Liberty Global’s LiLAC Group

Liberty-Global-470x260LiLAC was spun off as a tracking stock from Liberty Global last year. LiLAC is a provider of video, broadband Internet, fixed-line telephone and mobile services. After being spun off, it acquired Cable & Wireless, who owns a combination of cable and mobile assets in the Caribbean. LiLAC previously held large market share in the Chile and Puerto Rico markets and now looks to expand. Liberty Global is looking to acquire an array of cable assets in Latin America as they have done in Europe. With their acquisition of C&W it looks like they are on their way. Creating the LiLAC tracking stock gives management focus as well as a currency with which to potentially execute acquisitions.

Cable & Wireless Acquisition

Prior to being acquired by Liberty, CWC acquired Columbus Networks, a Caribbean cable operator owned by Canadian entrepreneurs and John Malone. Cable & Wireless paid 12.3x EBITDA for Columbus before any synergies. Columbus was growing EBITDA at 15% a year with a presence in predominantly Caribbean countries such as Trinidad, Jamaica, and Barbados. What was interesting about the combination is this would effectively give the combined entity a quad play in many of the countries in which they competed. It is very valuable to be able to have a mobile and fixed infrastructure presence as it reduces churn and creates an incremental, potentially low cost position. When you think about a mobile only player trying to compete against a fixed-mobile operator, the mobile only player should have structurally higher costs as they have to depend on expensive spectrum to transmit data. The combined hybrid player can use a fixed infrastructure presence to offload bits via Wifi at a much lower cost. In markets where the combined Cable & Wireless did not have a fixed infrastructure presence, they have started to selectively deploy the cable infrastructure in these markets being able to leverage the competitive video product. Cable & Wireless has continued the differentiation of their video product through exclusive rights to key sports content such as the Premier League and additional sports and high definition content. When looking at cable assets in the Caribbean region compared to the US or Europe there are a couple of key factors that make the Caribbean substantially more attractive: you have substantially lower penetration of services (around 40% penetration in the Caribbean) providing for a much higher and longer growth runway and the competitive landscape is much more benign especially with broadband given the very limited fiber overbuild. In addition to the consumer platform, the combination of Cable & Wireless and Columbus Networks strengthened the B2B firepower of the combined entity. Given the increased reach of the combined entity into the region as well as critical subsea fiber and backhaul, this combination creates a more compelling telco supplier for enterprises with multiple offices in multiple regions. CWC identified $125 million in synergies from the Columbus Networks combination, Liberty Global believes it can harvest additional synergies both from the Columbus Networks integration as well as from the combination of LiLAC with CWC. Given Liberty Global’s track record in harvesting synergies in previous acquisitions, the subscale nature of LiLAC, and the vast scale of Liberty Global, there should be some level of incremental synergy from items such as the rationalization of overlapping corporate costs and increased purchasing power leading to lower costs. Financially, the combined CWC and Columbus have historically grown revenue high single digits and EBITDA low double digits (not including any synergies). The CWC acquisition gives Liberty Global a significant quad play offering in a growing market. LiLAC is also in good position to acquire assets and continue to consolidate the Latin American market. A potential target would be Millicom. The former head of LiLAC’s Chilean business now runs Millicom. I believe there is a good possibility that John Malone goes after Millicom in the next 12 months.

John Malone

John Malone is a legend in the cable television industry. He became CEO of TCI in 1973 and more recently was CEO of Liberty Media. Liberty Global was spun out of Liberty Media in 2004 and merged with United Globalcom in 2005, shortly after UGC came out of bankruptcy. The company is structured so that Malone has voting control. It has three classes of stock: Class A shares get 1 vote, Class B shares get 10, and Class C shares get none. Malone owns 1% of Class A shares, 85.8% of Class B shares, and 3.5% of Class C shares. John Malone has a terrific track record of allocating capital. I believe the market is discounting the earnings power of the evolving LiLAC Group.

Chile 

The Chile market represents about 28% of LiLAC’s EBITDA. LiLAC’s Chile segment is called VTR. It has been showing very strong growth and has a long runway as penetration remains low.

VTR Growth

VTR’s network is a complete hybrid fiber coaxial network which can attain broadband speeds comparable to high speed cable networks in the US and Europe. They offer speeds up to 160 mb/s. This is much better service than its competitors. Additionally, they offer triple play packages that are far superior.

VTR Bundle

VTR’s biggest competitor is Movistar. As you can see, the pricing for the bundle is about the same but the broadband speed is more than twice as fast. VTR has existing infrastructure that gives them this competitive advantage. As VTR continues to add revenue generating units (RGU), I believe incremental revenues will drop straight to the bottom line.

Chile Broadband Market

VTR Internet

The broadband market in Chile is a duopoly with Movistar and VTR. Combined they have over 75% of the market. We know that VTR is far superior to Movistar. The overall broadband market is growing rapidly with a 12% CAGR over the last decade. VTR has kept its share of the market and has attained double digit broadband growth.

Puerto Rico

Liberty has entered into the Puerto Rico by way of mostly mergers and acquisitions. They are now the largest cable provider in PR. Puerto Rico accounts for about 12% of EBITDA. Similar to Chile, Liberty has key competitive advantages in PR with existing infrastructures allowing them to offer superior services while minimizing costs.

Broadband Market

Lib PR MKT

The broadband market in PR is also a duopoly. However, I believe Liberty has an even bigger advantage against Claro Puerto. Liberty offers speeds up to 200 mb/s where Claro fastest is 20 mb/s. The market continues to grow but not as fast as Chile. The pricing of their broadband has room to move higher. I believe Liberty is focused on stealing more market share from Claro so they can dominate the market. Having access to 80% of the homes in PR gives them a long runway for growth. The fiber deep hybrid-fiber-coaxial cable infrastructure that Liberty has is dominant compared to Claro’s DSL-infrastructure. I don’t see how Claro will be able to compete.

Bundles

Puerto Rico has a very strong bundling rate at 47%. This is the same rate as Chile. The triple play offering in PR outguns Claro or Dish. The broadband is four times as fast and it is priced less than Claro.

PR Bundle

The penetration in Puerto Rico is very low. It is expected to increase 100 basis points each year. This is a terrific opportunity for Liberty. Given that they have a first-class bundle, I expect them to capture the majority of new customers. With limited competition and access to most of the island, Liberty has pricing power. Anyone who wants fast broadband will use Liberty as there is no other option. As the demand for data and streaming increase, broadband will become more important. Liberty’s broadband is 10x faster than Claro’s and this is a long-term advantage.

Economy

It is not a big secret that Puerto Rico’s economy has been struggling. The American territory has stagnated since 2011. The economy has been depending on tourism and even that has now stagnated due to zika concerns. Governor Alejandro Garcia Padilla has said that the debt of PR is now too large to pay. The House of Representatives passed the Puerto Rico Oversight, Management, and Economic Stability Act, a bill meant to help Puerto Rico restructure its debt and prevent the island from being sued for defaulting on bond payments. I believe this will be positive in the long-term. John Malone was well aware of the issues in Puerto Rico when he decided to enter the market. He knew that economic activity might be slow for a period of time. Economic activity is already begin to tick higher now that Congress has passed the law. Puerto Rico has a bright future and as the economy recovers, it will benefit Liberty’s RGU’s.

Demand For High Speed Data

I expect high-single digit residential broadband revenue growth on the back of 1) Increasing broadband penetration from a 40% footprint penetration today, to closer to 50%-60% 5 – 7 years from now, and 2) Mid-single digit growth in data ARPU, driven by a mix-shift towards higher speed tiers and modest inflationary pricing increases. Broadband sells for near 100% incremental EBITDA margins excluding subscriber acquisition costs and is a much more attractive business than video as there are no programming expenses.

The Federal Communications Commission (FCC) actively monitors broadband and video pricing in Puerto Rico. Liberty will have to be careful about price increases in PR because of the FCC. Price increases would also open the door to new competitors. Data usage demand is expected to grow at a 36% CAGR over the next five years. In the last couple years, customers have been demanding more data due to bandwidth-intensive applications. Today there are multiple devices in most homes and we are spending more time on these devices. Demand for streaming HD movies and shows is not going to slow down. It will likely accelerate which will drive customers towards higher priced broadband options like Liberty.

Liberty has acquired terrific businesses in Latin America and the Caribbean. These acquisitions will allow them to scale their business cost effectively and meet demand. Liberty has the only hybrid fiber coaxial network in the markets it competes in. The current DOCSIS 3.0 technology is capable of providing downstream speeds of up to 1 gbps. The fastest speeds they offer today are 200 mb/s which is 10x faster than their competitors. LiLAC can increase broadband speed significantly with minimal costs. The only way their competitors could have similar broadband speeds would be to spend billions on network infrastructure. I do not believe there is a way to do this with a positive ROIC. Google is attempting to do this in the US and it is going horribly. You can read about it here, here, and here. Cable companies like Liberty have a monopoly on high speed broadband. Data can only be transported so fast using wireless technologies. There is major demand for wireless data do to its convenience. However, as more people use wireless data platforms, the traffic slows down the speed of the service. Due to the direction of technological applications, we will see more people turn to high speed broadband over the next decade.

Barriers To Entry

The industry is characterized by increasing barriers to entry. Smaller ISPs can often purchase data capacity from larger ISPs or internet backbone providers at wholesale prices and then sell these services to consumers. This is often the case with smaller companies, which do not have the resources to invest in infrastructure and networks. However, smaller ISPs are usually subject to lower margins and often depend on regulators to set competitive access pricing.

For ISPs that seek to have national coverage and be a major player, barriers to entry can be substantial. As a non-incumbent operator, competitors must either build a copper or fiber network, which is prohibitively expensive for entrants with limited access to capital. Accordingly, most new entrants will invest in “last mile” services, which connect business or residential customers to the internet via a larger ISP or backbone carrier’s infrastructure. On the other hand, new entrants with limited capital are unlikely to succeed in regions without existing network infrastructure.

Risks

The primary risks are related to the Latin American macroeconomic environment and political environment. Currency movements will impact profitability. LiLAC is a levered equity as most Malone businesses are. The cost of capital is relatively high indicating that moderate to accelerated growth is a must. There is a risk that incumbent operators in Chile/Puerto Rico will seek to overbuild Liberty’s infrastructure with fiber which would result in increased competition. However, due to the fact that this option is prohibitively expensive, it is unlikely. Finally, LILAK is a tracking stock, therefore holders will not be legally entitled to the assets associated with the tracker which could lead to a discount to intrinsic value.

Valuation

The valuation of LiLAC looks to be very reasonable. The stock appears to be trading at about 6.8x EBITDA. This is dirt cheap when looking at some of its peers.

LiLAC Estimates

2017 will be the first full year of financials inclusive of the CWC merger. In the years following, I expect a moderate 5-7% revenue growth with EBITDA margins around 45%. Depending on synergies, EBITDA margins could be closer to 46-48%.

LILAK SOTP

Looking at LiLAC another way, I performed a sum-of-the-parts analysis. It appears that the market is undervaluing the business. The long-term competitive advantages of the business provide a terrific moat. As I have mentioned previously, I am not relying heavily on forecasts or valuations. My forecasts are biased and therefore they are often wrong. Valuations are being run on every company by computers everyday with the most accurate information available. The biggest advantage I have is understanding a particular business better than most and focusing on pieces of information being overlooked by the market. In this circumstance, I believe the market is overlooking the value of the existing fiber coaxial infrastructure. Their competitors are at a huge disadvantage and building an infrastructure is not really an option. This should pave the way for solid growth for a long period of time. I have taken a position in LILAK this week under $28 a share. I believe LILAK will outperform the market over the next ten years.

Disclosure


Long LILAK

 

 

 

 

 

 

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