Sunrise or Liberty Global?

Which one to bet on! - Part 2

Key points of the thesis

• Why is this spin-off different? We'll look at the role of John C. Malone, the cable cowboy, in this operation and the hallmarks of his capital management.

• Alignment with the spin-off: The parent company and its main shareholders will remain involved in both companies, the CEO of Liberty will lead the Swiss project as Chairman, with an executive with skin in the game.

• Liberty Global, a telecommunications conglomerate, is difficult to value as a whole because it consists of listed and unlisted companies, so the share price does not reflect its value, even if we discount the spin-off.

In our previous article we analysed Sunrise, the Swiss spin-off of Liberty Global, and set a conservative valuation that could lead to an opportunity from 13 November, the first day of trading for the new company.

In the spin-off playbook, the usual move could be to wait for Sunrise to separate and its subsequent drop in share price for the usual reasons: funds leaving because they do not fit the type of investment or individual investors selling out of ignorance. This type of strategy has offered an annualized return of 13% in the last 5 years, according to the S&P Spin-Off index, of course, investing in all of them according to their market cap and without carefully analyzing them separately.

The case of Liberty Global and Sunrise is different, since it involves John Malone, also known as the Cable Cowboy, one of the 8 CEOs cited in the famous book “The Outsiders” by William N. Thorndike for having generated a 30% annualized return between 1973 and 1998 until the sale of TCI to AT&T. His formula is based on these four pillars:

• Minimize tax payments by minimizing profits.

• Conduct opportunistic and unconventional capital management:

  • Issuing stock and borrowing to buy businesses when stocks are relatively expensive.

  • Aggressively buy back shares when the stock is relatively cheap.

  • Carry out spin-offs to facilitate business valuation.

These unwavering principles guided Malone through the sale of TCI and have continued to live on in the “Liberty” companies (Global, Broadband, Media or SiriusXM). Although the market narrative considers aggressive buybacks and debt as a “bearish” motive, we like Malone’s opportunistic and long-term approach and we will explain why with the case of Liberty Global.

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Taxes? No thanks.

While other CEOs are busy offering their best EPS data to analysts, Malone and his right-hand man, Mike Fries, are trying hard to minimize pre-tax profits. Through financial leverage, they manage to increase returns, through business acquisitions and their integration, and allow them to reduce the tax burden through the deductibility of interest. As we can see in the following graph, from 2005 to 2023, Liberty Global has managed to neutralize operating income with financial expenses, while business cash flows have been increasing, at least until 2019, when a series of businesses begin to be spun off or sold, bringing out the value through another means. The high predictability of income in this industry allows for high indebtedness at an average of 5 times Net Debt/EBITDA.

Opportunistic capital management

Allergic to dividends, Malone is known for aggressively buying back shares when they are cheap as a way to generate shareholder value. In Malone's words, he will not hesitate to divest a business at 10 times FCF to buy back his own shares at 6.

*Price adjusted to the 2014 split

At its peak valuation in 2013-2015, Liberty took advantage of the opportunity to acquire companies such as Virgin Media (UK), Ziggo (Netherlands) and Cable & Wireless Comm. (Caribbean) among others, partially paid for by the delivery of shares, which meant the issuance of 60% of the total shares. From 2016, Liberty Global invested an average of 2 billion dollars per year to buy back more than 50% of the shares. Unusual and opportunistic, this is the management style that characterizes Malone and that earned him his chapter in the aforementioned book.

Widely cited in the literature, it also makes an appearance in Joel Greenblatt's book "You Can Be a Stock Market Genius", where he analyzes some of the spin-offs carried out by Malone. In the book, Greenblatt teaches us that the prospectuses of spin-offs can provide valuable information about the expectations of the board of directors and executives regarding the value of the new company. This information can be obtained by analyzing the appointments of the board and executives, their shareholdings and the incentives they receive. Let's see what is at stake with this operation.

Malone and Fries show you the way

Fries, the current CEO of Liberty Global, will become Chairman of Sunrise and will accumulate Malone's voting power in addition to his own (through a private agreement), as well as retaining a right to Sunrise shares if Malone decides to sell them. Likewise, Fries cedes the same rights to Malone with respect to Liberty Global. The interests of both remain tied to both companies and guarantees their continued control over them. Specifically, Fries will have around 30% of the voting power in Sunrise and Malone 40% in Liberty Global. The remaining voting power is very fragmented, with only three other reported positions exceeding 2%. We believe it is clear that these excellent money managers see value in both companies.

We have discussed the Sunrise case at length, let's briefly look at the value that Liberty Global could have post-spin-off.

Valuation

Sunrise's parent company is a complex network of telecommunications companies and other related investments, geographically diversified across different European countries. We have focused our efforts on analyzing Sunrise, where we believed we could add the most value. If you want to learn more about Liberty Global and its business, we invite you to visit the thesis published in two parts on Substack

Cocoa Beans Podcast

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Part I:

Liberty Global: Parte I - No puedes ser el más grande, pero sí el más inteligente (English version at the end)

Part II:

Liberty Global: Parte II - No puedes ser el más grande, pero sí el más inteligente (English version at the end)

For our part, and based on the linked thesis, we have updated the numbers of the valuation by parts of the Cocoa Beans thesis and adjusted the circumstances of the separation to arrive at a fair value that would be as follows:

Excluding Sunrise, a conservative valuation of Liberty is close to $25 per share, when it is currently trading around $21 (Sunrise included). While it is not easy to catalyze all the value in such a complex and debt-laden holding company, we are confident that Malone's strategy of selling/spinning off businesses and aggressively buying back shares will unlock value in the medium term.

Overall, with our Sunrise valuation, the upside potential is around 63% and with the spin-off underway the catalysts are close at hand.

So, to the question Liberty Global or Sunrise?, our verdict is clear:
Liberty and Sunrise.

Strategy

We have no record of an American company having a Swiss spin-off and we have reason to believe that this circumstance may be an aggravating factor to the usual moves with spin-offs. Let's look at a recent example:

In 2022, Swiss company ABB Ltd., which is engaged in automation, electrification, robotics and digital solutions for various industries, spun off a small turbocharger division. The parent company, with a market cap of around CHF 46 billion, spun off a business that started trading at around CHF 2 billion with around CHF 700 million in revenue (remember that Sunrise would be close to CHF 3 billion in revenue).

After the first few days of trading, the spin-off playbook was followed perfectly: an initial sell-off by institutional funds for whom the new company did not fit their criteria: size, geography... and by individual investors who only wanted to invest in the parent company. ACLN's share price fell by around 20% in the first few days of trading. Given the small size of the spin-off, this meant only a -3% for pre-record date shareholders.

One year after the separation, the spin-off uncovered value for the pre-spinoff ABB shareholder, who kept both companies with an IRR of approximately 19%, ex-dividend. Other more interesting moves, taking advantage of the special circumstances of the spin-offs, could have been:

• Strategy B: Pre-record date entry and increase the position in the spin-offs to match the invested capital of the main strategy. Result : IRR of 29%.

• Strategy C: A 50-50 post-record date entry in both companies would have resulted in an IRR of 38%, mainly by overweighting the spin-off and avoiding the initial drop.

Application to Liberty-Sunrise : In addition to the usual reasons mentioned for initial sell-offs in spin-offs, in the case of Sunrise there is the added aggravation of being in a different market to that of the parent company, with a different currency and, as we have previously mentioned, the instrument that investors in Liberty will receive is an ADR. This can boost sales, especially among retailers with a greater lack of knowledge of these products.

Our play: Convinced of the current undervaluation, of the possible strategies, the one that seems most promising is to participate in the spin-off as Liberty Global shareholders through its C-shares (preferred shares without voting rights) and wait for Sunrise to start trading. The initial position in Sunrise will be small given the 5:1 ratio; an investment of $1,000 in Liberty Global at the current price would result in a valuation of $400 for the proportional part of Sunrise when the target price is met; but we believe that the market can provide the opportunity to buy more Sunrise shares at a more attractive price, increasing the profitability of the operation.

DISCLAIMER: All the information provided in this document is purely informative and does not constitute a buying recommendation (according to Spanish Law Article 63 of Law 24/1988, of July 28, on the Stock Market Regulator, and Article 5.1 of Royal Decree 217/2008, of February 15). DuckPond Value Research is not responsible for the use of this information. Before investing in a real account, it is necessary to have the appropriate training or delegate the task to a duly authorized professional.