Liberty Latin America
In October 2017, the Fund began building what has currently become an approximately 10% investment in Liberty Latin America Ltd. (“Liberty LatAm”). Liberty LatAm is a leading cable and mobile telecom provider to twenty consumer markets and over thirty commercial markets across Latin America and the Caribbean. Liberty LatAm’s services include broadband internet, cable TV, fixed-line telephony, mobile, and a suite of other value-added business-to-business offerings. The business is competitively entrenched in low penetration markets, has a series of attractive projects offering high incremental returns on invested capital, and has the opportunity to acquire complementary companies within its geographic footprint to achieve superior operating scale. Liberty LatAm is led by an experienced team including John Malone, Mike Fries, and Balan Nair, a group of disciplined capital allocators who have created enormous shareholder value in the telecom and media industries over the past forty-plus years. Recently spun off from Liberty Global, Liberty LatAm stock has languished even as the company’s future earnings power has become more apparent, creating a meaningful discount between the company’s stock price and our conservative estimate of its intrinsic value.
Cable is a Good Business…In the Right Markets
The demand for faster internet access continues to grow, driven by the addition of new users and ever-increasing data needs as users consume more content online. Demand for streaming video is the biggest driver of this increase in data usage. Most people are well aware of the surge of subscriptions for over-the-top services like Netflix, Hulu, and Amazon Prime, but a large number of other applications and services such as Facebook, Instagram, and Snapchat deliver video at increasing volumes. Consumers are requiring this streaming video be delivered at higher qualities, and this trend will continue apace with the adoption of 4K streaming, greater interest in virtual reality, and whatever technology comes next.
Cable companies are well-positioned as the data pipeline (internet service provider) of choice to meet this demand. In a typical market in which Liberty LatAm operates, the primary competitor to a cable provider’s offering is a DSL (copper) network delivered by incumbent telephone companies. Through a hybrid fiber-coaxial (HFC) network, cable operators offer a superior product because the maximum delivery speeds possible on thin copper telephone wires, per physics, are slower than what can be delivered on HFC. This advantage for an HFC network translates into broadband speeds of up to 300Mpbs versus only 5Mpbs for DSL. This difference becomes critical for the user as high definition video requires broadband speeds of at least 5Mbps and 4K video needs 25Mbps – speeds that DSL barely can and fundamentally cannot meet, respectively. Of course, higher speeds also offer a superior internet surfing experience across multiple devices in a home. In an increasingly digital world, we expect consumers to be relatively price insensitive for the superior internet speeds provided by cable companies.
Incumbent cable companies enjoy a favorable competitive structure that tends to reduce direct competition. With high up-front capital investments to build out networks and a low marginal cost for offered services, second movers/competitors have little financial incentive to overbuild or replicate a network, as that effort would destroy profitability and impair invested capital for both players. If a cable operator has already passed a house, it is much cheaper for that operator to sell services to that home than it is for another cable operator to build a new network to reach that house. And it follows that because the marginal costs of bundling additional services to existing customers are low, the incremental profit margins are high.
Liberty LatAm enjoys these complementary advantages of having a superior offering versus the next best technology (DSL) and a disincentive for fellow cable operators to compete and applies them to geographic markets with lots of room for growth. As people and countries become wealthier (i.e. as per capita GDP grows), they consume more broadband internet service:
As this chart reflects, most of Liberty LatAm markets have considerably lower penetration rates of broadband internet and other advanced fixed network technologies than are found in the developed world. In its markets, Liberty LatAm has clear opportunities to deploy capital efficiently by laying fiber and cable in high density housing areas. Each home that the company’s HFC network passes adds a potential customer for multiple services. In most of its operating footprint Liberty LatAm offers a “triple-play” bundle of services that includes broadband internet, cable TV, and fixed-line telephony. Where available, the company also bundles a mobile offering with these triple-play services to offer a “quad-play.” This breadth of services allows Liberty LatAm to cross-sell its offerings at attractive margins. Liberty LatAm is earning incremental returns on capital in excess of 20% on these investments to pass new homes.
As explored above, we expect the demand for broadband internet service to continue to grow for the foreseeable future, particularly in Liberty LatAm markets. The future of its other fixed residential service — namely cable TV and fixed-line telephony — are less certain. About 19% of the company’s 2017 revenues came from cable TV. While cable TV will be under both pricing and volume pressure as over-the-top alternatives (e.g., Netflix) continue gathering subscribers, cord-cutting is much more prevalent in the U.S. than other markets due to the historically high prices of cable TV in our country. Outside of the U.S., cable TV is much cheaper, and it provides some of the best value per entertainment dollar spent (expressed in cost per hours of content consumed). In fact, in many of Liberty LatAm markets cable TV remains underpenetrated and aspirational. With these cheaper prices, the incentive to cut the cord is greatly decreased, which makes cable TV revenues defensible and stable for some time. Management could even further decrease cable TV pricing and still have a profitable offering. We are less confident about the company’s fixed-line telephony offering given the trend toward mobile-only households. Notably, a recent CDC survey indicated that nearly one in two households in the U.S. still have a landline, which suggests that fixed-line telephones may hang around for longer than is typically expected by the market. In any case, this service is less than 10% of Liberty LatAm total revenues, and its decline is incorporated in our expectations for the company’s future earnings. To the extent the offering remains stickier than we anticipate, owner earnings generated by these subscribers are largely a bonus.
Strong Competitive Positioning in These Attractive Markets
Liberty LatAm is currently organized in three geographic segments:
- Under the VTR name, Chile is the single largest Liberty LatAm market at just under 30% of the total company’s revenues and profitability. Chile is the richest country in Latin America with a liberalized economy and an expanding middle class that has a growing appetite for broadband internet service. Regarded as the best cable operator in Latin America, VTR is the market leader and enjoys 55-60% share across all parts of its residential triple-play bundle – broadband, cable TV, and fixed-line telephony. VTR is also growing mobile subscribers via a quad-play bundle. With significant investment already in place (3.4 million passed homes) and more ongoing, we are optimistic that VTR can further grow its market share. This effort is aided by VTR broadband speeds, which are twice as fast as that of its closest HFC rival and serve as a competitively-advantaged entry point to cross-sell its bundle. VTR is already highly profitable and the business can further expand margins as it captures additional market share and grows revenues.
- The largest overall segment of Liberty LatAm’s business, accounting for roughly two-thirds of total sales and profitability, is Cable & Wireless (“C&W”). C&W is an integrated telecommunications provider in a variety of Caribbean markets, including Panama, Jamaica, Trinidad & Tobago, and the Bahamas. Representing about 40% of the segment’s overall revenues, mobile telecom services (both consumer and commercial) are the largest portion of C&W business, with fixed residential services and a regional undersea network making up the bulk of the remaining business. In general, mobile has less favorable return characteristics than Liberty LatAm’s other service lines as its less-sticky customers tend to invite more motivated competition. However, C&W generally operates in a duopoly with Digicel, a formidable but highly-levered (currently at about 6.5x EBITDA) regional mobile player. Earlier this month, Digicel’s bond yields spiked as bondholders became more and more nervous about the company’s sluggish operating performance and ability to refinance its obligations in 2020.
- Digicel’s financial constraints will likely keep the company’s competitive aspirations in check and facilitate a harmonious cohabitation of the two players. Connecting 40 countries, C&W’s undersea network is a unique strategic asset which we expect to grow more valuable as regional broadband consumption increases, and we also expect it to unlock synergies in regional acquisitions. Liberty LatAm is continuing to improve the profitability of C&W, which itself was the result of the merger of C&W Communications and Columbus International in 2015. Since it acquired C&W in 2016, Liberty LatAm management has been focused on taming the company’s bloated cost structure, and the team expects to realize $150 million in annual savings by 2020 via headcount reduction, improved equipment procurement, and scale content acquisition.
- Lastly, Liberty LatAm operates in Puerto Rico under the brand Liberty Cablevision. This business currently represents about 10% of total revenues and profitability. Liberty Cablevision has proven to be a wonderful business with among the highest cable EBITDA margins in the world:
While Liberty Cablevision faces macro and demographic headwinds, the company does have an opportunity to gain market share at the expense of its sole fixed-line competitor, American Movil. Liberty Cablevision has entry-level speeds of 100 Mbps while Movil’s DSL offering is significantly slower. Hurricanes Maria and Irma had devastating effects on the island’s electrical grid and a material impact on the segment’s 2017 operational results. We are closely monitoring recovery of Puerto Rico, particularly changes in the island’s population, which was already contracting before the storms due to the island’s financial difficulties and has accelerated in the last six months as the island has struggled to get back on its feet. In the face of these challenges, Liberty LatAm progress on its own network restoration has been laudable. As of early February 2018, over 60% of Liberty Cablevision customers were back online (from ~0% after the storms), and the restoration should be largely complete during the second quarter. At this pace of recovery and with some stabilization of overall populations levels, we expect a strong financial recovery by 2019, which would again make Liberty Cablevision a cash cow for Liberty LatAm.
Thinking beyond the company’s existing Latin American and Caribbean markets, Liberty LatAm is positioned to become a scale player in a region that currently lacks one. Liberty Global CEO and Liberty LatAm Executive Chairman Mike Fries is on record stating, “There is a massive consolidation opportunity in a market that remains highly fragmented.” A prime example of management’s ambitions as a consolidator is the recently announced acquisition of Cabletica, a cable operator that passes 40% of homes in Costa Rica. This all-cash acquisition will leverage Liberty LatAm equipment and content economies of scale, vast subsea fiber network, and operational expertise to improve profitability within the Costa Rican market. Management plans to continue pursuing these types of strategic add-ons, especially if they can be accomplished at similarly-attractive valuations as this Cabletica transaction (just over 6x EBITDA post-synergies). In the most recent earnings call, Fries shared, “The deal we just announced in Costa Rica, which we’ve been working on for over a year, is a great example of that. And I’ll tell you, the pipeline is full of both large and small opportunities.”
Great Partners (Who Are Increasing Their Ownership)
If you’re going to ask about quarterly earnings, you’re at the wrong meeting, and you probably own the wrong stock…What we care about is value. We want to create value for our shareholders. And I think the best way to create value is to have a very long view, so that’s what we do. So when we have the opportunity to expand into an area we think is going to have long-term value, we do it. We don’t have to worry about the impact on earnings. So it makes a different kind of organization.
John Malone, Cable Cowboy: John Malone and the Rise of the Modern Cable Business
Liberty LatAm was formed and is led by a group of Liberty Global veterans who have created an exceptional amount of value for shareholders over more than four decades through operational excellence and prudent capital allocation. We share their views about the importance of long-term value creation and are thrilled to be partners with this group, which is led by telecom and media billionaire John Malone. Malone sits on Liberty LatAm’s Board of Directors and is a member of its Executive Committee alongside Liberty LatAm CEO Balan Nair and Mike Fries. Beyond Mr. Nair, Liberty LatAm management team is full of executives recruited from across other Liberty Global businesses, giving them deep experience in global cable operations and an ability to bring best practices to bear on Liberty LatAm’s markets.
Importantly, insiders have been increasing their ownership in the company. Malone has led the way, significantly increasing his stake in the business in 2017 with stock purchases totaling $37 million at share prices above current levels. He now owns 6% of Liberty LatAm economic interest and controls 25% of its voting interest. Several directors and officers within Malone’s sphere have also acquired shares in the last year. Additionally, as is typical in Liberty-related businesses, management is well incented to grow the per share value of the business.
As investors, our overarching goal is to identify businesses that are materially mispriced by the market and sell below their intrinsic value. The search for this margin of safety leads us to devote the bulk of our research efforts on companies that are either undiscovered or unloved by other investors. Overlooked companies tend to be smaller in size and/or located in emerging markets, where dedicated investors can create meaningful informational advantages. On the other hand, out-of-favor businesses are often found in plain sight but evoke undue pessimism for one reason or another. Both undiscovered and unloved businesses can reward investors who have long time horizons and patience. Liberty LatAm, whose stock price has declined roughly 50% since its high-water mark as a tracking stock, falls into both categories for a number of reasons:
- Before being spun-off as an independent business at the end of 2017, Liberty LatAm was a Liberty Global tracking stock. Tracking stocks are typically more complex to analyze, which was true of Liberty LatAm financial results during this time. Disclosure was scattered, and information was buried deep within Liberty Global broader financial reports. Further complicating matters, reported results were distorted by one-off charges and integration costs from acquisitions.
- With Liberty Global owners receiving shares of Liberty LatAm from the spin-off, a much smaller Latin American operation ended up in the hands of investors who were holders of a mature European cable operator. Europe-focused funds were forced to divest their new Liberty LatAm stake, and a number of other investors were simply uninterested in holding a business with such a different profile from their original Liberty Global holding.
- The option to cut the cord — consumers choosing to forego pay TV and replace it with cheaper over-the-top subscriptions like Netflix — has disrupted cable TV value proposition for consumers and decreased market valuations for the industry. This trend is continuing in the U.S., but for the pricing and value reasons discussed earlier we have found that this trend is not nearly as pronounced in Liberty LatAm markets.
- The potential disruption from a shift in wireless technology from 4G to 5G has been a focus of our research. 5G promises to reduce latency and increase wireless speeds by at least a factor of 10. Many believe this new technology will replace broadband internet and, in the process, reduce the need for the fixed network infrastructure provided by cable operators. We believe 5G is still a few years from being commercially deployable in Latin America, and our research suggests that HFC networks will remain a superior method of transporting data to most homes. Telecom equipment giant Huawei Chairman Eric Xu recently said, “while 5G was faster and more reliable, consumers would find no material difference between the two technologies.” Wirelessly transporting the gigabytes of data that most broadband customers use would be prohibitively expensive. Additionally, we expect the mobile telecom providers will need the cable operators’ HFC networks to deploy all of the new antennas necessary to roll out 5G.
- Poor reported earnings in 2016 and 2017 pushed Liberty LatAm even further out-of-favor. A couple of factors weakened the numbers. The first is structural and reflects the preference of John Malone-controlled businesses to use debt and rapid depreciation schedules to minimize taxes and maximize shareholder returns. This “levered equity” model results in financials that are unattractive at first glance when analyzed with traditional metrics. During this period, Liberty LatAm showed elevated leverage ratios, negative net income, and interest coverage of only one times operating income. The second factor was a confluence of events that created temporary declines in earnings that we expect to normalize in the next year or two. Sizeable integration costs following the C&W acquisition and the effects of hurricanes Maria and Irma were the main culprits. The hurricanes will have an ongoing impact on Liberty Cablevision results in Puerto Rico for at least another year.
Our ultimate input in determining intrinsic value is not reported net income in current periods, but rather long-term owner earnings. On this basis, Liberty LatAm profitability is much more attractive, and leverage is less pronounced, especially when normalizing operating results for hurricane recovery in Puerto Rico and the full realization of synergies following the C&W acquisition. Furthermore, Liberty LatAm’s depressed free cash flows can only be appropriately understood when differentiating between growth and maintenance capital expenditures. A large portion of the company’s historical and expected future capital expenditures are high-return growth investments to upgrade its network and to pass more homes — both of which are critical to future earnings growth. Importantly, much of this upfront investment is being made ahead of anticipated consumer behavior. As long-term investors, we whole-heartedly support this decision to depress current earnings and cash flows to realize even more earnings in the future.
Despite all the noise in its recent results, Liberty is a cash-generating machine led by intelligent capital allocators whose interests are aligned with ours. We expect the company to produce a double-digit owner earnings yield within a couple of years. We are pleased to be long-term partners with this first-rate team as it applies superior operational practices to competitively-entrenched businesses that have attractive reinvestment opportunities and room for growth.