What are we reading?

  1. Bubble in quality? (here)
  2. What are we seeing 29-11 version (here)
  3. Has Buffett lost it? (here)
  4. Banks 10 years return (here)
  5. CNBC complete interview with John Malone (here)
  6. Haircuts for Indian finance — bald or bold (here)
  7. Core investment tenets – upslope capital (here)

What are we reading?

  1. You got a free internet upgrade and then your bill went up (here)
  2. Interesting q2 investment commentary from horizon kinetics (here)
  3. Interview with Liberty Media founder and John Malone partner, Peter Burton (here)
  4. A dozen things I have learnt from John Malone (here)
  5. PershingSquare Holdings buys Berkshire Hathaway – Page 10 (here)
  6. Netflix’s content budget seems greater than it seems (here) (Worthwhile to read the entire series)
  7. How I spotted a fraud before it was too late (here)

What are we reading?

  1. Charter executive questions 5G (here)
  2. Dawn of 5G: Will wireless kill the broadband star? (here)
  3. Here’s why your cable company wants to be your wireless provider (here)
  4. Charter tests 5G in six cities (here)
  5. T-Mobile calls Comcast irrelevant but results disagree (here)
  6. John Malone thinks cable and wireless are destined to consolidate (here) — dated post
  7. Liberty Global quietly reshapes its 5G strategy (here)
  8. Why the US cable industry is poised for recovery (here)
  9. Case for cable (here)
  10. Charter looks beyond MVNO and prepares to launch wireless next year (here)
  11. Charter is testing 6G Wireless (here)

Discovery Communications (DISCK/A)

It has only been 25 short days since we published our blog on Discovery (here) Few things have happened since then. Discovery is up 26% since then. Not that the short term vindicates the thesis. It just indicates how dirt cheap DISCK was at one point.

Screen Shot 2017-12-20 at 6.58.51 AM

This was necessarily driven by two things: a. John Malone talking about it here

b. John Malone putting his money where his mouth his here.

Will be interesting to watch what happens with DISCK/A.

Disclosure: Own DISCK.

 

 

Discovery Communications

Note: I have used a lot of approx. calculations as a proxy to quickly look through DISCA/K’s numbers.

Discovery Communications (DISC(A/K)) entered into a merger agreement with Scripps Networks on July 31st, 2017. Discovery will pay $90/share to Scripps shareholders in a combination of cash and stock. The transaction is expected to close in Q1 2018.   Below outlines the transaction details on how Scripps SH will get paid.

Screenshot from 2017-11-26 18-12-52

Furthermore, the amount of Discovery stock that Scripps will get paid depends on the 15 day VWAP of Discovery shares before the close.

Screenshot from 2017-11-26 18-18-17.png

Essentially, if the 15 day VWAP is less than $22.32, Scrips SH will get paid 1.2096 shares of DISCK; if 15 day VWAP of DISCK > $28.70, then 0.9408; if 15 day VWAP of DISCK between $22.32 & $28.7, then it will be the 15 day VWAP averaging to $27.

The strategic rationale explained by Discovery for the acquisition was to create a scaled up independent media company. Discovery will own 0.3M hours of programmable content with 8K hours being produced annually between the two networks. The potential for Scripps to grow outside the US will provide top line synergies while the cost synergies are expected to be around $350M annually. The two companies together will account of 20% of ad supported paid TV network in the US.

The combined network of discovery and Scripps is shown below.

Screenshot from 2017-11-26 18-31-31.png

Top line & bottom line synergies are shown below:

Screenshot from 2017-11-26 18-34-00

Screenshot from 2017-11-26 18-34-57

Since the acquisition has been announced, DISCK has been on a slide clearly indicating the market’s reaction to the deal and the fact that Discovery is losing subscribers at the rate of 3% a year and 5% in the recent quarter driven by its smaller network. The Scripps deal will give it faster access to the skinny bundles / OTT as shown here by Bloomberg. (Article link here)

Screenshot from 2017-11-26 18-37-33

The stock is in doldrums crashing to low of $15/share and currently trading at $16.46/share. DISCK was trading close to $26/share at the time of the announcement of the merger.

The key reason behind this crash seems to be the suspension of buybacks in order to fund the merger, dilution, higher indebtedness and the industry fears of cord cutting and Discovery’s move to double down on the pay TV video model.

So, how does DISCK plan to pay for the $63/share to Scripps shareholders?

Screenshot from 2017-11-26 18-43-30.png

Screenshot from 2017-11-26 18-43-53

Screenshot from 2017-11-26 19-04-11

The additional $8.6B meant that DISCK has to suspend buybacks till it pared down debt to manageable proportions (3.5X OIBDA as stated during the transaction). The expected leverage at the time of closing is 4.8X. Going by the playbook of John Malone, at 3.5X, it will be a debt that will stay on the books forever and then the buybacks will start again. Before they start buying back stock, Discovery will have to retire $6B+ worth of debt.

Let us take a look at how the two companies put together look like (using full year 2016 numbers)

Screenshot from 2017-11-26 19-16-26.png

At first glance, one would wonder why would you put together two companies that are making $1.8B/year separately into a merger to generate $1.0B?

A closer look reveals that combined NI is $1.06B. Because of the huge premium paid, the D&A will shoot up. This is part of the price being paid to acquire intangible assets of Scripps and will be amortized.  When you look at Capex for Discovery and Scripps, combined they do not spend more than $200M.

NI + D&A – Capex = $1.06B + $1.57B – $0.2B = $2.4B over 770 million SOS. A good proxy for owner’s earnings.  See below tables for calculation on the SOS.

Screenshot from 2017-11-26 19-22-00

So what happens to the increased debt and taxes? Interest expense goes up and taxes come down. The additional debt is at weighted average of 3.6% and additional $316M of interest expense is offset by $506M of income tax savings. If there is further reduction in the tax rate, that would be an additional cherry on the top. Further, the cost synergies of $350M will translate to approx. $100M in year 1 and approx. $200M post tax dollars starting year 2 and drive both cash flow and the NI to grow.

$2.4B + OIBDA Growth (Assume 10% year year initial two years from sales synergies) + Cost synergies growth ($100 1st year, $200 second year), Discovery & Scripps combined will generate $2.7B and $3.2B in year 1 and 2 or $9.5B in first 36 months.

At 770 M shares (post dilution) at $17/share, the market is valuing Discovery at $13B or at 5.5 times owner’s earnings. The market has priced Discovery for failure. If they succeed in realizing the synergies, it will be a blockbuster stock. If they manage okay with the integration, it will still be a great bet with acceptable returns.

Even though Discovery is losing subscribers, it is growing its OIBDA every year and with the Scripps merger,  it will greater access to the OTT market. Discovery’s international platform will also benefit Scripps. Currently, the market is pricing Discovery Communications to be dead in the water.  It will be interesting to see how this plays out.

Disclosure: Not to be taken as investment recommendation. Might trade in DISCA/K

Sources for this post: S-4 Form, Merger Presentation, 10-Q’s

 

Trip Advisor and Liberty Trip Advisor (TRIP & LTRPA/B)

Trip Advisor is an online travel booking website that operates in the crowded and competitive online travel segment. It operates mainly through tripadvisor.com and its variants.

The market size for travel spending is about $1.3T annually and is growing. Close to 40% or $500B of this spend happens online through services provided by OTA’s like flight, hotel and car bookings.  Key players include Priceline.com, expedia.com and their affiliated websites and meta-search players like kayak.com, trivago.com etc.  The business models for OTA’s are pretty simple a. Attract users on the website b. Offer the best rates and get users to book the room / flight / car  c. Get a commission from the hotels and use a part of it to market the website and 4. Repeat cycle. OTA’s are a high growth, high margin, high ROIC businesses.

For example: Priceline with its flagship priceline.com and booking.com . Priceline has a market cap of $66B and a PE of 27 and is richly valued.

In Millions of USD

2015 2014 2013 2012 2012-2015 CAGR
Revenue 9,223.99 8,441.97 6,793.31 5,260.96 20.4%
Gross Profit 8,591.81 7,584.13 5,715.89 4,083.68 27.8%
Selling/General/Admin. Expenses, Total 5,060.41 4,303.00 3,185.50 2,188.75 31.9%
Net Income 2,551.36 2,421.75 1,892.66 1,419.57 21.3%
Net Income % 27.7% 28.7% 27.9% 27.0%
Total Equity 8,795.47 8,566.69 6,909.73 3,896.97 30.8%
Long Term Debt 6,158.44 3,824.20 1,750.58 936.65 86.2%
ROE % 29.0% 28.3% 27.4% 36.4%

Example two would be Expedia which primarily derives its revenue from the large US market. It mainly operates through hotels.com, Orbitz and expedia.com. Expedia is trading at 19 times earnings and TripAdvisor was a spin off from Expedia in 2011. Also, it has John Malone’s fingerprints all over it through its 18% stake that is being spun off through Liberty Expedia (a post for another day)

In Millions of USD

2015 2014 2013 2012 2012-2015 CAGR
Revenue 6,672.32 5,763.48 4,771.26 4,030.35 18.1%
Gross Profit 5,362.76 4,584.40 3,733.22 3,131.74 19.4%
Selling/General/Admin. Expenses, Total 3,955.00 3,233.70 2,573.22 2,066.39 23.9%
Net Income 764.47 398.1 232.85 280.17
Net Income % 11.5% 6.9% 4.9% 7.0%
Total Equity 4,864.39 1,784.27 2,145.46 2,280.26 28.4%
Total Long Term Debt 3,201.28 1,746.79 1,249.41 1,249.35 36.4%
ROE % 15.7% 22.3% 10.9% 12.3%

What is Trip Advisor’s beef in this space?

Trip Advisor has an annual revenue of about $1.5B and is a growing business. TRIP has a rich base of user content and reviews that makes the site an ideal one-stop shop for travel planning. It currently has around 1.8M accommodations, 3.8M restaurants and 600K+ attractions that can be researched and planned on its website. It attracts over 350M unique visitors every month and has over 300M reviews on its sites. No other website can provide the breadth and depth of content and research that TRIP does today. This content is similar to how Amazon reviews drives traffic for Amazon. TRIP is also available in 46 languages making it accessible globally.  (All data are from its 2015 annual report)

When users research and plan trips through its website, one can search for hotels using Trip Advisor’s meta search and price compare with all other websites and book the best option available for the user. TRIP then takes a cut from the OTA (Priceline, Expedia) and the commissions thus derived are the major source of revenue today for TRIP.

In Millions of USD 2015 2014 2013 2012 2012-2015 CAGR
Revenue 1,492 1,246 945 763 24.8%
Gross Profit 1,434 1,206 927 751 23.8%
Selling/General/Admin. Expenses, Total 1,109 797 597 429 36.8%
Net Income 198 226 205 194 0.7%
Net Income % 13.3% 18.1% 21.7% 25.4%
Total Equity 1,412 1,125 865 727 24.5%
Total Long Term Debt 200 259 300 340 -16.1%
ROE % 14.0% 20.1% 23.7% 26.7%

TRIP through its huge user generated content has been attracting a lot of users and has been growing at a good clip. However, TRIP get a cut of the OTA’s commission that the hotels pay the OTA for directing traffic. So, TRIP is a marketing spend for OTA’s to attract  users.

Recently, TRIP has also been investing heavily in its business to enter the OTA business itself. Currently, one can book hotels directly on TRIP without having to leave its website. Over time, the company believes that it will reap rewards for this feature. However, in the short term, it has depressed margins. Furthermore, as seen through Priceline and Expedia, the margins in the OTA space are mouthwatering. If TripAdvisor is successful in entering the OTA space, its past growth and margins will not be a good indicator for the future. It must also be noted that PriceLine and Expedia are also getting into the content ranking space for hotels etc. in order to intensify competition with TRIP.

Today, TRIP can definitely be counted to create value to end users for their travel planning needs. The bigger question is can TRIP appropriate the value in the process? After researching, users are usually looking for the cheapest available room at a selected hotel. At the risk of being biased through personal experience and of those around me, today almost everyone uses TRIP for planning. However, when it comes to booking, there is almost always a cheaper option available (5-10%) than found on TRIP’s site or any of the other links that it provides. This is the significant difference between Amazon and TRIP. On Amazon, one is almost guaranteed to get the cheapest price for things. In the case of TRIP, there are significant discounts available today through mobile apps that take the price way below the advertised price on TRIP (mobile or website) with a very reasonable investment of a few minutes. How long will this continue is a question but it is possible that it is preventing TRIP from appropriating value from what it is creating.  It is creating a ceiling for the booking process than the floor and that is a significant problem that TRIP has to address quickly  if it needs to be competitive long term.

Valuation:

Currently TRIP is valued at $9B at a PE close to 47. However, this company has fingerprints of John Malone / George Maffei all over it with their 21% economic interest and 56% voting interest. Going by John Malone’s play book, free cash flow might be a better indicator of value for TRIP. TRIP generated around $873M of free cash flow in the last three years making its FCF yield at close to 3% of market cap per year. The Malone play book of levered buybacks, rising debt to be at an acceptable multiple of EBITDA, delaying the taxman’s liabilities are yet to play out at TRIP. Even with all the above unexplored levers and its foray into the OTA space, TRIP is richly valued today at 3% FCF yield and is not a slam dunk investment in our opinion.

Liberty Trip Advisor holdings (LTRPA/B) owns about ~31M shares in TRIP valued at $1.9B. The market cap of LTRPA is $1.6B at a 15% discount to TRIP. (LTRPA is trading at a premium as it has a $400M margin loan on LTRPA and LTRPA at this point does not have access to the cash flows of TRIP) However, it is a holding company with the money losing buyseasons business. LTRPA is designed to be a tax free way for TRIP (TRIP buying LTRPA will not be tax free) or other OTA’s to buy TRIP through LTRPA. In other words, LTRPA is a vehicle for John Malone to cash out on TRIP in a tax free manner. In August 201(7)6, LTRPA would complete two years enabling it to make tax free swaps with other entities (another leaf from John Malone’s playbook)

Disclosure: No Position