Liberty Interactive LLC (QVC Group) Ticker: LINTA
Liberty Interactive, trading under the tracker stocks QVCA US (market cap $10.8bn) and LVNTA US (market cap $4.9bn), is currently undergoing a number of corporate actions that will result in it focusing almost exclusively on QVC, its retailing business. QVC will be boosted by the addition of HSN, the home shopping network pioneer. These are two largely virtual retailers with decades of profits, unique brands, and long experience of producing entertaining content to make their sales. They have moved earlier and more quickly to digital and mobile commerce than traditional retailers. This all means a combined group of considerable strength with plenty of opportunity and the expertise to take the fight to pureplay online retailers.
|Isin||Issue Out||Rating M / S&P||Coupon||Min Piece||Maturity||Details||Offer||YTM|
|US530715AJ01||$504mn||B2 / BB||8.25% s/a||$1k||Feb 2030||Bullet||112||6.80%|
The bonds above are senior unsecured at the holding company level, so subordinated to debt issued by subsidiaries, and to all subsidiary liabilities including trade payables. Ultimately there is little protection and bondholders are mostly piggybacking off bank debt covenants that give considerable wiggle room for the group to undertake corporate actions. It can add substantial senior debt as long as QVC adheres to the 3.5x consolidated leverage covenant on bank debt (see funding section). That said, we are happy with the financial performance of the group and its long track record of comfortably paying up dividends, on which bondholders are ultimately and entirely relying.
Liberty Interactive currently has two main lines of business, QVC and Liberty Ventures. The latter will be separated in late 2017/early2018, after which Liberty Interactive will change its name to QVC Group.
- QVC – Currently listed under the tracker stocks QVCA/B, QVC is a multimedia retailer that has three decades of history in shopping channels and has expanded into online and mobile channels as technology has advanced. It represents over 95% of Liberty Interactive’s revenue and more than 100% of consolidated operating profit. As of October 2015, it owns zulily, a major online retailer founded in 2010. International sales account for almost 30% of QVC’s revenue. In July it announced an agreement to buy out HSN Inc (Home Shopping Network), the 40-year-old TV shopping pioneer in the USA in deal fully financed with QVCA shares. HSN also has several home and apparel lifestyle brands (the Cornerstone division) and was early to launch its website in the late 1990s. Cornerstone holds five brands, which have a smattering of “experiential” retail stores in the USA. The acquisition is expected to complete during Q4 2017.
- Liberty Ventures – Ventures includes various interests in telecoms and digital commerce, including evite.com (100%), giggle.com, Liberty Broadband and LendingTree. It is in the process of acquiring GCI, Alaska’s largest cable provider, which it will combine with parts of Ventures’ assets and liabilities, including stakes in Charter Communications and Liberty Broadband. Ventures will subsequently be split off from the rest of Liberty Interactive and renamed GCI Liberty (GCI). Tracker stocks LVNTA/B will become GLIBA/B. QVC will retain $750mn of assets and liabilities from the GCI side of the current business (see transaction overview below).
Given the coming split off transaction, we are focusing on the QVC side of the business as it will soon be configured. Before we do that though, a quick word about who’s involved. Liberty Interactive Chairman, John Malone, has a general modus operandi that runs on two fronts to maximise cash generation and increase value: operationally they reduce costs, invest to grow, acquire cheaply and sell operations that no longer fit. At the same time, corporate and capital structures are used to enhance cash generation and value goals, hence the liberal use of leverage, tracker stocks, share buybacks, refinancing debt at lower rates, and splitting off or spinning out businesses – and all of these can provide very useful tax benefits to further boost cash and value. Malone has been undertaking permutations and combinations of these actions over the past two decades via entities including Liberty Global, Liberty Interactive, Liberty Media and Liberty Ventures. He and his assembled executives across various lines of business have a long term gameplan for companies they invest in, and are known for their deal making, exceptional tax savvy, and generating value for investors. Their track record is a positive.
Management has said the combining with HSN will make QVC the third largest multi-category retailer in North America behind Amazon and Walmart in terms of ecommerce and mobile commerce transaction dollars. The overall goal of combining HSN with QVC and zulily is to establish “a leading pure-play discovery-based retail and commerce company”. Simply put, QVC and HSN have long used live and pre-recorded video to engage viewers and build long, loyal relationships with highly-engaged customers. Brands, exclusive lines and celebrity ranges are key features. HSN has high mobile penetration and catalogue experience, Zulily is a little different in a few respects: it launched in 2010 as a purely online business and offers a new selection of unique products and styles that cannot be found elsewhere. Its flash sales events are time-limited (usually 72 hours) and offered daily. Customers must be registered with their site. It targets mothers and therefore has a younger customer profile – the important Millennial generation. It is also one of the largest standalone e-commerce companies in the USA, and now operates overseas as well via the UK website.
There is a considerable set of skills, brands, and retailing heft to serve increasingly interactive customers via complementary programming and operational collaboration. QVC, HSN and zulily will continue as distinct brand identities – they do not want to mess with them – but only two million of the combined group’s customers currently shop at both QVC and HSN, so there is scope to increase sales without the high expense of attracting entirely new customers. Traditional retailers are trying to catch up with digital/omnichannel selling. QVC has decades of experience building content and merchandising in a virtual space, already has good brands and loyal clientele, and lacks the drag of bricks-and-mortar in C-grade malls across North America. HSN has a similar but complementary profile. Both have come through several business cycles. In short, QVC has a compelling position it can leverage.
Financials Liberty Interactive LLC – to be renamed QVC Group
As mentioned, QVC brands QVC and zulily represent the lion’s share of the current group, whose results are summarised below. As a retailer, it tends to follow general macroeconomic trends, and the progression shown here is broadly in step. In mid-2016, however, QVC encountered an unusual combination of underperformance in an unprecedented five product categories: jewellery, electronics, kitchen, handbags and haircare. One or two might be expected to fall behind in any given year, but five was a record. We can see the effect in the lower operating profit and margin in 2016, although by the time we get to net profit before tax line the fallback to $667mn is masked by $1.175bn gains from financial instruments (fair value movements in options) on the Liberty Ventures side of the business, bringing the net profit result up over $1.8bn. It’s pleasing to see the operating margin almost back to double digits in 1H 2017. Throughout, the group has remained comfortably profitable and soundly cash generative with interest cover averaging around 4.5x. Management is focused on generating more consistent and balanced growth across categories, accelerating new customer acquisition, using all available sales channels (broadcast & digital) and continuing to cut costs to fund innovation.
Note that these figures reflect the 38% of HSN Inc’s results that the group already owns via the equity method. In 2016 QVC recorded a $48mn share of earnings from affiliates in the 2016 income statement, a $184mn affiliate asset in the balance sheet (versus a market value then of $684mn; the original capital invested has been reduced by regular cash dividends) plus almost $200mn of special dividends in the cash flow statement. We discuss HSN’s performance in more detail below.
In YE 2016 Liberty Ventures, which will split off, contributed $428mn revenue, an operating loss of $43mn and had interest expenses totalling $74mn. Its portions of cash and total debt were $338mn and $1.7bn respectively, and with almost no intangibles, its TNW was $1.9bn. It also generated $244mn in operating cashflow.
Assets include a large chunk of goodwill ($6.1bn; $860mn from the zulily acquisition in late 2015) and other intangibles (trademarks $3.3bn). These don’t amortise unless found wanting and impaired at regular testing. There is $747mn of amortising intangibles that include television distribution rights, customer relationships and other assets. These are undergoing accelerated amortisation to match asset use and will be eliminated by the end of 2021, with the bulk of the expense coming during 2017 and 2018. Net equity of almost $6.9bn is thanks to years of solid performance with retained profits of over $7bn. While we’ve applied our usual strict approach by discounting all intangibles entirely in our calculation of tangible net worth, there is some decent value in there and a nil TNW position is probably more than strict enough. Total debt of $7.9bn is manageable and leverage of 3.8x is high, but not outrageous. We see combining QVC’s full earnings, cash flow and balance sheet with HSN’s as a positive development.
HSN Inc – to be acquired
Acquiring the remaining, publicly-traded 62% of HSN Inc will make the combined businesses one of the largest digital retailers in the world, with $14bn in revenue, 23 million customers, 17 multi-platform networks (5 in the USA) and 27,000 employees across eight countries. QVC covers the USA, UK, France, Germany, Italy, China and Japan. HSN is predominantly US-centric, but some of the Cornerstone websites ship internationally and it is present in the Philippines via ShopTV. In financial terms HSN comes with lower operating margins than QVC, but it has been consistently profitable, has very good cash flow and comes with comparatively low debt and leverage.
A year ago HSN sold a couple of underperforming apparel websites from the Cornerstone portfolio, with related impairments of $31mn and other associated costs also eating into profit. At the same time, like almost all other retailers, it has experienced tough competition and pressure in shipping prices and costs, and it is in the process of closing one distribution centre and increasing automation in its supply chain. Management has admitted it is not happy with recent performance, but the anniversary of divestments will mean a return to true like-for-like comparisons and a gradual shift in supply chain costs will support future margins along with simply executing better. Plus there are the opportunities to build sales together with QVC.
The balance sheet has just $9.9mn of goodwill against net worth of $215mn. Other intangible assets of $254mn are trademarks and trade names. Leverage is much lower than QVC’s, at 1.8x, and cash interest cover has been in double digits for years.
QVC will buy out HSN with 1.65 shares of QVCA, for every HSNI share, and will issue $1.3bn of QVCA shares to do it – there’s no cash or debt being used in the transaction, except any paid for any fractional shares. The price implies an enterprise value for HSN of $2.6bn, or roughly 10.4x LTM EBITDA, which seems fair enough. QVC shareholders will end up with just over 93% of voting rights for their 90% of common equity in the combined group; HSN shareholders will hold the remainder.
Once the acquisition is completed in Q4, management estimates HSN will bring across $529mn of total debt plus $48mn cash; total outstanding debt is expected to be $6.8bn at that time. It will also mean total debt facilities of $9.3bn, which if fully drawn (unlikely) would indicate leverage of 4.5x against combined LTM EBITDA of $2.1bn. As it stood at the half year, there was material headroom under both QVC’s $2.65bn bank facilities and HSN’s $750mn RCF, so proforma leverage would’ve been roughly 3.7x on combined outstanding net debt of just under $7.5bn as at the end of June. Although buying HSN outright will probably add $1.3bn or so of goodwill to QVC’s, we think the upside of additional profit, cash flow and operational opportunities outweighs the impact on the balance sheet.
Once QVC and HSN come together, management is aiming for a modest $75mn – $110mn benefit from synergies over three to five years, in such obvious areas as purchasing, fulfilment and back office functions. Sheer scale will be a big help. Inventory is one area we think both QVC and HSN can tighten up a little, and they should be able to improve contracts with broadcasters, etc, over coming years. Capex savings may also be possible going forward, particularly in technology innovation, but are not being quantified at this point. Gains on the revenue side are harder to pin down and management hasn’t given any target. QVC feels that QVC and HSN are already in the best international markets, so wild expansion that direction is not on the cards, but it may come more modestly via zulily. Broadening the combined customer base that shops at both QVC and HSN brands from the current 2 million provides a solid opportunity regardless. We think management is underpromising in order to overdeliver on both the quantum and timeframe for synergies.
That’s not all that will be going on, however. Once GCI is separated from QVC in Q1 2018, the $750mn on both the assets and liabilities sides will transfer to QVC. Assets include interests in ILG (“a leading provider of professionally delivered vacation experiences”), a portfolio of green energy investments, tax attributes from equity awards in prior spinoff transactions, and a smattering of other small investments. Instead of Liberty Interactive running two lines of business that each has a tracker stock, there will effectively be two separate companies, QVC Group and GCI Liberty, each with normal shares that will be eligible for inclusion in stock indices and, management hopes, will shed the tracker stock discount they have historically carried.
A key feature of the reattribution will be the transfer of $329mn of cash from GCI, which will be applied to QVC’s credit facility balance. The resulting boost to annual free cash flow from tax savings associated with exchangeable bonds liabilities is estimated at $130mn. The press release announcing the deal said “cash can be used for investments, stock repurchases and debt reduction”. Share buyback activities, sidelined during this year’s corporate action announcements, are certain to return once the dust settles, but we do not expect debt or leverage to blow out. Allowing for the reattribution, proforma debt was estimated at $7.6bn, and that brings us to funding.
Funding – post acquisition and reattribution
Liberty has long maintained debt at both the corporate level and within operating groups, and as per the above table, little will change after GCI is split off. There is one other exchangeable, the CHTR 1.75% 2046 exchangeable that may be reattributed to the QVC side if Liberty’s offer to exchange it for mirror debentures at GCI Liberty are not wholly taken up. If that happens, GCI Liberty will provide an amount of cash equal to the net present value of principal and cash interest payments through to the put date (October 2023) along with an indemnification through to that date for additional amounts payable if holders put while CHTR exchange feature is in the money. The assumption at this point is that all the issue will be exchanged.
QVC tends to go for long term funding and we can see that the new group will have a year or so of breathing space before any material maturities arise. HSN has a simple debt structure, with a revolver plus an amortising term loan, both being medium term in maturity. Given the combined ability to generate profits and cash, and barring any stumbles in execution, we don’t expect any difficulties in amortising, extending and refinancing as appropriate (or advantageous).
Corporate debentures, being at the holdco level, are structurally subordinated to QVC Inc senior secured notes, as they will be to HSN level debt. The QVC Inc notes rank pari passu at the QVC Inc level with the QVC Inc credit facility. Listed under ticker QVCN, they’re rated BB+ with maturities range from April 2019 to March 2043 and yield 1.9% – 5.9%.
Financial covenants on the QVC Inc credit facility include consolidated leverage ratio maximum of 3.5x based on total debt, not net debt and an adjusted EBITDA. Essentially, if QVC remains within that, it can take on more debt. It can also undertake sale/leasebacks of $500mn in a year (or 15% of shareholders equity, whichever is greater), and investments of $500mn in a year and up to $1bn over the life of the agreement (i.e. to 2021). So there is fair degree of leeway for QVC to make accretive acquisitions.
HSN’s needs to maintain a consolidated total leverage ratio of 3.0x or less, and can broadly do what it wants if it does. If leverage goes above 3.0x to a maximum of 3.5x, payments are limited to $150mn per year. It also has an interest cover ratio covenant of 3.0x using a fairly broad definition of EBITDA.
QVC is better placed than many retailers to meet the onslaught from Amazon and other online retailers. HSN provides complementary skills in the entertainment shopping segment, and brings millions of customers, profit and cash flow and enhances the balance sheet. The cross-selling opportunity is there to be exploited in coming years. Both QVC and HSN have had some operational issues to contend with over the past 12-18 months, which we believe they can correct – they are not existential threats. Zulily provides an opportunity to broaden the demographic base to underpin the group in the longer term. Overall, we see the credit as sound and the business model as flexible enough to react in a sector facing a secular shift to digital, where QVC Group is quite at home. All this and a 7.00% return is a combination that we are comfortable with throughout the economic cycle.
Please contact the desk if you have any questions.
27 September 2017