Kabel Deutschland – How relevant is negative net equity combined with a lot of debt for a “wide moat” business ?
Background: Kabel Deutschland is one of the short positions of the portfolio and currently the only one which didn’t work out yet…
In one of the blog posts, reader Stairway commented with an interesting analysis.
I hope it is fair to summarize the argument as follows:
Due to the stable business for a cable operator and the growth potential, an investor does not need to worry about a high debt level and negative net equity, but can exclusively focus on expected future cash flows.
Considering myself a cautious value oriented investor, I always ask myself the following questions first:
1. What happens if things really go wrong ?
It is important to note that the question is not “how likely is it that something go wrong” or “can something go wrong”.
So if something really goes wrong, we look normaly at a liquidation scenario. Looking at Kabel Deutschland, one could answer the question 1. above (“what happens”) relatively easy: For the shareholder this would mean ZERO. Negative net equity combined with addditional intangible assets, a high debt load plus leasing liabilities would leave the shareholders with nothing but their paper.
Just to revisit the numbers again:
Equity: Negative at -1.6 bn EUR
Intangibles: 0.6 bn EUR (Tangible net equity -2.2 bn)
Financial debt: -2.9 bn
Pension liab.: -0.05 bn
Leasing liab.: 0.9 bn undiscounted
Market Cap : 3.6 bn
EV : 3.6 + 0.9 + 2.9 +0.05 = 7,45 bn
2. The second question one would ask is: What is the value of Kabel Deutschland based on “normalized” CFs, without assuming any growth.
Free Cashflows to Equity (as stated in Bloomberg) were per share
So there seems to be a clear growth trend. However, if we look at the last half year report, we can clearly see that free cashflow shrank dramatically to ~0.20 cents in the first half year despite lower interest rates.
So I think it would be quite aggressive to calculate with significantly increasing free cashflows. In my opinion, especially the Internet business is quite capital intensive in contrast to the traditional cabel TV business.
So if we would use for example the 3 year average free cashflow of 2.55 EUR, we would end up at an EPV of ~25 EUR if we capitalize at 10%.
3. The third question is: Can we attach growth value to the business ?
Again, in my opinion, this is highly questionable. First of all, Kabel Deutschland is restricted geographically, so they can only expand in 2 ways:
– puchase other cable operators
– offer additional services to existing clients in competion to Deutsche Telekom etc.
For both growth paths, I would not attach any positive value. I hesitate anyway to attach value to a M&A strategy and the DSL/Telephone business is currently free cash flow negative.Any potential cost advantage of the cabel networl will in my opinion be offset by the lack of a mobile network when Kabel competes with the traditional TelCos like DTE and Vodafone..
I think it will also be quite interesting, how the “Premium TV” part will develop if Apple really enters the market.
4. Downside catalysts.
Despite Kabel Deutschland being expensive, one still has to ask: What could be a potential catalyst from a short perspective ?
From my point of view, I can see two potential catalysts, despite some obvious tailwinds like lower interest expenses:
1. Further free cashflow developement: If free cashflow doesn’t improve in the second 6 months compared to the first half year, maybe some analysts have to plug in lower growth assmptions
2. Apple / Google TV: If Apple really manages to bring a new groundbreaking TV service like they did with the Ipod and Itunes, then I think the Premium TV segment of Kabel Deutschland will be toast. Sooner or later. In the short term, a potential hype of Apple TV could in general deprtess prices of cable operators
The only upside risk in my opnion would be a offer from one of the big US cable operators for the Kabel. I am not sure how realistic that is, but as Kabel Deutschland is trading at a sgnificant premium to US operators (~9x EV/EBITDA against 6-7 x for US operators), this would dilute those companies significantly.
Summary: In my opinion we can summarise Kabel Deutschland in the following way:
1. From a (long) value perspective, the shares are univestible because of the aggresive financing structures. Despite a certain “moat” int he existign business, the financing structure leaves zero margin for (temorary) problems and therefore eliminates any margin of safety.
2. From the short side, there seem to be some catalysts at the horizon which could effect the shareprice to approach its fair value which in my opinion is more in the range of 20-25 EUR.
So as a comsequence of this exercise, I will actually INCREASE the short from currently -1.21% of the protfolio to ~-2% going forward, Limit 40 EUR.