Liberty Global

Liberty Global is the largest holding of Seth Klarman’s Baupost Group, hence — worth paying attention. Mike Fries is a CEO since inception in 2005. The company is a holding of Mobile, Internet, TV cable companies across the Europe. If we combine the assets of all these companies, Liberty Global is trading at a cheap valuation.

Main products: mobile and fixed broadband subscriptions, TV content and platforms (like Horizon, which is a box that you connect to TV, which makes your old TV smart).

Main subsidiaries:

• Virgin Media (UK and Ireland), which was acquired in 2013
• VodafoneZiggo (Netherlands)
• Telenet (Belgium)

Virgin Media and VodafoneZiggo are joint ventures, which means Liberty Global has only partial control over them.

Let’s start our analysis from bull reasons for owning this company.

Three Reasons

Three great reasons to own this company that relate to moat, management, or price.

Reason 1. Cheap valuation. Based on Discounted FCF analysis, the company will generate 25 dollars per share in the next 10 years. If we add the current tangible book value of 26 dollars per share, we can see that fair price is 50 dollars vs current 20 dollars. This is 60% upside.

Reason 2. Synergy effect. By acquiring companies and merging them into a single network, Liberty Global saves on the costs which otherwise have to be incurred by each of the companies individually.

Reason 3. Seth Klarman, who is a guru of value investing, is a large shareholder, therefore we can rely on his judgement on the quality of this business.

Now, lets see the bear arguments.

Inversion

Reason not to buy # 1. The company is profitable and book value grows, but sales and cash flow from operations remain flat over 10 years.

Reason not to buy # 2. The stock has been in decline for the last 7 years. The market might have a good reason not to appreciate this business. This could be because of the confusing accounting and the fact that big part of accumulated book value is goodwill.

Reason not to buy # 3. Liberty continue to invest in fiber infrastructure in the UK. Why this is a good investment? Aren’t we already have fiber network already? The management seems convinced that providing 1 Gigabit internet for each home is important. I personally don’t need so much bandwidth, and I assume other people don’t need it as well. Management might overestimate the potential of this service.

Reason not to buy # 4. The management tends to focus on EBITDA numbers in 2021 report, instead of GAAP or Owner Earnings, which is a red flag that may indicate that they want to mislead investors, as EBITDA doesn’t count interest payments, so earnings are artificially increased.

Reason not to buy # 5. It seems there are more competitors in video services industry each year. Netflix, Disnay, Amazon Prime, Youtube. A lot of them compete for user’s laisure time. The company may lose users over time in its video segment of the business.

Reason not to buy # 6. The pace of technology change is pretty high. So far the company managed to react quickly, however, this is hard and it could fail next time.

Reason not to buy # 7. The enterprise value was 20 bln in 2013. Now, 10 years later it is still 20 bln. The company didn’t pay any dividends, so where disappeared all the profits?

• Rebuttal. Net debt decreased on 10 bln, according to Gurufocus. So the enterprise value remained the same, but the structure of this value now in favor of current shareholders.

Cash and Debt according to Gurufocus

Reason not to buy # 8. In 2015 the company experienced 35% decline in book value per share and negative earnings for 3 years in a row. Nevertheless, the management in the annual latter haven’t mentioned it and just said that they are no problems at all, and everything is going as planned. By the way, this year the stock fell by 25%, and another 25% the next year, so it seems market also noticed this that something is off.

Reason not to buy # 9. The book value has been growing, but big part of this growth is goodwill. It could be that the company just gets bigger by paying for the assets more than they actually worth. This could explain why the operating cash flow doesn’t grow much despite all these acquisitions.

Reason not to buy # 10. Mike Fries is not only a CEO of Liberty Global, but also an Executive Chairman of Liberty Latin America (LLA), which was separated from Liberty Global in recent years, so shareholders of Liberty Global doesn’t have ownership of LLA. This second position might distract Mike Fries from work at Liberty Global, which can be considered as a red flag.

As we can see, there are a lot of reasons not to buy the company. I think the most important one is that operating cash flow and sales remain flat over 10 years, while the book value is growing mostly because of the goodwill, which is not reliable source of value.

Event

There was no company-specific event that lead to a decline in stock price. Nevertheless, the stock price declined regardless.

Let’s now go over the checklist from book “Invested”:

1. Be capable of understanding.

Is this company inside my Circle of Competence?
Yes. I am user of broadband internet, as almost everyone I know. The business is pretty simple to understand. The company builds infrastructure, and users pay subscription to access it.

Are any of my Gurus buying or selling this company?
Seth Klarman has been an investor for years now (since 2018). His entry price was around 25 dollars. He trimmed his position by 10% in 2022, probably without a profit, or even with a minor loss. Nevertheless, it remains his largest holding at 14% of the portfolio.

What is my overall level of confidence with my research into this company?
I spent several hours reading the company’s website, annual reports and calculating growth numbers. The accounting for this company is very convoluted. All I can say is that I have now more doubts about the potential of the company, so I think this company falls in the “too hard” category for me.

Describe the business and industry in one paragraph.
The business is basically providing cables for fast electronical communications. In previous century it was radio, then TV. Now it is internet. Despite rapid changes and innovations, it seems that the business can survive if it quickly adopts to the new technologies. There has been a lot of mergers and acquisitions in the industry lately. The management convinced that this will bring benefits of economy of scale.

Describe the challenges and economic cycles of this industry.
Business is capital-intensive, it is costly to create new infrastructure, so it requires economy of scale to generate new profits. There is no special economic cycles that affect the industry, apart from spike in demand in Covid period.

What are the company’s plans for growth?
The company plans to grow in Europe via new acquisitions and Joint Ventures. Once some of the companies are merged with each other, the total value of them will increase due to synergy effect (fewer expenses, for example).

Currently, depending on what management chooses, there are 2 potential ways for the company to return the money to shareholders:

1. Sell the assets (to private equity, for example) and distribute the dividends. Separately, on the private market, in 2020 the valuations were high for cable companies.
2. Expansion. Perform mergers for synergy effect to generate a new cash flow streams. Distribute the new free cash flow as a dividends later.

Will growth peak within ten years?
Yes, I think so. We already see the flat operating cash flow and sales. The company might achieve higher profits via economy of scale, but so far we can not see a positive impact of this strategy on the operating income.

2. Moat

The company has a lot of moats, but they are not very strong, in my opinion. Some of the most prominent ones are Brand, Price and Toll Bridge moats.

Brand. You will buy subscription from the provider which name you know. And brands like Vodafone and Virgin are pretty well known.

Switching. Usually, you don’t change your internet subscription often. You can still can do it of course, so this kind of moat in this industry is not super strong, but it exists.

Network effects. Don’t play a role here.

Toll Bridge. Arguably, we can say that Liberty Global has this kind of moat. If you are the only one who provides 1 Gigabit internet, you will always have customers. And it is probably hard for competitions to build another similar infrastructure, simply because it is too expensive.

Secrets. There are no particular secrets for Liberty Global apart from big experienced in the industry. They had a lot of trial and errors (since 2005) so they now know what works and what doesn’t.

Price. Merger and acquisitions allowed to achieve economy of scale which makes it possible to successfully compete on price.

How hard is it to compete with this company?

Well, you would need around 15 bln dollars (which is current approximate tangible book value) and several years to build a similar infrastructure. And after that you still have to compete with existing brands. If you build or acquire them, it will cost you additional several billion dollars. So yes, it is possible to compete, but it is hard. This is why we can see a lot of consolidation in the industry.

What are the Big Four Growth Rates? Are they speeding up or slowing down?

Liberty Global does reporting in 2 ways: via 10-K form according to US rules and another report via UK rules. In this article, I’m going to analyze numbers from 10-K report for consistency, as numbers for UK are slightly different.

Net Income growth rate of Liberty Global can be calculated using different entries in the annual statements:

1. Net earnings (loss) — record in the Income Statement that reflect earnings for the entire company.
2. Net earnings (loss) attributable to Liberty Global shareholders — company’s earnings minus earnings attributable to noncontrolling interests (other owners that own part of Liberty Global’s subsidiary, Telenet).
3. Comprehensive earnings (loss) — record in the Consolidated Statements of Comprehensive Earnings (Loss). It reflects the earnings with adjustment to currency fluctuation of the assets. Basically, if at the end of the period the same asset is worth more in USD because of the change in currency exchange rate, we have an increased earnings.
4. Comprehensive earnings (loss) attributable to Liberty Global shareholders — the same thing minus earnings attributable to noncontrolling interests.

We probably are not interested in earnings of the entire company, we just need to know the earnings attributable to Liberty Global Shareholders. So we can exclude items 1 and 3. The main question, is whether we need to take into account fluctuations in currency rates. I think yes, because, for simplicity, I define the investment attractiveness based on gains in a single currency. Otherwise, it would be very hard to measure how much we can get from this business.

This is the growth rate for the last 10 years, based on annual 10-K reports:

Growth Numbers calculation

It is worth to note that in 2013 the Book Value increased 400% due to purchase of Virgin Media in UK by issuing more shares. The existing shareholders got diluted, but they got also their share of new assets. Nevertheless, it will be hard to calculate the impact of this purchase if we don’t use the “per share” numbers in calculating the rate of return.

When we look closely at the numbers, we can see several red flags:

1. Operating Cash has been flat over the last 10 years (2%), and decreasing in the last 3 years.
2. Sales growth has been flat as well (1%).
3. Net income has been flat or negative for 7 years, with huge positive spikes in 2019 and 2021 which happened due to selling the assets.
4. In 2021 the company reported 13 billion of earnings, mostly as a result of creating a Joint Venture with Telefónica. Liberty Global contributed Virgin Media’s U.K., and in exchange got 50% of the new Joint Venture. According to the annual report, Liberty Global got more from this transaction than Telefónica did, which is strange, as it brings a question why Telefónica agreed on this. But anyway, if we look at the assets of the new Joint Venture, we see that their value is basically equal to the Goodwill:

Goodwill is intangible, it is created when the company purchases assets at higher than the market price. If we don’t count the Goodwill, the value of new enterprise is basically 0. And that brings questions whether earnings reported in 2021 are actually real.

Apparently, we can not use 263% as a windage growth rate, as shown in the table earlier, because most of this growth comes from the goodwill. I think that the operating cash growth rate shows the more descriptive picture, so I took it as a real windage growth rate.

As for ROIC calculation, we can see the following picture:

The Return On Equity jumps a lot because of meaningless fluctuations in GAAP earnings. However, we can see that Return On Invested capital is pretty low. That shows that company extensively relies on debt in its operations.

3. Reasonable Price with Margin of Safety

Currently, there are 569.1 mln shares outstanding, each worth around 20 dollars, which gives us 11 bln market cap.

Pricing Method #1 Ten cap method

It is hard to distinguish maintenance cost from investments for growth, so for this particular pricing method I use Free Cash Flow and not Owner Earnings.

As we can see, 8 * 10 = 80 dollars per share is the the fair price for this business (vs current 20 dollars per share).

Pricing Method #2: Payback Time

For this method we use the same Free Cash Flow, but this time it will compound at 2% windage growth rate.

This gives us 66 dollars per share, which is still 3 times higher than the current market price.

Pricing Method #3: Margin of Safety

Windage PE ratio is the lowest number of 2 options:

1. Twice the growth number, which gives us 2 (operating cash growth) * 2 = 4
2. Highest PE for Liberty Global in the last 10 years is 125, according to Gurufocus, which is clearly not reasonable for our calculations.

Therefore, our Windage PE for Liberty Global is 4. I’m going to use Free Cash Flow instead of Net Earnings, since Net Earnings often have non-recurring items for this business.

We get a very conservative estimate of 4.5 dollars per share, which is 75% lower than the current market price.

As we can see, depending on the pricing method, the company either is significantly undervalued or significantly overvalued. This is an indicator that this company is very hard to understand.

Conclusion

Trying to understand the financial reports of Liberty Global is a pain. They constantly issue new shares to make acquisitions. At the same time they to buybacks to “return value to shareholders”. The book value per share jumps 40% one year and falls by 50% the next year. Also, there was a year when they made a stock split. It also complicates annual report comparison between different years.

Another interesting question is how “from nowhere” the book value increased on 9 bln dollars in 2019. I understand that this happened because of selling different subsidiaries to Vodafone, but if so, the book value in previous years didn’t correctly represented the true value of assets.

Warren Buffett recommends to stay away from companies with confusing accounting. Liberty Global could be a perfectly good investment, but to me the accounting looks very convoluted, so I’d put it into the “too hard” box and move on.