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 Japan.  And it was a dollar-denominated business 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 US, but increased over 30% outside the US, over the same period.

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.

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