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Liberty Latin America (LILAK, 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. The company was spun out of cable giant Liberty Global (LBTYK) a few years ago, where under previous management it acquired and grossly overpaid for Cable & Wireless Communications (C&W). While C&W has some great cable and fiber assets, it was also a poorly run turnaround, and as the incumbent telephone company in many of its markets it faced years of declining fixed and mobile phone revenue even as the cable side of the business was growing nicely. The stock went into an extended swoon as a result, which only got worse when Hurricane Maria devastated Puerto Rico in September 2017 - though operations there have since fully recovered - and then collapsed when Covid struck. Recently the company announced a rights offering, which has introduced additional selling pressure, and the stock price is now near an all time low.
Current CEO Balan Nair left his position as chief technology officer at Liberty Global and took the reins at LILAK 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.
By Q4 2019 it was clear that management's strategy was working, as the company was generating strong and growing FCF while also posting excellent gains in cable and mobile subscribers. Meanwhile, the first elements of what will likely prove to be a long sequence of highly accretive acquisitions are in place, beginning with the closing of their $250 million acquisition of Cabletica in Costa Rica, plus the subsequent announced $1.95 billion purchase of AT&T Puerto Rico, which is set to close in Q4 of 2020, and the $500 million acquisition of Telefonica's fixed and mobile assets in Costa Rica, which is set to close in 2021.
Q1 2020 would likely have been seen as a huge success as C&W had been successfully turned around, with 6% YOY OIBDA growth (operating income before depreciation and amortization), due to stabilizing legacy mobile operations, solid growth in cable and B2B services, and the early fruits of management's efforts to make legacy C&W as efficiently run as the rest of the company. But then the pandemic hit, and instead of being seen as a superbly managed growth company that successfully executed a turnaround, LILAK is instead seen as company with 3 strikes against it: an emerging market, levered, old fashioned telco. The price responded accordingly, and then dropped even more as technical selling from the rights offering pressured the stock to an absurd low.
The market is pricing in disaster, but this does not reflect anything close to reality. Business has held up well during Q2, is improving month by month, insiders are buying the stock hand over fist, and the company was able to issue $1.15 billion of new long term 2028 debt at a bit over a 5% yield. All this speaks to a huge mispricing in the stock.
The business held up remarkably well in Q2, announcing strong FCF in the quarter and subscriber additions in their Q2 earnings presentation. And they offered strong words of encouragement, saying in the Q2 EPS transcript:
Following a strong first quarter, as anticipated, our performance in Q2 was negatively impacted by the pandemic. April was a low month. On a positive note, we started seeing improvements in May. And then in June... even as the situation remains challenging in most markets, we have seen our business improve month-over-month. As a matter of fact, July is also better than June... Despite this difficult backdrop, we added 47,000 broadband subscribers... our focus has been on cash generation, and we reported adjusted free cash flow of $130 million in the quarter...
And finally, last week, we were excited to announce the acquisition of Telefónica's fast-growing Costa Rica Mobile business. Together with Cabletica, which itself has been a great growth business for us, this combination will create a fantastic opportunity to deliver a leading converged offering in one of the region's best markets.
I note that Q2 is a seasonally strong quarter for them for FCF - only Q4 is better - and that some of the adjustments they impose add back meaningful amounts of FCF for things like the unclosed acquisition in AT&T and stock based compensation. But even after adjusting for seasonality, and then subtracting stock based comp, it's still strong FCF for the quarter despite extreme pressure from the pandemic. And they did this without engaging in any mass layoffs, without reducing CAPEX below normal as a percent of revenue, and without disconnecting customers who are unable to pay them due to the pandemic:
Now the reason I feel bullish about it as well is in the second quarter, we took a lot of broadband customers that are actually receiving services from us off of our RGU count... they were not really disconnects and you will see them naturally come back. They still have our modems in their home... built a lot of goodwill with a lot of customers, where we've chosen to do the right thing... to make sure that they still have service even though that they can't afford to pay at this point. And I feel that will payback in many ways.
So to sum up, they haven't cut employees or customers or reduced investing in the business, and they grew subscribers, and they generated FCF, all during the worst pandemic since 1918. And things are getting better for them, with April the worst, then May better than April, June better than May, and July better than June.
Here are my conservative projections through 2025. I assume a full recovery from the pandemic in 2022, use modest growth assumptions, and - importantly - I don't include any additional accretive M&A.
|in $millions, except per share numbers||2021||2022||2023||2024||2025|
|OIBDA - P&E additions||1,033||1,322||1,370||1,420||1,471|
|Taxes and minority interests||207||249||258||268||278|
|FCF before SB comp||278||538||578||603||629|
|Share based comp||75||50||52||53||55|
|Net debt at year end||8,577||8,542||8,799||9,063||9,334|
|Net leverage at YE||4.55||4.00||4.00||4.00||4.00|
|YE share count (millions)||232||219||201||186||172|
|YE share price||$19.91||$34.17||$43.80||$54.81||$61.00|
In the model above I compute pro-forma numbers for LILAK assuming the AT&T PR and Telefonica CR acquisitions close at year end 2020, and other than that I follow guidance from management. Management has not provided a growth forecast, so I model a CAGR of 2% in revenue and 3% in OIBDA, reflecting modest growth assumptions and operating leverage in the business. For legacy LILAK, I use actual 2019 data, but which are updated to reflect current foreign exchange rates. In 2022 I add in $85 million of efficiency savings, split evenly between CAPEX (P&E additions) and operating costs, in line with guidance that OIBDA less P&E additions will be 25% of revenue in 2022. For the acquired operations I assume zero synergies in 2021 and $70 million beginning in 2022, once again reflecting guidance. Finally, in 2021 I impose a one time 5% "penalty" to revenue and OIBDA, reflecting the potential hangover impact from the pandemic.
I assume all FCF is used to reduce leverage until they reach a target leverage of 4.0x, right in the middle of their stated 3.5 to 4.5 target range, and after that all FCF is used to repurchase shares. I assume they hold $500 million in cash, and the interest rate is constant at the current 5.9% blended average rate. LILAK can be a bit of a black box when it comes to taxes and minority interests, so I use actual 2019 numbers for legacy operations, scaled up in proportion to [OIBDA less P&E additions] as the company grows, and for acquired operations I assume a 30% cash tax rate.
During the Q2 2020 earnings release the company announced its intention to issue a substantial number of new shares, increasing the share count by roughly 27% through a rights offering, which would raise roughly $350 million of new equity. The company's stated reason was:
We feel this is an appropriate step to ensure we have flexibility to participate in accretive M&A opportunities, while maintaining a prudent capital structure.
I note that in my own model that without the capital raise the company would end 2021 at 4.74x leverage, above their high end target range of 4.5x. My model does include a 5% Covid related hit in 2021, and does not include any of the $70 million in synergies or $85 million in efficiencies the company has projected for 2022. If one were to include those on a pro-forma basis, then leverage without the capital raise would be 4.47 without the capital raise and 4.29 including it. No matter how you look at it, in order to participate in more M&A and also to stay within their self imposed 4.5x upper leverage target, they needed to raise some cash.
The market responded quite negatively to the news - especially considering just how strong the second quarter results had been - driving the share price down from $9.22 right before the announcement to $7.79 the next day. However, the response from company insiders is quite telling, with senior management and all members of the board committing substantial new capital to the raise, including $20 million from board member Eric Zinterhofer, $20 million from legendary cable investor John Malone, and open market purchases from both the CFO and CEO.
Regardless, the capital raise is now complete, and the associated technical overhang is over.
LILAK is a superbly managed company with great cable assets. The business had been successfully turned around, with the growing cable business finally overtaking the declining legacy phone company, just in time for the pandemic to send the share price into a massive tailspin. The price then went even lower after the company announced the now completed rights offering.
Despite this, the company remains FCF positive even in the teeth of the pandemic, and trades at an absurd price relative to conservative estimates of future earnings, suggesting that returns of 5 to 10 times over the next 5 years are completely realistic. Reflecting this, company insiders are acquiring shares at a rapid rate, both through the rights offering and in open market purchases. I think this makes all the sense in the world.
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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.