax payments for the foreseeable future.

5- Liberty may benefit from esoteric tax laws over these debentures.

The American Recovery and Reinvestment Act of 2009, signed into law on February 17, 2009, adds new section 108(i) to the Code, which gives an issuer the ability to elect to defer the recognition of COI income arising from the repurchase of outstanding debt instruments during calendar years 2009 and 2010.  For an issuer reporting on the basis of the calendar year, any deferred COI income instead would be reported for U.S. tax purposes ratably over a five-year period beginning in 2014 and ending in 2018.  The election to defer the recognition of COI income under new section 108(i) of the Code is made on the issuer’s timely filed U.S. tax return for the year of the repurchase, and generally is irrevocable without the consent of the Internal Revenue Service.
http://www.shearman.com/files/Publication/c073c4af-0a3d-4922-9c7d-d6ae935610fc/Presentation/PublicationAttachment/fa348437-ff99-4778-907a-de4916998caa/TAX-031709-Impact-of-Recent-Changes-in-US-Tax-Law.pdf

6- Transparency regarding these debentures is low.  Management does not explain its hedges (if any), how the comparable yield is calculated, etc.  It does not state how much tax deductions are thrown off every year, when these tax liabilities are due, etc. etc.

Valuation

1- According to page B-2 in the S-4A dated June 29, 2012, Ventures will have total assets of $2,070M against $4,041M of total liabilities.  However, assets should be adjusted for the market prices of Expedia and TripAdvisor as Liberty is in the process of selling those stakes in a tax-efficient manner.

Expedia:
12.0M shares sold at 34.316 = $411M  *ignoring tax effects of forward sale contract
9.8M shares at $48.33 = $474M   *July 5, 2012 market price
12.8M B shares at $48.33 = $618M  *assuming no B share premium (or discount)
Market price $1,504M
Carrying value $621M
At 35% tax, book value should be adjusted upwards by $574M

TripAdvisor:
8.45M shares sold at $40.00 = $338M
13.3M shares at $46.27 = $618M
12.8M B shares at $46.27 = $592M
Market price $1,548M
Carrying value $184M
At 35% tax, book value should be adjusted upwards by $886M

Tree and Interval Leisure:
28.2M TREE shares at 11.36 = $32M
17.6M IILG shares at 18.98 = $335M
Combined market price = $367M
Carrying value $110M ??? *the actual carrying value is likely lower
At 35% tax, book value should be adjusted upwards by $167M

2- A further adjustment should be made for the cash that will end up at Ventures.

The accompanying financial information does not reflect an anticipated attribution of cash to the Ventures Group of $1,325 million (which includes proceeds from the sale of TripAdvisor, Inc. shares in May 2012 and the impact of certain other post-March 31 business activities) from the Interactive Group which is expected to occur at the distribution date. A portion of this cash is not currently included on Liberty’s consolidated balance sheet as it will be borrowed under QVC’s credit facility in connection with the completion of the recapitalization.
http://www.sec.gov/Archives/edgar/data/1355096/000104746912006970/a2209305zs-4a.htm

Some of that cash will be from the Expedia sales that I accounted for previously.  $1,325M – $411M = $914M.  Ventures’ cash and cash equivalent balance of $0 should be adjusted by $914M.

EDIT: I’m not entirely sure how much cash Ventures will be given and I believe I confused TripAdvisor with Expedia.  8.45 million shares of TripAdvisor were sold at $40.00/share for proceeds of $338M.  So Ventures should receive $1,325M – 338M = $987M in cash excluding TripAdvisor.

Adjusted total assets = 2070 + 574 + 886 + 167 + 914 987 = $4,611M $4,684M
Total liabilities = $4,041M
Adjusted equity = $570M $643M

You may wish to make negative adjustments to the assets if you believe that the Expedia and TripAdvisor stakes are overvalued if Liberty is selling.

3- Some adjustment should be made for deferred tax liabilities.  Ventures has a total of $1,559 in total tax liabilities.  Here’s a breakdown of the tax liabilities associated with each series of exchangeable debentures:

3.125% Time Warner due 2023:  If Liberty were to buy back this debt now, it would have a tax benefit of $47.95M from capital losses.  There are $205M in tax liabilities from comparable yield deductions.

4.0%, 3.75% Sprint due 2029, 2030:  $152.6M tax liability in capital gains.  $206 tax liability from comparable yield deductions.

3.5% Motorola due 2031:  $50.75M tax liability in capital gains.  $112M from comparable yield deductions.

3.25% Viacom due to 2031:  $28M tax liability in capital gains.  $106M from comparable yield deductions.

Notes:
-If Liberty were to buy back its 4%, 3.75%, 3.5%, and 3.25% exchangeable debentures (all of them except for the 3.125% Time Warner ones), the tax would be $230M.

-The comparable yield interest deductions total $631M by my calculations.  However, please note that my calculations may be incorrect!  Consult a good tax lawyer and/or accountant for accurate information as I may have easily miscalculated these deductions.

-The two items above total $862M, accounting for 88% of the $978M “Discount on exchangeable debentures”.  The balance may have to do with tax benefits from the American Recovery and Reinvestment Act of 2009 (taxes associated with debt repurchased in 2009 and 2010 can be deferred), the IRS ruling, and/or the amendment of the Time Warner debentures (the interest rate was adjusted from 0.75% to 3.125%).

- The $321M listed as “Deferred gain on debt retirements” may correspond to the difference between Time Warner related shares’ market price ($1165 for TWX/TWC/AOL on Dec 31, 2011) and their cost basis.  While the Time Warner debentures mature in 2023 (and holders may exercise their put option before that), the debentures can be settled in cash so Liberty does not necessarily have to trigger the capital gains on those shares.

3b- In addition, there is roughly a $876M tax liability associated with the Expedia, TripAdvisor, Tree.com, and Interval Leisure stakes if you were to make an adjustment between their market values and carrying values.

In total there would be $2,435M in total deferred tax liabilities.

The big picture

Ventures will have significant leverage ($4,611M $4,684M of assets versus an equity base of $570M $643M would be a ratio of 8:1 7.28:1 before the rights offering).  It will be a bet on management’s ability to allocate capital and ‘outrun’ the costs of Ventures’ long term debt.  Considering John Malone’s track record, I would happily make this bet.

Now as far as Venture’s fair value goes, it is incredibly difficult to calculate and depends highly on the discount rates used.  It also depends heavily on fluctuations in the value of its Expedia and TripAdvisor stakes.

I would arbitrarily apply a discount of $200M on the $1,559 of total deferred tax liabilities ($2,435M adjusted), which I believe to be conservative.  Applying a margin of safety of 2:1 and valuing Ventures at $770M $843M, Liberty Ventures is worth buying with a market cap of $385M $421.5M.  Using more aggressive discounts on the tax liabilities and/or altering the margin of safety will obviously support much higher valuations.

Rights Offering
Ventures will give rights to shareholders at a subscription price of 80% of the VWAP of Ventures.  For every share of Ventures stock, shareholders will receive 1/3rd of a right.  There is an oversubscription privilege to purchase additional shares if some rightsholders do not exercise their rights.  It may be worth taking advantage of the oversubscription privilege as a few retail shareholders may fail to exercise or sell their rights.

The shares without rights should trade at 93.75% of the ‘correct’ share price (the price if there was no rights offering).  This is assuming that the share price will never dip below the subscription price before the rights are exercised.

Disclosure: I have owned Liberty Interactive in the past very briefly.  I currently own no shares though I may buy call options on it in the future.  I will likely buy Ventures at a market cap of $385M $421.5M * 0.9375 and below.

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6 thoughts on “Special situation opportunity: Liberty Ventures

  1. Thanks for posting this. The transaction seems to be below most everyone’s radar and I had, myself, kind of forgotten about it. As a Greenblatt fan I’m always very interested in what Malone is up to, especially considering he multiplied his invesment in the original Liberty Media spinoff almost 10 fold. I did quite well with an investment in another Liberty spinoff, Ascent Media, a couple of years ago, so I’m looking forward to this one as it seems even more opaque.

    It’s clear to me after perusing the S-4 that from the information provided it is quite difficult to nail down a valuation for Liberty Ventures. I’ll be very interested to see where it starts trading as I myself wouldn’t offer a lot for the shares. This bodes well for a good investment!

    A couple of things jumped out at me when I ran through your valuation. First, it looks like you didn’t include the full value of Tree.com (you value it at $32 instead of $320 million), but perhaps you accounted for this elsewhere and I just missed it. Second, the adjustments to the $1.325 billion in cash to be ascribed to the new tracking stock are not clear to me: 1) is the gross or the net (after-tax) amount of the May TripAdvisor share sale to be deducted? and 2) you reduce cash by the gross amount of the Expedia forward share sale ($411 million) but I don’t see where this is explicity stated in the S-4. In fact on page 63 there is a reference to the “cash in the amount of approximately $1,325 million (which includes proceeds from the sale of TripAdvisor, Inc. shares in May 2012 and the impact of certain other post-March 31 business activities)”. Since the forward sale took place in March and does not settle until October, this would seem to exclude it as a deduction to ascribed cash. Again, if it were included, should the deduction be for the gross or net amount? The swing on the issue of gross or net alone is $170 million for these two transactions, a significant amount as relates to the book value of thecompany. I have a sneaking suspicion that there is some intended obfuscation here.

    Another point I don’t really understand is the reason for the rights offering in the first place; there doesn’t seem to be an immediate need for additional liquidity. After all, the company will have over $1.3 billion in cash when the Ventures tracking shares are created. What difference could the $72-$220 million in subscription rights capital (assuming shares trade somewhere between an average of $10 to $30 during the price determination period) make? Is this another smokescreen? For my part I don’t see any reason to purchase shares in Ventures before the transaction is completed as I think current small and medium sized investors will be dumping their odd lot holdings in Venture shares until the end of the year and perhaps beyond. And hopefully even some large shareholders will be dumping their shares too! It will be another 3 months before we have any clarity around the balance sheet of the new tracking stock so what’s the rush?
    Any insights into the above?

    Despite the adjustments above I come up with a figure for the ‘value’ of the company slightly lower than yours, but not by much. I agree that a 50% (or greater) discount is needed to make the investment attractive because of the high leverage and lack of reporting transparency. To a large extent, however, the value of Ventures will be determined by 1) how the $1.3+ billion of cash is invested and 2) how the balance sheet is managed, both of these being future events that we cannot know.

    • 2) you reduce cash by the gross amount of the Expedia forward share sale ($411 million) but I don’t see where this is explicity stated in the S-4

      I think I made a mistake and confused Expedia with TripAdvisor. So when Liberty sold its TripAdvisor shares, the proceeds were/are attributed to Ventures. Page B-25 of the S-4 says: “In May 2012, Liberty sold approximately 8.5 million shares of TripAdvisor, Inc. for cash proceeds of $338 million. As TripAdvisor is attributed to the Ventures Group, the proceeds will be attributed to the Ventures Group.”

      I believe I’ve already accounted for the tax that has to be paid (difference between sale price – carrying value, multiplied by 35% right?). The tax on the sale is attributed to Ventures??? (I would assume so???)

      So the $1.325B in cash already includes the $338M from the Trip sales, so $987M of that is cash that Ventures otherwise never had. On the other hand, I don’t understand what the “certain other post-March 31 business activities” are.

      And then there’s slideshow information found in this 425 filing:

      http://www.sec.gov/Archives/edgar/data/1355096/000110465912040342/a12-5904_5425.htm

      [Ventures assets: ...] “Cash of ~$1.59b(3)”
      “(3) Cash from various sources including cash on hand, cash from operations, proceeds from the sale of 8.45 million TripAdvisor shares, and proceeds from QVC bank credit facility. Expected balance of QVC bank credit facility at closing of $1.3-1.5 billion.”
      So there is an additional 265M (1.58B-1.325B) in cash from somewhere.

    • Another point I don’t really understand is the reason for the rights offering in the first place; there doesn’t seem to be an immediate need for additional liquidity. After all, the company will have over $1.3 billion in cash when the Ventures tracking shares are created. What difference could the $72-$220 million in subscription rights capital (assuming shares trade somewhere between an average of $10 to $30 during the price determination period) make?

      I believe that when they were originally thinking about the split-off, the prices of Expedia and TripAdvisor were not as high. So the liquidation value of the company would have been a few million dollars at most. The leverage there is really high. Because they are tracking stocks, if Ventures is unable to repay its obligations then Interactive will be liable for Venture’s liabilities, debts, obligations, etc. So by giving Ventures that extra cushion, Interactive shareholders won’t have to worry as much about the chance of Ventures blowing up.

      Management makes some comments which have been republished in 425 filings:
      [Maffei] “Right. So if I was to look at it another way, when we look at the balance sheet of Liberty Ventures, it will show, as John noted, very little positive net equity value, if you were to hard liquidate today. But that will ignore that our ability to defer many of the taxes, we already talked about the ones related to the exchange not coming due until ‘29, ‘30, ‘31 and it will ignore the fact that some of that gains, capital gains that we could choose when to take or not. And it will ignore the fact that an asset, which will never really be on the balance sheet, but which will have growth over time, is the future deductions in excess of cash paid, in effect, as John noted, that interest free loan from the government. So that’ll be the exercise for us to talk to the marketplace and educate and that’ll be the exercise for us to invest wisely.”

      http://www.sec.gov/Archives/edgar/data/1355096/000110465912013210/a12-5904_1ex99d5.htm

      I believe that there may be a second reason for doing the rights offering which Malone doesn’t tell you. If you read carefully, holders of B shares will receive rights to buy A shares (not B shares). The B shares have more voting power so they are theoretically worth more. Why is Malone doing this? A long time ago, Malone entered into an agreement with Liberty where he has limitations on selling his B shares (Liberty has the right to buy B shares from him in case Liberty wants to prevent a hostile takeover). By receiving A shares he will be able to sell them on the open market. My speculation is that he will use the A shares as collateral for borrowing (he did get margin called in ’08 and was selling Liberty Capital shares at a very low price). There are certain things he can do to defer taxes if he can use the shares as collateral. e.g. he can use the shares as collateral for an equity collar for the shares (which is what Liberty Media did for its DTV shares).

      The rights offering might affect the supply/demand situation for Ventures and cause Ventures’ share price to be depressed. But this is speculative. A downside to the rights offering is that size is an anchor. More assets under management will make it more difficult to generate unusual returns for investors. For investors of Interactive and Ventures as a whole, it would probably be better if the split-off didn’t take place. Keeping the parts together will avoid the need for a rights offering and overall size would be lower.

      I agree that a 50% (or greater) discount is needed to make the investment attractive because of the high leverage and lack of reporting transparency.

      I’m not sure I would go that far. I’m not sure if companies should be penalized for high leverage. In many cases high leverage is a bad idea (e.g. Gambler’s Ruin) and some type of discount should be applied because of bad management. However, Ventures’ leverage is mostly safe. It has long-term debt that is unlikely to be called. (Though a cash buyout of Motorola/Sprint/Century Link reference shares will require Ventures to put up a lot of cash.) Ventures does have a put option on its debt so it has some protection against really adverse events (e.g. high volatility). Its deferred tax liabilities are a pretty safe form of leverage; though some tax may be due early if the exchangeable debentures get called early.

      And remember that the present value of its deferred tax liabilities is overstated. By how much they are overstated is hard to figure out… it depends on when its tax liabilities will be due and that is uncertain.

  2. Correction: Sorry, my comment on the value of Tree.com was off. Just checked the 10Q and I see that the shares outstanding are 11.2 million and thus Venture’s ownership will be 2.8 million, not 28 million. I never do enough checking! My valuation for Ventures will be commensurately lower.

  3. Pingback: Liberty Ventures: not that interesting at $40 | Glenn Chan's Random Notes on Investing

  4. Pingback: (LMCA) Liberty Broadband spin-off | Glenn Chan's Random Notes on Investing

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