A New Type of Special Situation: Conversion from a Tracking Stock to a Spin-Off
As someone who constantly keeps his ear to the ground for unique and interesting types of investments, it isn't often that I see a completely new type of special situation. That's exactly what I found yesterday in the tracking stock Liberty Starz Group (LSTZA).
For those of you who aren't familiar with tracking stocks, here's a description of what they are from Investopedia:
Common stock issued by a parent company that tracks the performance of a particular division without having claim on the assets of the division or the parent company. Also known as "designer stock".
When a parent company issues a tracking stock, all revenues and expenses of the applicable division are separated from the parent company's financial statements and bound to the tracking stock. Oftentimes, this is done to separate a subsidiary's high-growth division from a larger parent company that is presenting losses. The parent company and its shareholders, however, still control the operations of the subsidiary.
Your initial reaction to tracking stocks might be very similar to what mine was..."These things suck. Let me get this straight, I own this stock yet I have absolutely no say in anything and technically don't even own anything. I'll pass."
The limitations of tracking stocks often cause them to trade at a discount to what they would trade at if they were a real stand-alone company, and rightfully so. As such, logic would dictate that when a company decides to completely spin-off a division instead of using a tracking stock for it, the value of a tracking stock should rise significantly to eliminate any discount that has been associated with it.
That's exactly what is happening at John Malone's Liberty Media right now. Liberty decided to stop using a tracking stock for its Starz Movie Channel division and officially spin it off (forgive the long links instead of the cool looking hyperlinks, Apple's Safari browser doesn't work well with the CAPS software).
Liberty Media to split off Capital and Starz units
I added the Starz tracking stock to my CAPS portfolio around a month ago when I read about it in Marty Whitman's Third Avenue Funds most recent quarterly report. Here's a summary of Third Avenue's thoughts on Starz.
Liberty Media rolled out a tracking stock for its Starz division towards the end of 2009. For those of you who don't have cable and aren't familiar with Starz, it's sort of like HBO. Cable and satellite television providers give their subscribers the option to pay extra to subscribe to numerous Starz and Encore movie channels. Some of the money from these premium channels goes to the cable and satellite companies and some goes to Liberty Media's Starz division.
Starz has been attempting to increase its revenue lately by introducing "on-demand" service and by creating its own original programming, along the lines of HBO's Soprano's or True Blood, but thus far less popular.
One thing that I particularly like about Starz is that it has a new management team. As I mentioned yesterday in my post about The Pantry, new management can often unlock significant value in companies...if they're good. Starz’s new CEO, Chris Albrecht, has a solid twenty-year track record at fellow premium television provider HBO. One of the nice things about a spin-off is it often enables companies to attract quality management because anyone on board stands to benefit directly if the company does well.
Another awesome thing about Starz is that it has a ton of cash. As of Third Avenue's quarterly report, the division had practically no debt and cash / equivalents of nearly $1 billion on its books...equivalent to a whopping 37% of its market cap.
So how does one make money off of LSTZA?
For one, the discount that it has been trading at because it was only a tracking stock instead of a real stand-alone company should begin to disappear once the spin-off is complete. While it is slightly higher today than when Third Avenue wrote about it, at the time LSTZA was trading at only five times EBITDA and ten times free cash flow.
Furthermore, the company's revenue should grow in conjunction with inflation. It has CPI-based price escalators built into its contracts with cable and satellite providers.
As I mentioned earlier, Starz is working on creating its own original programming, which is cheaper than purchasing movies from the studios. It could benefit significantly in terms of subscriber growth and margins if any of its new series catch on.
I added shares of LSTZA to my CAPS portfolio on May 24th at $51.27. Today it is currently trading at only 2% over that, slightly underperforming the S&P 500 benchmark thus far. I have decided to hold off on buying shares of Starz in real life for a number of reasons. First, I absolutely love spin-offs, but I have very little experience with the conversion of a tracking stock to an independent company, so this will be an interesting experiment. Furthermore, I'm not wild about investing in a movie channel. Also, while it's cheap LSTZA isn't knock-your-socks-off cheap and it doesn't pay me a dividend to wait until Mr. Market realizes its true value.