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Liberty Global (LBTYA or LBTYK) is an international provider of video, broadband internet and telephony services in Europe and Latin America. It becomes the largest cable company in the world after its recent acquisition of Virgin Media. In this article, I will analyze why it is a good investment for investors.

European Cable Market and Liberty Global's Positioning

Although it is also operating in Chile and Puerto Rico, Liberty Global has its majority of revenue coming from Europe. The European cable market is growing, driven by the underpenetrated broadband service and the consumers' increasing need of faster connection to the internet. Compared to the slower DSL internet connection provided by their telecom competitors, the cable companies in Europe have a competitive advantage of offering faster connection from their network laid out in the past many years. They further enhance their value proposition by bundling the broadband service with their attractively priced telephony and video offerings.

To lower the infrastructure and programming costs, the cable companies need to become larger, which leads to their consolidation in Europe. Liberty Global is leading the consolidation. It is targeting the countries in the industrial heartland of Europe, where the economies have been affected less by the global economic recession since 2009 and individuals have more discretionary income to spend. Actually, the majority of Liberty Global's revenue comes from Germany, Belgium, the Netherlands and Switzerland. Most of Liberty Global's networks in these countries are also fast and modern, offering industry-leading connection speeds and requiring minimum capital spending in the maintenance. This fast network combined with the underpenetrated broadband services in these countries allows Liberty Global to grow its subscribers for many years. On top of that, Liberty Global is also bundling attractively priced telephony and video offerings to its broadband service to extract more value from each subscriber. As a result, during the first half of 2013, it grew its operating cash flows at least 5% in these countries except the Netherlands, and Germany led the growth at 10%.

Recently, Liberty Global put itself farther ahead of its competitors by acquiring Virgin Media in the UK. Virgin Media's gem is its national fiber-optic cable network, which it spent billions of dollars to build and offers the industry-leading broadband speeds. This network will be Virgin Media's competitive advantage in winning the broadband market share in the UK. If it can leverage Liberty Global's enormous scale and expertise in selling the bundled products, Virgin Media may also grab larger share of video offerings from its fierce competitor BSkyB (BSYBY.PK). Likewise, Liberty Global can leverage Virgin Media's expertise in the mobile and B2B services to provide itself additional sources of growth.

Investment Analysis

We can estimate the 2013 financials of the combined Liberty Global and Virgin Media by summing up their individual annualized first half results:

$B

 

2013e

 
 

LGI

VM

LGI+VM

Rev

11.86

5.58

17.44

OCF

5.44

2.26

7.70

P&E Additions

2.54

1.20

3.74

P&E Additions/Rev

21%

22%

21%

FCF

0.66

0.86

1.52

Operating cash flow (OCF) is the difference between revenue and SG&A. Property and Equipment Additions (P&E Additions) is used instead of CapEx to account for the amounts financed under vendor financings or capital lease arrangements. Free cash flow (NYSE:FCF) is the normalized cash flow available to Liberty Global after deducting the P&E Additions, interest expense and tax from its operating cash flow. This is the key metric for the valuation of the company.

Let us estimate how the financials will be in the next two years. Based on the previous analysis, Liberty Global is in an excellent position to grow its broadband service. Its management projects the revenue and operating cash flow will grow 5% annually. We use this as the upside case. For the downside case, we assume slower growth at 3%. Actually, these assumptions are quite conservative given Liberty Global's historical growth rates and its competitiveness in the market. The percentage of the P&E Additions to revenue is likely to decrease, due to the slower capital spending in the future as expected by the management. Since the company has already spent billions of dollars on its network, it is time now to reap the reward. Both scenarios are shown below:

$B

2015e

 
 

Down

Up

Rev

18.50

19.23

OCF

8.17

8.49

P&E Additions

3.89

4.04

P&E Additions/Rev

21%

21%

Interest Expense

To calculate the future interest expense, we need to estimate the corresponding amount of debt on the balance sheet. As of now, Liberty Global has 41.9B gross debt and its leverage ratio-defined as the ratio of gross debt and operating cash flow-is 41.9B/7.7B = 5.4. The management is targeting to reduce this ratio to mid-4s by the end of 2014. Given the estimated upside operating cash flow of 8.49B, the debt amount will be reduced to 8.49B x 4.5 = 38.2B. Applying the weighted average interest rate of 5.68% as shown in the most recent 10-Q filing, we can calculate the interest expense to be 38.2B x 5.68% = 2.17B by 2015. The details are summarized here:

$B

2013e

2015e

Debt

41.90

38.21

OCF

7.70

8.49

Leverage Ratio

5.40

4.50

Interest Rate

5.68%

5.68%

Interest expense

2.38

2.17

Tax

It is difficult to estimate Liberty Global's tax payment due to its large tax assets on the balance sheet. Some of the largest tax assets are shown in the table:

Country

Tax asset ($B)

UK

4.8

Germany

0.5

the Netherlands

0.7

Belgium

0.1

These tax assets are so large that Liberty Global need not to pay income tax for a couple of years in some of these countries, especially for its Virgin Media business in the UK. Actually, the most recent 10-Q filings for Liberty Global and Virgin Media show that they each paid 60m and zero cash for taxes, which is equivalent to an annualized tax payment of 240m for the combined company. For the purpose, we can conservatively estimate its future tax by applying the UK statutory tax rate 23%, as shown below:

$B

2015e

 
 

Down

Up

OCF

8.17

8.49

P&E additions

3.89

4.04

Interest expense

2.17

2.17

Income before tax

2.11

2.28

Tax Rate

23%

23%

Tax

0.49

0.52

The estimated 490-520m annual tax is quite conservative compared to the current 240m payment.

Share Buyback

Liberty Global is very aggressive in share buyback to create value for its shareholders. The management is targeting a 3.5B share buyback program in the next 2 years. Given its current market cap of 32B, this program will reduce its outstanding shares to 400 x (1-3.5B/32B) = 356m.

Upside/Downside

We can put all these together to estimate the FCF/share for both scenarios:

$B

2015e

 
 

Down

Up

Rev

18.50

19.23

OCF

8.17

8.49

P&E Additions

3.89

4.04

Interest expense

2.17

2.17

Income

2.11

2.28

Tax

0.49

0.52

FCF

1.63

1.76

Shares

0.356

0.356

FCF/share

4.57

4.93

The implied FCF growth rates for down and up cases are 3% and 7% respectively. These are much lower than the management's guidance of 15% FCF annual growth. It is likely that the P&E Additions will be lower than our estimate due to the reduced capital spending. Liberty Global's tax payment may also be much lower due to its tax assets on the balance sheet. If we use the management's guidance of the FCF growth rate, we have FCF = 1.52B x 1.15 x 1.15 = 2.01B and FCF/share = 2.01B/0.356B = 5.65/share, much larger than our upside case.

Taking the above conservatively estimated FCF/share, we can calculate the share prices under three scenarios:

  

2015e

 
 

Down

Base

Up

FCF/share

4.57

4.93

4.93

FCF yield

7%

5%

4%

Price

65.30

98.69

123.36

Pct Chg (NASDAQ:LBTYA)

-17%

26%

57%

Pct Chg (NASDAQ:LBTYK)

-12%

33%

66%

FCF yield is based on its historic variation in the past 2 years. For both A and K shares, the risk/reward is decent. The upside may be much larger if the management's FCF guidance is realized.

Conclusion

The European broadband service is underpenetrated and growing. Liberty Global is in a strong position to grow its market share and create value for its shareholders. Investors should take note and become owners of this excellent business.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Liberty Global: A Growing Company With Decent Upside Return