« Box Office Winning Streak Ends | Main | Dollar Weakness is Bullish »

March 16, 2009

The Backdoor Way to Play DirecTV

In February, following release of DirecTV's (DTV) 4Q08 results, I wrote several favorable comments about DTV on RealMoney.com. I followed up by publishing the following commentary which discusses Liberty Media Entertainment (LMDIA) as an attractive backdoor play to purchase DTV at a substantial discount. With SeekingAlpha.com publishing an article from Bullish Bankers discussing Liberty Media and LMDIA, I decided to republish my article which first appeared on February 13th....

John Malone's Liberty Media owns 54% of DTV via the Liberty Entertainment tracking stock (LMDIA). LMDIA owns other assets but the DTV shares represent over 85% of the total asset value.

If you apply values to LMDIA's non-DTV assets, you can isolate the embedded value of the DTV shares. Based on yesterday afternoon's trading, the implied value of LMDIA's DTV shares is 34% below the current trading value of DTV. As a result, a plausible long idea is to own LMDIA and hope that the valuation gap closes and DTV shares appreciate.

As I will outline, there are some risks to being long LMDIA, so another option is to go long LMDIA and short DTV. In this case you are playing solely to close the 34% valuation gap and leave aside any upside in DTV shares. That might not be a bad way to go in this market environment. If you were long/short on less than a 1:1 basis you could still maintain some extra upside exposure to DTV.

Fortunately, there is a catalyst on the horizon that could cause the gap to close which makes the naked long LMDIA option a good one. Liberty has announced its intent to split its DTV shares and a few other related assets into a new, asset based stock. On its own, the split further isolates the DTV shares and makes it easier to identify the value. However, Liberty has made it pretty clear and DTV agrees that the real purpose of the split is to make it easier for DTV and LMDIA to combine. That combination would close the valuation gap enabling LMDIA shareholders to capture most if not all of the upside depending on the combination terms. The fact that DTV has good fundamentals and just issued surprisingly strong 2009 guidance calling for double digit growth makes the LMDIA option even more attractive.

Obviously, there are some risks or the LMDIA's discount valuation would not exist. Before we get to that, let's look at the numbers beginning with LMDIA's asset value and isolating the value of the DTV shares so we can see the discount.

Download file

The $3.714 billion in non-DTV assets is merely the total of the other assets listed in the first table.

As mentioned before a valuation gap this simple and this large would not exist without a reason. Here's a rundown.

The non-DTV asset values could be too high. This may very well be true given that realizing value form an illiquid asset is virtually impossible in today's environment. However, if yu haircut the non-DTV assets by 50%, LMDIA would still be trading at a 20% discount to NAV.

LMDIA's plan to split in two and create an asset-based stock owning the DTV shares may not go through. This is a legitimate concern because Liberty first proposed this plan with a different asset split in September and then pulled it in October. I think it will go through this time as several of the troublesome issues were resolved in the new plan (mainly excluding Starz! from the stock with the DTV shares). A proxy has been filed, credit markets are more stable, and reputations are on the line.

John Malone has voting control of LMDIA and potentially a merged LMDIA/DTV. Malone has a bad reputation as a financial engineer who looks out for himself at the expense of minority shareholders when the going gets tough. Regardless of whether this is fair, it is the perception and it will keep some investors from investing in LMDIA.

The deal is complicated and includes a third entity. This is true. If you buy LMDIA today, you will soon own stocks, the DTV stock and another stock whose primary asset is Starz!. The Starz! stock could collapse as it is sold. Or investors might just be thinking it is not worth the trouble.

The deal may be blocked by Liberty bondholders. There is a clause in Liberty's bond covenants that gives bondholders the rights to "all or substantially all" of Liberty asset value. Since the DTV shares do not produce cash flow, the cash flow from Starz! will remain at Liberty, and $1.9 billion of debt is going with the DTV shares, analysts think bondholders will not block the deal.

The merger terms between DTV and the new Liberty stock may be unfavorable to LMDIA shareholders. This is possible though rumored exchange rations suggest that the risk is no more than a 10% discount. I think comments coming from Liberty and DTV, while lacking detail, suggest that neither side is looking to rip off the other side. And of course, Liberty's 54% ownership and necessary approvals from DTV's independent directors make a neutral deal most likely.

Posted by Steve Birenberg at March 16, 2009 11:33 AM in DTV