Qurate's Cash Flow Is Its Margin Of Safety

Summary

• Qurate's share price is down 45% over the last six months.
• Qurate's 2021 performance hasn't matched 2020 performance but the company continues to generate ample free cash flow.
• Management is committed to returning cash to shareholders via special dividends.
• Qurate has significant debt on the balance sheet, but repayments are long-dated and well spread out.
• Consistent dividends provide a sufficient margin of safety to shareholders despite a large debt burden.

Ben Gabbe/Getty Images Entertainment

Qurate Retail (NASDAQ:QRTEA) is down over 40% since I wrote up the company in March. The market is concerned because QRTEA's 2021 performance is lagging 2020 performance and the company's balance sheet is highly levered. Despite these concerns, I think QRTEA remains a low-risk investment due to its ability to generate cash flow and management's aggressive dividend policy. In this article, I will discuss QRTEA's margin of safety in more detail and focus on downside protection.

QRTEA's Debt Level is Large but Manageable

To a particular subset of investors (myself usually included), a large debt burden is a big red flag. An over-leveraged balance sheet opens the door to bankruptcy; you can't go bankrupt if you don't have any debt. QRTEA has a significant debt burden. The company has over $9b in short- and long-term debt against a current market cap of just $3b and a book value of $3.9b. However, the majority of this debt is not coming due anytime soon, and the principal repayments are well spaced-out. The principal repayment schedule looks like this:

(Source: Company 10-K)

Only 70% of the total debt comes due within the next decade, and only 30% comes due in the next five years. Despite a large overall debt obligation, the debt looks a lot more manageable when taking the principal repayment schedule into account. QRTEA's ability to generate cash flow also makes the debt more manageable.

Qurate Generates Consistent and Ample Cash Flow

QRTEA's history of cash flow is impressive. Looking back over the previous ten years, the company has averaged $1b in free cash flow per year, with a minimum of $675mm in 2011. The five year average is even better, coming in at $1.2b with a minimum of $825mm in 2019. 2020 was a record-breaking year; QRTEA generated $2.1b in free cash flow and $1.2b in net income. To summarize in table form:

FCF 10-yr min:	$675mm
FCF 5-yr min:	$825mm
FCF 10-yr Average	$1,000mm
FCF 5-yr Average	$1,200mm

Click to enlarge

QRTEA benefited from the trend of shopping more from home during pandemic lockdowns in 2020. 2021 has been solid but less impressive than 2020. Q3 revenue was down 7% YoY and net income missed analyst expectations. Despite a weaker Q3, which management blamed on supply chain constraints, QRTEA has generated over $500mm of FCF this year. Over the last five years the company has averaged $350mm in Q4 operating cash flow. Using history as a guide, QRTEA's final cash flow number will likely be similar to 2019's number. At worst I think we are looking at somewhere between $600 and $700mm in free cash flow. This could admittedly be the worst annual FCF amount in over a decade, but it is far from being a total disaster.

QRTEA is Returning Cash via Special Dividends

QRTEA's management has committed to returning substantial cash to shareholders via special dividends. This is a relatively new development; the company's first special dividend came in 2020 and another special dividend of $1.25/share was declared and paid in November of this year. Management, including new CEO David Rawlinson, have commented as recently as the Q3 conference call that they intend to "[return] the substantial majority of cash flow to our shareholders." Some of this return has come in the form of share buybacks, but it is the cash dividends that provide a margin of safety to investors. To illustrate the point, let's consider possible future dividend and debt repayment scenarios.

First, consider a "worst-case" scenario where QRTEA's average annual FCF drops to their ten-year low of $675mm. Let's also assume management runs on autopilot and pays out a consistent special dividend, even to the point of bankruptcy. I think there is 0% chance of this happening, but it helps to illustrate my point. The Debt Payments column tracks the principal repayment dates.

(Source: Author Spreadsheet)

The "blind dividend into bankruptcy" scenario results in QRTEA running out of money around 2025, after returning $1.5b in dividends to shareholders. At a market cap of $3b (at the time of this writing), the dividends in this farcical worst-case scenario still provide a 50% margin of safety against total ruin.

In a slightly more realistic scenario, consider the same situation but with the condition that management only pays a dividend equal to a given year's FCF minus scheduled debt repayments. In this case, QRTEA's balance sheet remains healthy, all debt obligations are comfortably met, and the company is still able to return over a third of the current market cap in dividends over the next five years:

This looks like a pretty safe bet to me. I'll get into opportunity cost risk and tax implications later on in the article, but I hope it is clear that the risk of absolute ruin for an investor is low and that the dividend payments act as increasing protection from total loss.

For reference, using the trailing 5-year minimum FCF value ($825mm) or the trailing 10-year average FCF value ($1b) result in safe and lucrative outcomes:

Assumptions and Risks

The scenarios above are not meant to be precise predications; they serve only to illustrate the point that QRTEA's cash flow and dividend policy provide a meaningful margin of safety against total ruin. I don't account at all for debt refinancing, adjustments to repayment schedules, stock buybacks, the ability to sell assets to raise cash in an emergency, etc. The core assumption of the scenarios is that QRTEA can continue to generate cash from their business at levels comparable to their historical performance. I believe that QRTEA's performance in 2021 demonstrates their ability to generate meaningful cash flow, even a difficult operating environment. That being said, there is no guarantee that this is the case, nor is there a guarantee that management will continue the special dividend policy.

A QRTEA investment is unlikely to result in total ruin, but there are two risks it is important to acknowledge: opportunity cost and lost capture of returns due to taxation. In a scenario where QRTEA, say, pays out its entire market cap in dividends over the next 5 years but then runs into trouble and goes bankrupt, an investor is protected against ruin (they got their investment back in cash), but getting a 0% return on a 5-year investment is still a poor outcome. The opportunity cost compared to average market returns is very high in that situation. If an investor owns QRTEA in a taxable account and is forced to give back 15% or more of their dividends in taxes, the margin of safety goes down and the potential opportunity cost rises. I own QRTEA in a tax-advantaged retirement account for precisely this reason. I acknowledge that this option isn't open to all potential QRTEA investors.

Conclusion

Despite poor stock performance and high leverage, I view QRTEA as a low-risk investment. The company's business model consistently generates cash flow adequate to cover their debt repayments and sizeable dividends provide an increasing margin of safety to investors. This article has focused on downside protection, but if the company is able to replicate even their worst performance years for the next five to ten years, investors at a $3b market cap will do very well. I am long QRTEA and plan to hold my shares indefinitely.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of QRTEA either through stock ownership, options, or other derivatives. 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.

This article is not financial advice, it is only an expression of my own opinions as an individual investor.