A Hidden Gem At Liberty Latin America

Summary

• New management is executing on its bold strategy to sharply turn around this cable/mobile operator, and then roll up the industry.
• The company will close on its first highly accretive acquisition, AT&T Puerto Rico, in mid 2020. The stock was up 10% on the news, not nearly enough.
• The turnaround is working. After years of negative FCF, the company achieved positive FCF in 2018, grew to $223 million in 2019, and now boasts an 8.1% FCF yield.
• 2020 FCF guidance of $150 million (which excludes contributions from AT&T assets) grossly understates the company's current cash generating power, which is roughly $300 million today and heading much higher.
• They're holding an extra $2 billion of debt, with annual interest ~$125 million, to fund the upcoming acquisition. Guidance includes this interest expense, but nothing from the assets being acquired.

Liberty Latin America (NASDAQ:LILA) is a cable and mobile operator in Puerto Rico, Chile, Panama, Costa Rica, and the Caribbean, and also owns an extensive subsea and terrestrial fiber optic cable network that connects over 40 markets in the region. LILA is typically the number one or two player in all their markets. The company was spun out of cable giant Liberty Global (LBTYK) a few years ago, where under previous management it had acquired and grossly overpaid for Cable & Wireless Communications (C&W), sending the stock price into an extended swoon. This only got worse when Hurricane Maria devastated Puerto Rico in September 2017, disrupting one of the company's best markets.

Current CEO Balan Nair left his position as chief technology officer at cable giant Liberty Global and took the reins at LILA on October 2017. He immediately introduced a bold vision for the company. First, by deploying industry best practices, the company would turn itself into a growing FCF machine. And second, he would attempt to roll up the industry in the region with highly accretive targets. Synergies can be a dirty word in the minds of some investors, but in the cable space they are very real.

Both the turnaround and the roll up have begun, as can be seen in the company's Q4 2019 earnings call presentation. The turnaround is evident in their consistent strong gains in cable and mobile subscribers, the return to operating cash flow (OCF) growth, and the strong FCF generated. The first major element of what may prove to be an ongoing series of highly accretive acquisitions, which will close in mid 2020, is their $1.95 billion purchase of AT&T Puerto Rico. The company paid a "mid 6's multiple" on OCF for this business excluding synergies, and low 5's including them.

The Hidden Gem

In their Q4 2019 earnings call LILA guided to $150 million of FCF for 2020, after announcing $223 million in 2019. The latter was aided by favorable working capital of perhaps ~$25 million that will unwind in 2020. Adjusting for this, FCF in 2019 would have been ~$200 million, and guidance for 2020 would be $175 million. Their FCF guidance excludes any contribution from the acquired assets, as they say in their Q4 2019 earnings call:

we have laid out our 2020 public guidance targets, excluding the AT&T assets, and we will revisit our targets as needed post close of that transaction.

But - and here's the main point - they are already holding the $1.95 billion of cash they are going to use to pay to AT&T at closing on the balance sheet right now, along with an extra $1.95 billion of debt. They are paying ~$125 million of interest on that debt right now, and will continue to pay it throughout 2020, but they don't offset this hit to FCF guidance by including any of the earnings power of the assets they are buying. Normalized for these two items, the 2020 FCF run rate would be $300 million, or double the $150 million guidance.

Estimating FCF

Let's crunch some numbers and see if we can confirm this. Modeling their FCF is tricky because of the uncertainty forecasting cash taxes (which are a bit of a black box), cash payments to noncontrolling interests, vendor financing, and changes in working capital. Cash taxes and payments to noncontrolling interests over the past 3 years were:

	2019	2018	2017
cash taxes	$130m	$146m	$111m
payments to noncontrolling interests	$38m	$23m	$46m

Click to enlarge

I estimate FCF as: operating cash flow (OCF), minus

• P&E additions (which avoids the vendor financing issue)
• interest
• cash taxes
• cash distributions to noncontrolling interests

For 2019 this is $206 million. Reported FCF was $223 million, reflecting the working capital benefit they called out, and some unknown adjustment for vendor financing.

Now let's forecast FCF for 2020. They guided to low to mid single digit rebased OCF growth, and P&E additions equal to ~18% of revenue. I will assume 1% rebased revenue growth and 3% rebased OCF growth, in line with guidance, and then adjust for FX at the end. Interest on $8.5 billion of debt at 6.3% is $536 million, up $91 million from 2019. I'll use the same cash taxes and payments to noncontrolling interests as 2019. Crunching all the numbers, that's:

$1,587m OCF - $702m P&E additions - $536m interest - $130m cash taxes - $38m cash payments to noncontrolling interests

=$181 million of 2020 FCF.

Adjusting for FX at the time of their guidance puts this at $175 million. But note the huge increase in debt service over the already inflated number from 2019! If we were to exclude both the AT&T assets and interest on the associated debt, FCF would be ~$125 million higher, or about $300 million.

FCF After Closing On AT&T Puerto Rico

What if we were to include both the cash generated by the acquired assets and the interest on the associated debt, instead of just the latter (as the company has done) or neither (as I computed above)? Since the debt service is already subtracted from the guidance, all we have to do is start at $175 million (normalized for the one-time working capital item) and add in cash generated by the assets. Here's what we know about the AT&T assets:

• $850 million revenue
• $300 million OCF excluding synergies
• Low teens P&E additions as a percent of revenue
• => ~$120 million P&E additions at e.g. 14%
• $70 million annual synergies, starting 1 year after closing and fully realized after 3 years
• Merger related expense complete after 18 months

This is $180 million of pre-tax FCF that needs to be added in, not including the $70 million in synergies. At a 30% effective tax rate - just a guess on the rate since I'm really not sure what to do about their taxes - this is $125 million without synergies, and $175 million including them, of additional fully taxed FCF.

My guess is there won't be much FCF from AT&T in 2020, since there will be merger related expenses, and because they will only own it a half a year. But in 2021 it might be $125 million, and then ramp up from there. So that's $300 million for 2021, if they hit their guidance and if there are no other changes in their business.

But we also know they are expecting meaningfully better results from their legacy operations over the next couple of years. They've guided to OCF - P&E additions in the mid 20%'s as a percent of revenue by 2022. At 25%, pre-tax FCF would be up another 2.3% of revenue, or $90 million, and perhaps $70 million after tax. If half of this is achieved in 2021, and if they grow 3% a year aside from this, FCF will be:

• $150 million in 2020
• $345 million in 2021
• $400 million in 2022
• $450 million in 2023

That's after tax and after minority interests. It also assumes the cash being generated is put in a box and buried, and isn't used to pay down debt or used for M&A etc.

Conclusion

The market has missed a hidden gem in the true FCF generating capability at LILA. The company's $150 million in FCF guidance for 2020 is artificially suppressed due to the exclusion of the earning power of the about to be acquired AT&T Puerto Rico assets set to close mid 2020, while at the same time including the interest cost of the associated debt. The stock price has pulled back near historic lows during the recent market correction, and trades at 8.0x FCF on 2021 numbers. This is way too cheap for a growing, well managed company.

Analyst’s Disclosure: I am/we are long LILA. 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.