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

2008: 1.96
2009: 2.47
2010: 3.22

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

Upside risk

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.

11 comments

  • vllt ist ja EUTELSAT was für dich wenn du netten FCF bei Wachstum und TV/Breitband suchst…

    Kabel D scheint ja nicht wirklic zu fallen …

  • Talked to several analysts (well, not the best contact person, but they give at least some input) about that topic. The same situation occured some years ago and it is very likely, that they will agree to a new contract. However, this is a possible threat (although not a highly geared one).

  • Just as an add-on to my last paragraph: I fear that KDGs management could undermine the solid cashflow situation of the company by paying back too much in a too short time frame. It seems to have an more “american way” of running the business and distributing earnings, but sofar it worked out very well.

  • Hi mmi, thanks for your side of the story, an interesting read, however, I diagree! (Would be boring if one agrees on all ideas, wouldn’t it?)

    Step by step: (Your quotes in apostrophes)

    “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.”

    –> First of all, I would not use Bloomberg FCF data, since it is usually flawed in one or the other way. KDG is set to achieve 800 Mio. € in EBITDA this year, whereas only ~380 Mio. € will have to be invested. Substracting an addition 170 Mio. € in interest, we will still have a significant Free-Cashflow. (Taxes can be ignored, since KDG still comes with tax-loss carry forwards until 2016 which will keep the tax rate under 15%). This positive Cashflow will now be supported by two trends in the years ahead:

    1. Increasing margins because of the rising share of the “Internet&Telefon” business; and
    2. Stable or even decrease CAPEX, since the backbone will be finished by the end of 2012.

    Therefore I can not really understand, why it is “aggresive” to calculate with rising Free-Cashflows. There is actually very little need of further capital investments in the Internet business and competition from DT is very low because of the superior price/output of KDGs Internet product.

    By the way: I am not relying on any modeled assumptions here, because KabelBW and Unitymedia did the same progress (implementing the “rückkanalfähige” backbone and cross-selling Telephone and Internet products to existing cabel customers) as Kabel Deutschland some years earlier and the strategy is paying off nicely.

    “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..”

    –> DT is losing market shares (again, see case study at KabelBW and Unitymedia) for several years now, because of weaker products in both, the Internet and the Telefon business. It is also clear, that DT will not be able to compete with fiber connections, because the costs are ten times (!) the costs of the cable firms. (for more info: see the last posts in the WPF thread).

    Concerning the current valuation against US peers: Its true that KDG comes with a premium, but this one is justified, since KDG has a nearly guaranteed top-line growth between 5-7% p.a. and will be able to rise its EBITDA margin from 45% to 50% over the coming years (better product mix) as well as lower interest payments. This may well trigger a three-fold in earnings (JÜ) over the next four years.

    On basis on my research, operational risk is very low for KDG (stable cable subscribers and growing Internet & Telephone base). Also, I would not overestiamte negative equity on the balance sheet. Based on my calculations, KDG will earn 812 Mio. € in EBITDA next year, compared to expected interest payments of 160 Mio. € in 2013. As we have seen last week, the company is also able to finance itself with more and more favourable conditions.

    I can not really estimate the impact of Apple/Google entering the TV business, but whatever product those firms will offer, it seems to be highly unlikely that a significant share of users will unsubscribe to their tradition cable contract. Again: the “premium tv” business is not the core growth- and value-driver of the firm.

    To sum it up: I wish you the best luck with this short, but I would not bet against this franchise since KDG seems to be operationally and financially better equiped then ever. A greater risk could be KDGs management, which is eager to pay-back shareholders as much as 1/2 of current marketcap via dividends (min. 1,5 € this year) and share-buybacks (already 60m completed).

    However, it is always useful to read contrary opinions.

    Regards,

    Stairway

    • Stairway, thanks a lot for your detailed comments. Allow me some remarks:

      -for the current year I used the quarterly reports (not bloomberg) which clearly show dissapointing free cashflow in the first six months and doesn’t really fit into the “ever increasing cash flow story.

      – one additional point: If data requirement for internet connections develope like they did in the past, at some point in the future also the cable will have exhausted its capacity and you need fibre.

      MMI

  • Short in Cablevision Systems wäre 2011 besser gewesen 😀

    Vllt passiert ja mit Kabel Deutschland in 2012 das Gleiche 😀

  • Thank you for your analysis. My conclusions, where similar, when I had a brief look at Kabel Deutschland. I think there is much competition between internet service providers, which is a danger for profit margins. Combined with the highly leveraged balance sheet this could involve much risk.

    But on the other hand I must admit, that I don’t know very much about that company. I know that Stairway knows much much more about them, and he is by far less pessimistic.

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