LMCA update May 2014

Previously, I predicted that Liberty would repurchase its shares.  I was dead wrong.  Instead of buying back shares, Liberty decided to buy $124.5M in Charter shares at around $138.8 per share (press release).

I believe that Malone wants to play defensively by gaining more voting control over Charter and ensuring that Tom Rutledge can run the business without interference from other Charter shareholders.  (I honestly can’t think of any other reason why LMCA would buy CHTR shares instead of LMCA.  In the past, Liberty has bought back shares in the $110-$130+ range.  Its stocks have gone up since then so Liberty’s intrinsic value is higher now than in the past.)

Buybacks and deferred tax liabilities

Liberty has hidden value because the book value of its deferred tax liabilities are greater than their present value.  It essentially has interest-free loans from the IRS that are worth something.  However, if Liberty sells shares that have gone up in value, it will destroy the value of these interest-free loans.  This limits its ability to arbitrage differences in its share price versus the intrinsic value of Liberty shares.

Liberty can get around this by issuing debt to buy back shares.  This preserves the value of its interest-free loans from the IRS.  However, too much debt is dangerous.  The concept of Gambler’s Ruin means that Liberty should not take on too much debt.  If there is a small chance that Liberty goes to 0, ultimately the stock will go to 0.

I assume (perhaps incorrectly) that buybacks are not that attractive for Liberty.  It will either have to:

  1. Destroy the value of its interest-free loans from the IRS, reducing the attractiveness of buying back shares.
  2. Put itself in a situation where it has too much debt.

Voting control over Charter

Time Warner will be spinning off subscribers into a SpinCo.  Charter will issue shares to take a stake in the SpinCo.  Charter shareholders will be diluted down to 87% of the new holding company.  Buying CHTR shares increases Malone’s voting control over Charter.

Malone has learned that having control over his companies is important because the quality of management makes a huge difference.  He presumably values control over Charter more than the marginal gains that could be had from buying back shares.

Valuing Charter

On a statistical basis, Charter is expensive.  In YE2013, it generated $409M of free cash flow versus a $14.93B market cap (financial addendum).  P/FCF is roughly 36 (*using YE2013 cash flow, not TTM cash flow).  Charter is an unusual investment where one has to anticipate how much money they will make in the future.

Management has stated that Charter is in the middle of transforming its entire network to digital signals without any analog signals.  As well, it will begin encrypting its video signals.  This will force every TV in a Charter household to be attached to a set-top box to receive a signal.  This will cause disruption to existing Charter customers and many one-time expenses.

Many analog customers will be alienated by the digital transformation.  They will not see much of a benefit from digital transmission.  They will need a set-top box on every TV in their household to receive the same service.  This will ultimately result in a price increase as eventually Charter will charge customers for the use of each set-top box.  Households with multiple TVs may see a large jump in the price that they pay.  Customers will also have to self-install their new set-top boxes or pay $30 for a technician visit.  Charter will get a lot of phone calls from customers trying to install their new set-top boxes, questions about billing, and (angry) calls from customers who suddenly can’t watch TV.

This short-term pain should pay dividends in the long run.  With an all-digital system, Charter frees up bandwidth for faster Internet and more TV channels.  Management has provided investors with figures on how much capex is related to the all-digital upgrade and anticipates that capex will drop once the upgrades are completed.  With encryption, Charter can disconnect customers with the click of a button, avoiding the need to send a technician to disconnect cable.  It also reduces network problems from cable thieves.  They tend to steal cable poorly, causing signal issues for everybody on the same cable loop.  Some of them also repeatedly undo attempts to disconnect them, causing multiple technician visits.

Ultimately, the main reason to own Charter is Tom Rutledge.  Many people consider him to be the best operator in the business.  He has an excellent track record as Cablevision’s COO.  Cablevision’s margins have eroded since he has left.  In the long run, Rutledge should be able to dramatically improve Charter’s EBITDA per home passed and free cash flow.  This is a turnaround play that will likely materialize.

What Malone will be buying

Liberty has announced its intentions of spinning off Liberty Broadband.  It is anticipated that Broadband will be doing a subscription rights offering.  This will force all shareholders (including Malone) to buy Broadband shares.  I don’t see Malone selling any Broadband or LMCA/Media shares as it would be horribly tax inefficient.  The net effect will be similar to insider buying.

*Disclosure:  Long LMCA common shares.

5 thoughts on “LMCA update May 2014

  1. Enjoying your series of posts on LMCA, as I’ve been studying filings to better understand the interests and value of post-spin entities! I’m curious of your estimates of the value of LBRDA given its post-spin capital structure.

    Are you also looking at LINTA and LVNTA spin-offs? LDCA and LTCA seem to be interesting new entities to me.

    • I recently finished going through the LINTA presentation. I find it interesting that now they provide information on the green investments (largely driven for tax reasons), the tax details of the debt, etc. Because they didn’t provide this information BEFORE the LVNTA spinoff.

      The e-commerce section of the presentation seemed more promotional than the rest. They highlight revenue growth… even though Malone is a free cash flow/owner earnings kind of guy. (He focuses a lot on OIBDA/EBITDA as a measure of how well the business is being operated, and free cash flow as to how much it is making.) It seems like the eCommerce part isn’t that great. QVC is somewhat cheap but has little growth. TRIP has high growth but has appreciated a lot and Malone has been selling TRIP in LVNTA and he sold a little bit of LVNTA shares. Really good businesses have been going into LMCA: mainly Sirius XM and Charter and to a lesser degree Live Nation. I think that Liberty Broadband will be the most attractive piece of Malone’s empire, though other parts of it are attractive (e.g. Liberty Global).

  2. Glen – are you planning to do a deep dive into the Liberty Broadband piece and what the potential here is? I’d love to be able to understand it and see what you think.

    • They haven’t even filed a Form 10 with the SEC so I don’t want to write about it too prematurely. But as I explained in my other posts, the rights offering is not all that different from Malone doing insider buying. And it should be worth buying not because of any spinoff shenanigans or rights offering shenanigans, but because Malone will be buying LBRDA/B.

      Charter has the potential to increase its free cash flow to several times what it is today. If you model out higher penetration and cost efficiencies on the operations side (plus some extra oomph from accretive acquisitions), it is likely that Tom Rutledge will get there.

  3. Excellent, thanks a lot. We’ll wait on that Form 10 then and it would be great to see how you do the math on this (your analysis on Liberty Ventures was phenomenal). As you outlined, the fact that it has Malone’s stamp of approval and a portion of Charter rolled up makes it very attractive. I do believe Charter can grow penetration and if the last 2-3 yrs are any indication, they’ve come through on their promises made.

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