LiLAC Group: Liberty Global's New Tracker

I realize LiLAC has been covered plenty on Twitter and other blogs, but I just wanted to memorialize my thoughts along with some of those in our recent CFA Society Chicago's Special Situation Research Forum meeting.  Others have provided far better financial models than I could create, so I'll focus more on the qualitative reasons why LiLAC is attractive and why the opportunity exists despite John Malone's track record.

Overview/Background
LiLAC Group is the tracking stock that began trading on 7/2/2015 to represent Liberty's Latin American and Caribbean ("LiLAC") Group assets.  Liberty Global, is of course the John Malone controlled entity which sought to recreate the original TCI in international markets, that story is mostly complete in Europe now they're switching their roll-up focus to Latin America.  LiLAC Group today is made up of two entities, 100% ownership in VTR (Chile's largest cable company and around 70% of LiLAC's revenue) and 60% ownership in Liberty Cablevision Puerto Rico which recently completed the purchase of Choice in June 2015.  In total, LiLAC passes approximately 4 million homes, has 3.2 million RGUs off of 1.5 million customers.  The accounting is muddied up enough as it is, so I'm going to discuss LiLAC without adjusting for the minority interest in Liberty Puerto Rico, in the end it doesn't make much difference.

Why a Tracking Stock?
Liberty Global co-CFO Bernie Dvorak said at the annual meeting, "LiLAC tracking stock represents another milestone and we're eager to take advantage of this new structure to tap into further growth opportunities in the region."  John Malone seems alone in having success with the tracking stock structure, it's rather rare at least in U.S. markets but it creates a potential acquisition currency, capital allocation flexibility and allow's management to highlight the value of a particular set of assets, all while keeping the tax and cost advantages of one balance sheet together under one corporate umbrella.

• The Latin American cable market is still relatively early in its development, much of the population doesn't have access to broadband, and much of those that do are covered by "mom and pop" type operators. Establishing the tracker gives Liberty Global a pure play currency to offer (LILAK, the non-voting C shares) to acquisition targets that may want to have continued exposure to cable growth story but be relieved of running the day to day operations. 
• John Malone is famous for playing all aspects of the capital structure, most management teams focus primarily on the debt side, structuring their liabilities in such a way to minimize rates, recourse, covenants, etc, but few spend time optimizing the equity cost of capital like Malone.  By creating the two tracking stocks, Liberty Global will be able to simultaneously buyback shares in LBTYA while issuing shares of LILA for acquisitions and more effectively manage each group's cost of capital than could be done with a spinoff.
• By maintaining the larger corporate entity there should be some cost savings, one management team spread out over a larger asset base, more leverage with vendors, greater balance sheet capacity.
• The primary downside being added complexity and if one group gets into financial trouble, it will drag the other with it since they're not formally separated.

Valuation
Thanks at least partially to the recent worldwide selloff, LiLAC is an absolute bargain today at roughly 7.0x a run-rate EBITDA inclusive of the Choice acquisition in Puerto Rico but without any credit given to potential M&A, comparable cable companies trade for 9-10x representing significant upside.  Even with a one turn discount for being a tracker to 8x, LILA/LILAK should be worth $44-45 per share.

• Balance Sheet: $2.4B in debt, $232MM of cash, $1.5B market cap = $3.77B enterprise value
• One question that I still have on the balance sheet, per the 10-Q: "On June 30, 2015, in order to provide liquidity to fund, among other things, ongoing operating costs and acquisitions of the LiLAC Group, a subsidiary attributed to the Liberty Global Group made a $100.0 million cash capital contribution to LiLAC Holdings" - Is this just an initial reattribution for the tracker spinoff or something else?  It didn't appear in the initial S-4 or the LiLAC road show presentation.  Also it clearly signals acquisitions coming soon as it doesn't appear VTR or Liberty Puerto Rico need the cash for their day-to-day operations.
• Comparables: Cable & Wireless (CWC) trades at 9x EBITDA, Malone owns 13% (more $ wise than LiLAC) via Columbia acquisition that was done at 12x EBITDA, one could get folded into the other at some point; MegaCable Mexico trades at 9x EBITDA; Groupo Televisa bought Cablevision Red for 10x EBITDA
• On 3/14/2014, Liberty Global bought out their 20% minority partner in VTR (Chile) with $422MM worth of LBTYK shares, implying a $2.11B valuation for VTR.  If you discount that amount by the depreciation in the Chilean Peso since that time, you still get a value of ~$1.84B for the equity in VTR, versus a market cap of $1.5B for LiLAC which also includes 60% of Liberty Puerto Rico. ** Edit: I might be wrong about this piece, since the VTR secured notes were issued in January 2014, figured that the LBTYA shares were a straight equity swap?  If not, only used it as another valuation data point
• On a per RGU and per customer basis, LiLAC is significantly cheaper than Liberty Global, Charter, or Cable ONE (aware that they're unfair comparisons, but still somewhat interesting to see the relative value):

Upside Scenarios

• M&A, LiLAC has $467MM in liquidity and all signs point to management continuing the successful levered equity playbook by rolling-up Latin American assets using mostly debt; if you run a model assuming free cash flow gets directed toward M&A and their leverage ratios stay fairly constant you can quickly get to some 20-30% annualized returns.
• The June acquisition of Choice in Puerto Rico should provide both cost synergies and revenue growth opportunities since most of Choice's clients were primarily broadband only clients, there's an opportunity to up-sell them video and voice services.  In the Q2 earnings presentation, management quoted a 3.5x net leverage ratio giving proforma effect for the Choice acquisition.  I had a hard time squaring that number, but using a $2.1B net debt position, that means OCF is ~$600MM?  Seems like they're projecting some significant growth from Choice.
• VTR Wireless - they currently only have a little more than 100,000 customers, or 1% of the market in Chile, but there should be some opportunity to cross sell and create a 4 play model (video, internet, land based voice, wireless) to increase RGUs.
• Eventual full spinoff once the LiLAC business matures, closes tracker discount, or Liberty Global could sell LiLAC to another industry consolidator like Altice or Cable & Wireless.

Risks
LiLAC has some unique risks, it's a highly leveraged emerging market company in an industry that some have technology disruption concerns about:  

• LiLAC in typical Malone fashion is a heavily levered equity, does it work in countries with a high cost of capital?  70% of revenues are in Chilean Peso (remainder in USD - Puerto Rico) which is near 12 year lows against the dollar thanks the slide in commodities; VTR debt is in USD, but hedged into Chilean Pesos through 2021, the all in cost of the debt is 11.1%, management must expect strong growth to overcome that hurdle.  If the dollar does begin to weaken, it could result in a significant tailwind when combined with mid-to-high single digit organic revenue growth.
• Chilean economy heavily tied to copper and natural resources, also in an earthquake zone with the potential to damage infrastructure type assets.  Taxes are also rising in Chile on a laddered basis, topping out at 27% in 2018.  Counter -- Chile enjoys the highest economic freedom in Latin America and the Caribbean (ranked 7th overall, ahead of the United States), generally viewed as the most modern Latin American country.
• Puerto Rico has well known economic problems, in default on debt, may face austerity measures.  Counter -- as CEO Michael Fries is quick to point out, these are not new economic issues for Puerto Rico, LiLAC has been able to consistently grow through them despite the macro concerns. 
• Malone has less than 3% economic stake in LiLAC, owns significantly more of CWC in region, any potential conflicts arise from that?  Counter -- Cable & Wireless provides a natural acquisition partner, opportunity to fold one into the other.
• General technology disruption concerns: cord cutting, OTT, satellite providers, consumers might move down from triple play packages to just two services or down to just broadband.
• Competition for deals: Cable & Wireless, Digicel are active in region, Altice active everywhere, could drive up the price of M&A opportunities.  Are there enough attractive acquisition targets in business friendly countries?

Why Is It Cheap?

Everyone knows John Malone's incredible record, spinoffs are popular and every event-driven analyst is trained to look at them, so why is LiLAC undervalued?

• Tracking stock complexity - as mentioned earlier, it's a rare type of security that many traditional managers aren't going to be interested in from the beginning; it's also unlikely to be in any indexes, doesn't pay a dividend, has a limited natural shareholder base.  If the tracking stock doesn't work out, Liberty Global can either spin it out or fold it back into the parent company and close any tracker discount.
• Small size in relation to Liberty Global Group - shareholders of Liberty Global received 1 share of LILA/LILAK for every 20 shares of LBTYA/LBTYK owned, roughly in line with the size of the entities, LiLAC group is roughly 5-6% of the overall entity, creates some uneconomic selling as investors treat it like a special dividend and sell.
• Dislike for Emerging Markets - Latin American stocks are down roughly 50% from September primarily because of the region's emphasis on natural resources and the China bubble deflating reducing demand for commodities.  South American countries have a reputation for being unfriendly to business and heavily corrupt.

I ended up drinking the kool-aid and started a position on Wednesday around $33, made it a medium sized position that leaves some room to add if the sell-off continues.  My head hurts after looking at this for the past two weeks, if one wants to invest in a Malone levered equity, buying Liberty Broadband is probably a much simpler way to do it, no currency risk, cheaper debt, and much cleaner financials.

Disclosure: I own shares of LILAK