Liberty Interactive: Misunderstood QVC Assets Mask Value

I am recommending a long position in the tracking stock of Liberty Interactive (LINTA), owner of the QVC home shopping network, several niche e-commerce businesses, and a 38% equity interest in publicly-traded peer HSN, Inc. (HSNI).

QVC is a unique and high quality asset with an attractive business model and sustainable competitive advantages that will enable it to generate extremely high returns on capital for the foreseeable future. The business will grow domestically as it continues to take share from traditional retailers and internationally as it continues to penetrate its less-developed international markets. All of this growth comes at very high incremental returns.

Furthermore, with EBITDA margins of only 6.5%, the e-commerce segment ($1.5 Billion in revenues) is substantially under-earning and dragging down the returns of the overall company. These businesses generated 12% margins as recently as 2009 and over the next two years I expect management to significantly improve the performance of these businesses and/or take other actions to unlock value - a sale, spin-off, or tracking stock structure are all options being considered.

Assuming that QVC can continue to grow sales at the same mid-single digit rate that it has over the last five years (which included a recession) and that EBITDA margins of the e-commerce segment can be improved to 10% (still well below potential), operating cash flow should grow to ~$2.2 Billion by 2016 (a 6% annual growth rate).

I assume that management increases Gross Debt / EBITDA modestly from 2.4x to 2.5x and uses incremental borrowings and FCF ($900mm-$1 Billion / year) to reduce the share count by ~25% through the end of 2015 (assuming an average price of $28 for repurchased shares). Holding the multiple constant, and assuming no increase in the value of the HSNI stake, this implies a year-end 2015 stock price of $38.00 - a return of 60% over the next ~2 years.

Importantly, this valuation analysis gives no credit for any multiple expansion, entrance into new international markets, value created from acquiring the remaining interest in HSN, or the company's 49% interest in CNR Home Shopping Network, a Chinese home shopping network that is currently distributed in over 60 million homes. The Chinese business in particular could prove to be a very valuable hidden asset over time.

BUSINESS DISCUSSION
It is important to understand what makes QVC such a structurally good business. Approximately 75% of the products sold on QVC are exclusive, reducing direct competition with other retailers. The use of on-air hosts to promote products engenders consumer trust and loyalty and is an effective way to build brands and highlight the selling features of unique products. The top-5 items featured on-air each day drive 30%-35% of sales. Since promoted items will be in limited supply and the first price will always be the best (QVC does not rely on markdowns), consumers have an incentive to purchase immediately and not wait for a sale.

QVC is one of the few companies that can actually beat Amazon on price since they get favorable pricing from vendors in exchange for running what is effectively an infomercial (vendors recognize the branding/advertising benefits of having products promoted on QVC). So QVC offers an attractive customer value proposition that drives loyalty and encourages impulsive, full-price purchases.

ADDITIONAL UPSIDE POTENTIAL
The base case value of $38 assumes only moderate growth in QVC, some improvement of the e-commerce businesses, and continued share repurchases. There are numerous sources of upside beyond the base case projections.

First, the e-commerce segment could prove to be more valuable than the $1.5 Billion ascribed to it in my base case (8.5x 2016 operating cash flow, assuming $2 Billion in revenues at a 10% EBITDA margin). These businesses earned a 12% EBITDA margin in 2009 on revenues of less than $1 Billion, so a 10% margin at $2 Billion in sales is conservative. Assuming a 13% margin and a more "e-commerce-appropriate" 10x EBITDA multiple, for example, would create an additional $3 (13%) of upside.

Furthermore, QVC is likely to enter new international markets over the next few years. France, Spain, Canada, Brazil, Turkey, and Mexico have all been mentioned as potential near-to-medium-term opportunities. The success that QVC has had in entering Italy (despite the terrible macro environment) should give investors comfort that entering new markets creates substantial value.

Finally, while the investment case is not predicated on multiple expansion, in fact that is a highly-probable outcome - 8.5x operating cash flow is just too cheap for a business earning close to 100% returns on capital with sustainable competitive advantages and global growth potential. HSNI, which is less than half the size of QVC, has no international exposure, and structurally lower margins (because of their unfavorable carriage agreements), trades at 11x operating cash flow. Ascribing a similar 11x multiple to QVC's cash flows would result in an additional $13 (50%) of upside to my base case.

REASONS FOR MISPRICING
LINTA is mispriced because it is largely ignored or misunderstood by many investors:

The crown jewel (QVC) has always been buried within a highly-complex organizational structure, off the radar screen of most plain vanilla consumer/internet investors. With the recently-created LINTA/LVNTA tracking stock structure simplicity has increased greatly and should attract more investor interest.

Furthermore, QVC is a business that is still not well understood - it is perceived by many to have an aging customer base, be overly dependent on TV ratings, and vulnerable to threats from Amazon and other online competitors. At the QVC analyst day last year, management put out a lot of statistics showing that the age of the QVC customer base, while slightly older than the overall U.S. population, is actually trending younger due to strategic celebrity affiliations, innovative social marketing campaigns, and an emphasis on mobile/e-commerce.

Traditional valuation metrics are misleading. EV / EBITDA analysis fails to capture the low maintenance capex requirements of QVC's asset-light model, while P/E overstates the valuation because of the $350 million of annual non-cash amortization charges. More impropriate metrics like EV / Operating Cash Flow or FCF / Equity highlight the true undervaluation of LINTA.