Special Event: Starz Network Is Prime for Acquisition

STRZA is a very attractive spinoff opportunity trading at $15.50, with an upside target of $30-35. This was a 1:1 spinoff of Liberty Media. Technically, Starz is the parent and Liberty Media is spinning off all of it's other assets (49% ownership of Sirius XM, True Position, Atlanta Braves, Live Nation stake, and various other minority stakes).

The Starz piece is the smaller piece, but generated the majority of the prior combined company's operating cash flow. After the spin, the parent will change it's name and ticker to STRZA and STRZB. The spinoff will assume the previously used tickers LMCA and LMCB (but temporarily trade under the tickers LMCAD and LMCBD). The A-shares have 110m shares outstanding, and the B-shares have 10m shares (and 10x the votes of the A-shares).

Starz is a stable, growing, high-margin FCF generating business. This is a very asset light, high-margin business with ~25-30% ebitda margins, with returns on tangible capital employed >90%. It grew subscribers, revenue, and ebitda every year even through the 2008-09 recession. For 2012, I would approximately estimate:

Revenue $1610m
- Operating expenses $930m
- SGA expenses $225m
Adjusted OIBDA ~$450m
- D&A expenses $18m
- stock compensation expenses $14m
Operating income ~$420m
- interest expense ~$30-60m (will depend on the exact terms of the bank facility, but $60m is on the high side)
- taxes $130m
Net income ~$230m
FCF ~$240m (minimal capex)

Debt:
Starz will be giving Liberty Media about $1.8 billion in cash. This is from a combination of existing cash, $500m senior unsecured debt, and the remaining via a bank facility. By my rough calculations, and the Proforma offered registration documents for the $500m senior debt, Starz will have approximately $1.17 billion in debt at the spinoff.

The major risk and why it's being mispriced/ignored:
The major headline risk that everyone sees are that a few months ago, Starz and Netflix couldn't get together to renew their agreement. Starz was one of the first to do a digital streaming deal with Netflix years ago at ~$30m per year.

Nowadays, that seems absurdly low. Multiple sources have said that during negotiations Netflix was willing to pay around $300m per year. However, Starz's hang up was that they wanted Netflix to do a tiered pricing model and charge more for premium content, which obviously Netflix wouldn't do to it's customers. A few weeks later, Netflix announced that they reached an exclusive streaming deal with Disney, which people have estimated to be about $300m per year. Obviously this same problem could happen with Sony's content as well. The loss of exclusive content from Disney and Sony will make Starz less attractive to customers and ultimately weaken it's business.

Reasons to be optimistic:

1. While I certainly cannot predict the long-term future of media and the loss of exclusive content is a major risk, I believe that it is likely overblown and priced into the market. Starz will still have access to Disney's features into 2017 and 2018 (since deal involves rights to films "released" through 2015, and since Starz gets access to movies 8 months -12 months later, it will be able to show content through 2017 and into 2018. Similar deal with Sony which ends in 2017, but Starz will be able to exclusively show it's movies into 2019. While I cannot know for certain what will happen 5 years from now, I do know that 5 years is a long time. The landscape will be very different. Five years ago, Netflix wasn't doing much streaming, and there was no Hulu or Amazon Prime. I think that 5 years buys management a LOT of time to renegotiate deals, develop new partnerships, or very likely be acquired (more below). For the next few years, the content will be stable, and subscribers should stay and likely grow. For the near future, I don't see any reason to believe why revenue and ebitda will be markedly different than past trends.

2. Starz is a very resilient and growing business (not huge growth but growth nonetheless). Starz had 3-5% CAGR revenue and subscriber growth for the last 5 years, and grew every year through the great recession. Most of that time, Starz did not have any significant original programming. And for awhile, it didn't even have a CEO. Despite all those headwinds, the business still thrived and grew. I would expect it to continue to grow ~2-4%, and as housing stabilizes and grows, subscriber base should grow also.

3. Original programming is the focus and top priority of management. Ultimately, the winners in media will include those who create/control great content demanded by consumers. HBO is a great example. Most of my friends hate paying for their monthly cable fees, but they have to watch their Game of Thrones and are willing to pay for both cable and HBO just to access it. AMC Networks was very successful transforming itself into a must-watch channel in just a couple of short years with Mad Men, Breaking Bad, and Walking Dead. Starz has recently showed some promise with Spartacus (which I loved), and Boss and Camelot which I thought were also decent. They have a ton of new shows planned (Magic City, Da Vinci's Demons, Black Sails, Marco Polo, White Queen, Vlad Dracula, Incursion, etc.).

4. Management: Chris Albrecht is the CEO with the ideal background for Starz. He came on board in 2010. He was previously HBO's president of original programing and then became HBO's chairman during HBO's heyday from 1995-2007 when HBO got Sex in the City, Sopranos, Entourage, etc etc. Developing original programs is his top focus at Starz. Starz currently spends almost 600m on buying content from movie studios, and less than 100m on creating it's own programming. Starz plan on increasing it's investments in new shows, and gradually reducing purchased content.

6. Future partnerships and deals. While it is widely perceived as a negative that Starz not reach a deal with Netflix this year, in my opinion, this is a positive in that it's a "hidden option" of sorts. Netflix was only paying 30m per year, which is not a big contribution to the bottom line. But if Starz could renegotiate this deal, or reach a similar deal with Hulu or Amazon for anything close to ~300m, future earnings will grow significantly.

6. Prime acquisition candidate. Starz will be the only standalone premium pay TV channel. HBO is owned by Time Warner, and Showtime by CBS. It doesn't make any sense to stand alone on it's own. Starz could easily be acquired by Disney or Sony, Newscorp, Viacom, TimeWarner, CBS, or Comcast/NBC. DirecTV previously tried to acquire Starz in 2009 but couldn't agree on a valuation. Management has already indicated that this is a possibility already being explored. At the very least, being a standalone company will make it easier to do partnerships (such as the Epix consortium that did a streaming deal with Netflix for ~$300m per year).

Valuation

Given that this is a high margin, FCF generating, asset light media business, a fairly reasonable valuation for Starz should be around 12x EV/ebitda (with 10x on the low end, and 15x as a very aggressive scenario but still possible). Due to the embedded leverage with ~1.17 billion in debt, small changes in valuation and ebitda will significantly impact share prices. At $15.50 per share, Starz is trading at approximately 6.5x to 7x estimated trailing EV/ebitda. At a more reasonable valuation of 10x to 12x, it would be worth $28 to 35 per share. For reference, AMC Networks trades at 12x ebitda, and Outdoor Channel trades at 13x ebitda.

I believe that Starz is a prime acquisition candidate. Past transactions in this space have been valued at 15x-18x EV/ebitda: A&E by Disney at 15x in 2012, Discovery Kids by Hasbro at 19x in 2009, Weather Channel by NBCU/Private Equity at 15x in 2008, Sundance Channel by Cablevision at 19x in 2008, Travel Channel by Cox at 18x in 2007, Court TV by TimeWarner at 18x in 2006, CSTV by CBS at 17x in 2005, USA Networks by GE at 17x in 2003, and Bravo by GE at 24x in 2002.

Given the major headline risk that everyone is focused on, I really believe that the chances are high for some good unexpected surprises: a couple of new hit shows, a new streaming deal or partnership that will significantly accrue down to bottom line, or perhaps an acquisition offer. This reminds me of the MSG spinoff in 2010. At the time, the Knicks were ranked last in the NBA and people were worried about the huge renovation costs of Madison Square. Fast forward a year and the Knicks signed Amare Soudemire, and then Carmelo Anthony. Then Linsanity swept NY. Now seats are sold out, ticket prices are up, and MSG stock is up 2.5x!