Turning to specific stocks, describe the upside you see in LodgeNet [LNET].
JB: LodgeNet is the leading provider of inroom hotel entertainment systems in the U.S., with – according to which segment of the market you’re referring – 50% to 80% market share. In return for longterm contracts, they do everything – lay cable, install televisions, maintain everything and bill it – while sharing a piece of the revenue with the hotel operator. This has always been a capital-intensive business during periods of high growth, but starting around 2003 the company started to have a large enough installed base that it could increase profitability while still growing. Not unlike a cable-TV provider, there’s no reason it can’t produce steady-state EBITDA margins of 30-35%.
In a deal last year with Liberty Media, LodgeNet bought its primary competitor, On Command, in what is one of the best synergistic deals I’ve ever seen. Except at the very lowest and highest ends of the hospitality market, there is virtually no one else providing a comparable service. The deal creates obvious long-term cost savings in equipment, networks and overhead, while also putting the company in a very strong position when contract renewals come up.
After first rising after the deal announcement, LodgeNet shares have been on a sickening slide since last summer. What’s going on?
JB: There’s an increasing concern the company bit off more than it could chew in buying On Command, fueled by the fact that everything isn’t happening as smoothly and quickly as expected. These guys are based in South Dakota and are the most non-promotional people you can imagine, which gives us confidence that the merger benefits will materialize, even if not on Wall Street’s timetable. The more fundamental fear seems to be similar to what’s dragging cable stocks down: that the digitization of media will somehow leave LodgeNet behind. Hotels are going to tear out LodgeNet systems and replace it all with an IPTV solution, or people are going to bypass LodgeNet and just watch TV and movies on their laptop or iPod.
Aren’t those legitimate concerns?
JB: Sure, but we believe the skepticism is grossly overdone. The company hasn’t just been sitting on its hands, and will continue to offer hotels a variety of solutions, including those with high-end interactive programming, advertising and Internet-access capabilities. Having such a large installed base is a big advantage – digital systems are actually easier and cheaper for LodgeNet to upgrade, while tearing things out to put in the dream IPTV system would be extremely expensive and require manpower which hotels are loathe to commit. Finally, LodgeNet is now the only real full-service offer out there. We think the last thing in the world hotel operators want to do is take over more responsibility for running their entertainment systems.
What growth in revenue and earnings are you expecting?
JB: The company should generate postmerger revenue this year of around $550 million and we expect free cash flow to come in around $30 million. That’s after an estimated $80 million in capital expenditures, which should be a post-merger high and which should come down materially from that level. In terms of acquisition synergies, we’re being extremely conservative in only assuming 2-4% annual revenue growth. As expense and capex savings take hold, we think free cash flow will hit $60 million in 2009 and $85 million in 2010, growing in our model by 4% annually thereafter.
How do you value the shares, currently trading around $15?
JB: On an enterprise-value basis, the shares are currently trading at only about 5.5x this year’s estimated EBITDA. Based on our discounted-cash-flow model – with, again, what we think are conservative revenue-growth assumptions – we think the fair value is easily in the high $20's. We’ve followed LodgeNet for years and talk to people in the industry all the time. Consultants will grumble about how the company is slow to do this or behind in the technology on that, but when we ask who they plan to recommend to their clients, they almost invariably say LodgeNet. That to us just reinforces the inherent competitive advantages the company has.