Spinoff & Reorg Profiles
September 2005 Excerpt
Copyright 2005 William E. Mitchell
RESULTS OF THE PAST YEAR
We’re
pleased to report that the average 6-month return on all Spinoff & Reorg
investment suggestions over the past year was an absolute 18% (40% annualized),
outperforming the S&P by an average of 14% (30% annualized). These calculations do not include trading or
other costs.
The
best performer was Holly Energy Partners, up 44% six months after it was first
recommended on 10/26/04. The worst was PriceSmart tradable rights, down
19% in the six months after first recommended on 1/14/05.
Though
it may be difficult to match this absolute result in the coming year, we hope
to continue to provide ideas of at least this quality.
MALONE, AGAIN
In
July we wrote about the benefits of watching management behavior in corporate
reorganizations, likening it to a poker game in which only you are aware of one
other player that can see all the cards before they’re dealt. What we didn’t mention was that certain
managements play this poker game repeatedly.
By following their actions over time, one can develop a picture of their
typical behavior, and participate in serial reorganizations of a single family
of companies or assets. In the pantheon
of serial follow-the-manager special situations, few leaders have been as
prolific or reliable as John Malone, chairman of Liberty Media.
Malone
is a sort of Jascha Heifetz of restructuring, playing complex pieces on his various
corporate instruments for well over a decade.
For observant investors over the years, as well as Spinoff & Reorg, he and his works have been a gift that keeps
on giving. Like you, he desires to enrich
himself. Unlike you, he knows a great
deal about the prospects of his own firm, but must meticulously provide
outsiders with at least a reasonable chance of participating in those
prospects. As a result, by simply
following his actions, and doing enough homework to make sure you are acting
reasonably, you can do well.
For
example, recall one of our first recommendations in 2004, the spinoff and
rights offering in Liberty Media International (symbol: LBTYA). Though management didn’t say so, by looking
closely one could see that LBTYA was not only cheap, but more attractive a
business than its parent. It held non-US
cable assets, which were growing faster than would be expected of the more mature
US market. There were signals of market
power, such as its holdings in three of the top 6 cable carriers in
holding primarily unhedged offshore assets, making it a good way to hedge
against the risk of a declining dollar. We
proposed it here, and are pleased to note it is up about about 50% in the ensuing
13 months.
To
give the reader some idea of the frequency of reorganizations by Malone, note
that just since the LBTYA spinoff, the Liberty family has made at least two
more significant changes: LBTYA merged
with subsidiary United GlobalCom to form Liberty Global, and Liberty Media Inc.
(symbol: L) spun off Discovery Holding Company, which we will cover in more
detail on the next page.
The
story runs back much further than 2004. Malone
has been doing this sort of thing since at least the early 1990s. One of his biggest coups, the original Liberty spinoff from TCI, was
chronicled in Joel Greenblatt’s spinoff investing primer, You Can Be a Stock Market Genius (Simon & Schuster, 1997). According to Greenblatt, Malone personally
enjoyed a 2-year, 1000% return on a $50m investment in Liberty from 1992-4 by arranging
and then oversubscribing to an unpopular tradable rights offering. Anyone else could have participated, as Greenblatt’s
limited partnership did at the time.
Malone’s
reorganizations have tended toward the following modus operandi:
1.
Start
from an immensely complicated corporate structure.
2.
Extract
several valuable components of this structure into a separate firm small enough
to lead institutional investors to dump indiscriminately.
3.
Spin
the firm off at a time when its assets appear relatively unattractive to
investors and financial press.
4.
Buy
for his own account, on the open market, as institutions are selling.
In
the long run, these actions do serve both the shareholder’s interest and
Malone’s (as a dominant shareholder).
But Malone will not spell everything out for prospective shareholders. It’s just not always obvious what he’s up to,
nor where the value will ultimately reside, so the investor does best by
watching his actions and carefully reading the company’s public disclosures.
Discovery
Holding Company appears to be a new example of John Malone as reorganizational
virtuoso.
Discovery Holding Company
DEAL STRUCTURE
BACKGROUND
Liberty Media (symbol: L) spun off Discovery
Holding Company (DISCA) for the stated purpose of simplifying Liberty’s
corporate structure, which is a complex array of cable programming,
distribution and services assets.
TERMS
Holders of Liberty Media received 0. 1 share
of DISCA for each share of Liberty.
CURRENT
STATUS
The spinoff has completed. DISCA began trading in mid-July, 2005.
ANALYSIS
As is typical for a John Malone
reorganization, the financial press doesn’t like this deal. Also typical is that the press cites a
complicated ownership structure as a reason to avoid investing: the primary cash-generating asset of DISCA is
Discovery Communications, a private company 50% owned by DISCA, and 25% owned
by each of Cox Communications and Advance Communications.
Reflecting press sentiment, the Washington Post argued on July 21 that,
because it shares ownership of the subsidiary company, it would be impossible
for the parent to tap into the hundreds of millions of dollars Discovery
Communications generates each year in operating cash.
This doesn’t make sense to us. Assets are valued by the return they
generate, whether or not distributed. Malone,
with effective control of Discovery Communications, has a strong record of
effective reinvestment, and the reinvestment return on this business appears
high (see right).
On August 10, 2005, DISCA reported a substantial
decline in net income, mainly on increased staff cost to ramp up European
operations. Coincidentally, beginning as
this bad news was reported, and for weeks afterward, Malone personally bought
aggressively, accumulating over 1. 5 million more shares of DISCA, increasing
his position by about 10% over the shares he received in the spinoff.
AUTHOR
OWNERSHIP
Author does not own Discovery
Holding Co.
Company Information
BUSINESS
Discovery Holding
Company owns two main assets: Ascent
Media, a video production services company, and more importantly, 50% of
Discovery Communications Inc. ( DCI ), a private company that owns and operates
key cable programming assets, including Discovery Channel, Learning Channel,
Animal Planet, and Travel Channel.
The DCI position
comprises most of the value of Discovery Holding. The other owners of DCI, Cox Communications
(25%) and Advance Communications (25%), have signaled no intention to sell.
DCI is growing
rapidly and profitably: operating cash
flow increased at a compound annual rate of 32% over the past 3 years, and
annual revenue at 16% over the same period.
Between 2004 and 2005, subscriber fees rose 23% at DCI, a large increase
for a company already generating over half a billion dollars in subscriber
revenue. Advertising revenue was flat in
the
outside the
Three years ago,
Discovery Holding ceased to report detailed subscriber information in favor of
a rather general overall subscriber count of more than a billion. However, revenue has continued to rise
unabated since that time. Since such
reporting is largely under Malone’s control, and since he is buying, there is
reason to suspect conditions are better than they appear.
Several points
about DCI’s business look attractive.
First, its brands are category-killers:
there are no credible competitors to Discovery or Animal Planet in
English-speaking markets, and each cable subscriber really will never want more
than one such channel. Second,
brand-name cable programmers face relatively little exposure to the current
technological uncertainty in media distribution (cable vs satellite vs
internet). Third, the channels generate
higher-than average advertising revenue per rating point (source: Oliver & Ohlbaum), making them more
profitable relative to production costs.
Fourth, the company appears only now to be exploiting large overseas
markets.
VALUATION
DCI, the half-owned
subsidiary, has trailing revenue of about $2. 5 billion and operating cash flow
of about $660 million. The company
appears to be able to reinvest at rates north of 20%, suggesting that the Washington Post‘s complaint about
inability to tap into cash may be misplaced.
Is operating cash a
reasonable metric for valuation? Think
for a moment about this type of business.
It is not an automobile factory, where continuing production requires
constant investment in new plant and equipment, perennially consuming most
operating cash. Instead it’s a proven, strongly
branded, 20-year-old content business, with relatively little plant and
equipment and a long tail of cash flow returning from each production. So it would appear operating cash is a
reasonable benchmark. 26% of revenue is
a lot of operating cash.
Discovery Holding
Company’s share of this cash flow, whether distributed or not, is $1. 19 per
share. Thus the company, if it were running
as a cash cow with no reinvestment, might be fairly valued at $10 to $15 even before
considering its other primary asset (Ascent Media).
DISCA has been
hovering at about 15 since it was floated, with about 280m shares outstanding,
or about 13 times trailing operating cash.
Now add in the brand strength, sustained 32% revenue growth rate, stable
margins, room to grow overseas, and the other asset (Ascent, which is also profitable),
and the current price looks like an attractive starting point for a long-term
holding.
POSSIBLE TACTIC
Buy and hold.
back issues upon request to current subscribers.