Views On Liberty's DTV Swap

One-time cable empressario John Malone’s Liberty Capital (LCAPA), a grab-bag of investments, said Friday that the company is swapping its holdings in Rupert Murdoch’s News Corp. (NWS) in return for a controlling stake in satellite TV operator DirecTV (DTV), which Malone likes because he doesn’t end up paying taxes on the appreciation in his News Corp. stock, up 35% this year.

And there’s a wide divergence in the reactions emerging:

Andrew Baker, Cathay Financial: Liberty doesn’t get much that would move the needle for the stock from the deal, and as such, it should focus on take some of DirecTV’s cash (about $2.27 billion) and using it to buy back shares of LCAPA. Baker has a $92 price target on LCAPA, below the current price, and says that that represents a 35% discount to the value he places on all of LCAPA’s properties, roughly $141 a share. Buying back LCAPA shares might help close some of that discount, he writes.

Matthew Harrigan, Janco Partners: Harrigan likes the prospects of the DTV buy for Liberty quite a bit. “We view this deal as the rare transaction that will emerge as a major positive for both parties […] We think that Liberty is quite likely to revamp DirecTV’s underleveraged capital structure through aggressive share repurchases and possibly even a special dividend […] the issue now becomes whether LCAPA reduces its interest to the 25% necessary for control, maintains the 38.5% status quo, or (more remotely) eventually rolls in all of DTV so as access its cash flow for other purposes.” Harrigan has a higher net asset value on the Liberty Capital properties following the deal, at $147 a share compared to Baker’s $141, and he says that applying a 20% market discount to those holdings gives Liberty Capital shares a target price of $117, up from Harrigan’s prior target price of $8.

For Malone, it might be worth taking the cash out sooner rather than later. In a report on Nov. 10, Sanford Bernstein satellite analyst Craig Moffett wrote that cash flow has been deteriorating at both DTV and at competitor Echostar (DISH) because of rising subscriber churn (people fleeing to cable, I would presume), and that such a trend doesn’t bode well for the value of either satellite firm:

Higher churn contributed directly to a sharp 25% sequential decline in Steady State Cash Flow (SSCF) at DirecTV during Q3. Surprisingly, the stock traded up in response. The drop in SSCF was more modest – but was a drop nonetheless – at EchoStar, which has similarly rallied. […] The reaction of the markets has been surprising. Inflections in Steady State Cash Flow (SSCF) – which normalizes cash flows by differentiating between customer acquisition expenditures on growth and churn replacement – have historically proven to be good predictors of stock price inflections. If the correlation continues to hold, a corresponding inflection in DBS share prices could follow. […] Moreover, we expect further contraction in SSCF over the coming year, as Retention Marketing expense rises – especially at DirecTV – in response to pent-up demand for HDTV.

(And in case you were curious what it means for Rupert, Goldman Sachs media analyst Anthony Noto likes the deal as it concerns News: he says the swap removes “a long-term overhang” in News Shares, allowing Rupert to continue with share buybacks that will boost per-share earnings for the next two years and will allow investors to focus on things other than DTV, like News’s investment in interactive properties such as MySpace.)

For the moment, Malone’s fans certainly seem happy with the transaction: Liberty Capital shares are up almost 5% today, at $98, and almost 40% since they started trading back in early May. NWS shareholders are not as thrilled, pushing down NWS shares during normal trading by half a percent, and again slightly after hours at $22.33.

UPDATE: A report from Richard Klugman with Prudential Securities makes the case that satellite may be the only hope for telephone companies wanting to offer video to their phone customers, because Verizon’s (VZ) current approach, FiOS, is too expensive to deploy, and AT&T’s (T) approach, Project Lightspeed, hasn’t shown it can really serve up video competantly to thousands and thousands of customers:

[W]e expect DBS partnerships to expand in 2007 as they have proven to be useful for both phone companies and DBS companies to combat the common cable company enemy. Over the last two quarters, phone company bundles have represented nearly two thirds of DBS subscriber additions. (Admittedly, this statistic is overstated because some of the DBS-phone-bundle additions were previously stand-alone DBS customers.)

BellSouth (BLS) remains the most successful RBOC (Regional Bell Operating Company) with over 7% of its consumers on a bundled offer with DirecTV DBS service, nearly double the 2%-4% range of its peers. Qwest (Q) has begun making a big DBS push, adding 1.4% of its consumers with DBS bundles in thirdquarter 2006 alone. We expect AT&T to ramp up its DBS sales with EchoStar (DISH) as the companies are now rolling out their joint “Homezone” service, allowing a combined DBS-DSL service with large pay-perview libraries over an integrated DVR-equipped set-top box.

While it might not represent a perfect option, DBS resale and integration with DSL through Homezonetype services might ultimately turn out to be a better option for phone companies than building out their own video capabilities. Intuitively, it’s hard to envision phone companies ever building viable business plans as the fourth entrant in a mature, capital-intensive video market, especially when considering their scale disadvantage on programming costs, which are by far the greatest expense for video providers. If fiber-to-the-home proves too expensive and IPTV too difficult to scale, investors should ultimately expect to see tighter integration between the traditional phone and DBS industries.

DirecTV shares closed down about 2% Friday at $24.55, while DISH rose slightly to $37.75. The two are up 74% and 39% this year, respectively.