Real Hedge Fund Case Study – Long Pitch

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Company: Liberty Media Group (Ticker: LINTA)
Recommendation: Long Equity

Company Description

LINTA is one of three tracking stocks for Liberty Media, a holding company that engages in the video and online commerce, media, communications, and entertainment industries. LINTA is focused on video and online commerce through its interests in QVC and other e-commerce businesses.

Consensus Opinion of LINTA

LINTA has better growth, EBITDA margins, and ROIC than traditional retail and is only 30% percent penetrated into the Internet. Investors expect both a modest consumer spending in 2011 enabling a QVC fundamental recovery and the tracking stock split-off and e-commerce mix-shift to generate multiple expansion. Sentiment has turned more neutral because LINTA has gained 50% since September 2010. Consensus expects a QVC consumer recovery and modest growth over the next 12-18 months but there are headwind concerns resulting from difficult comps in 4Q10/2011. Also, consensus is calling for potential multiple expansion from structural changes in 2011 if Liberty is able to go forward with its spin-off of LSTZA and LCAPA, leaving LINTA as an asset-backed company rather than a tracking stock. Finally, consensus is calling for annual QVC growth rate of 6.8% in 2011 followed by an increase of 5.8% in 2012.

My View

LINTA will generate much higher operating results than consensus through accretive debt reductions and stock buybacks through 2013. Consensus estimates give zero yield to $3.0 billion of unrestricted cash accumulated on the balance sheet over the next three years. Management has been very clear about two things: accretive debt reductions and taking advantage of their NAV discount through stock buybacks, neither of which are being properly modeled. While LINTA is close to its peak relative EV/EBITDA multiple vs. retail, trading at 5.1x 2011 EBITDA, LINTA is still cheap based on its better operating profile vs. retail. Risk/reward is still favorable with near-term catalysts providing upside through multiple expansion.

Bottom Line: Consensus is modeling a $3.0 billion capital drag over the next three years, allocating this capital will drive 15% annualized returns to shareholders based on stock buybacks and accretive debt repurchases vs. holding cash.

How Do We Get Paid (what has to happen for this view to play out)?

Investors will be increasingly more likely to pay a premium to hard-line retail peers as e-commerce mix-shift grows and LINTA starts trading as an asset-backed security. The largest catalyst that investors are improperly discounting is the yield on capital allocation over the next few years, which I feel will drive substantial returns to shareholders through 2014. Post-spinoff, LINTA will start deploying capital to shareholders in the form of share repurchases and accretive debt reductions. The Key Catalysts are:

  • 4Q10: Strong holiday shopping season; comScore reported +12% YoY increase in Nov-Dec ecommerce spending.
  • 1Q11: Driving growth through new global e-commerce platforms.
  • 2Q11: LINTA wins bondholder appeal and LSTZA/LCAPA split-off, which will result in an asset-backed LINTA.
  • 2011: Further Asia expansion and possible expansion into other European countries.
  • 2011: $1.0 billion in 2011 will be allocated to accretive debt reductions and stock buybacks.
  • 2011: LINTA will drive reach and access with QVC Plus in Germany and a UK-based Channel.

How Much Do We Expect to Make?

There is a 50% upside to the stock over the next 2 years, which brings my price target to $24.presented on Investor Day on November 5, 2010 I am modeling a 11% beat to 2011 consensus EBITDA based on higher-than-expected operating leverage, or $2,220mn, and believe that the elimination of the tracking stock structure and further e-commerce mix-shift will result in multiple expansion in 2011. The stock will likely trade to 7.0x 2011 EBITDA, closer to the company’s retail peers, but discounted to the e-commerce group, as the TV viewing mix shift will be elevated.

Supplemental Data—Decision Tree

Decision Tree

Downside Scenario (25% probability)

The company’s current valuation does not reflect any upside to restructurings and international growth, which is why there is little downside to the company in this scenario. LINTA’s strong free cash flow yield will protect investors in the event of a downside scenario.

Base Case Scenario (15% probability)

This is currently where consensus lies, which is taking into account modest consumer spending in 2011, $88mn of share buybacks, $0mn of accretive debt repurchases, and no operating leverage.

Upside Scenario (60% probability)

There is some overlap from the base case scenario as the growth story is widely known, but operating leverage and capital allocation are being significantly underestimated. There is large upside to the base case as management returns capital to investors through accretive debt repurchases and share buybacks, and takes advantage of their fixed-cost leverage as their e-commerce mix shift continues to increase. Management has targeted a 50% e-commerce mix by 2014, which will drive operating leverage in their current model.

Supplemental Data—Capital Structure Arbitrage

Management has been vocal about doing accretive debt reductions and driving shareholder value through stock buybacks. Management is arguably the best in the industry and is highly regarded as a good manager of capital. QVC has reduced total debt by $1.4 billion since September 30, 2008. The slide below was presented on Investor Day on November 5, 2010.

Value Drivers

Consensus is modeling a capital drag through 2014, with cash building to $3.5 billion. Allocating this capital in the form of accretive debt reductions or shareholder buybacks will deliver 15% annualized returns to shareholders through 2014. Further shareholder value will be realized as LINTA further expands internationally, frees up cash from monetizing non-core assets, and eliminates the tracking stock structure.

Street is modeling a capital drag as cash builds through 2014

Supplemental Data—QVC Fundamentals Are Rebounding

During 3Q10 QVC margins expanded in all markets, adjusted OIBDA margin came in at 20.8% and domestic QVC revenue grew 7% YoY. The domestic business continues to benefit from healthy new customer revenue growth as well as strength in the accessories, apparel, and home categories. On the e-commerce front, sales remain strong and currently represent 31% of total domestic sales. Management has targeted a 50% e-commerce mix by 2014.

Worldwide QVC

International Opportunities

On October 1, 2010, Liberty launched QVC Italy. Management cites that the week-over-week sales ramp has been encouraging and the company is pleased with the quality of execution since launch. Online QVC Italy is showing healthy penetration in web search queries right out of the gate, with December posting a +20% sequential improvement. QVC is seeing outstanding results in its existing international markets, and there is large potential for further international expansion in other areas of Europe and Asia. Italy

Supplemental Data—Consensus Estimates vs. Mine

Consensus Estimates vs. Mine

Supplemental Data—Description of Management’s Ownership and Incentives

Liberty’s management team is subject to a deferred compensation plan that is based on “company-based performance conditions” that have to pass certain company-wide thresholds. Each eligible participant is assigned a cash target, the payment of which is deferred for typically a five-year period.

The company grants certain of its directors, employees and employees of its subsidiaries options and stock appreciation rights (SARs) to purchase shares of Liberty common stock. The company measures the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the Award.

During the nine months ended September 30, 2010, Liberty granted to QVC employees 3.5 million options to purchase shares of Series A Liberty Interactive common stock. During those nine months, Liberty also granted its own employees 6.5 million options to purchase shares of Series A Liberty Interactive common stock.

Liberty Interactive common stock

Comparable Company Analysis

LINT A trade

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