Liberty Global: Profit vs.Wealth
Board: IVS: Liberty Global
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I’m over in Europe at the moment, working with a media company in the land of Liberty Global, which inspired me to write up a few of the reasons why I love this company as a long term investment. I listened to the audiocast that the Inside Value team put together, and I just have to underscore that it’s an unbelievable opportunity that we can buy a company run by one of the few CEO’s profiled in Will Thorndike’s amazing book, The Outsiders. With all of the other Outsider CEOs, besides Buffett, we don’t have that opportunity. And finding a fantastic leader who has generated 20+% compounded returns over a 30+ year period, in a situation similar to the one he was in when he accomplished that, and when the market doesn’t see the opportunity because it can’t see past the negative earnings number, is extraordinary. If you haven’t read The Outsiders and are considering investing in Liberty Global (or are just interested in reading one of the best business books of all time), read the chapter on John Malone and TCI. It’s fantastic, and you’ll really get a sense for why the Inside Value team refers to Malone as a “master capital allocator.” I mean, he pioneered a lot of capital allocation techniques that other CEOs take for granted today (although most CEOs do a shoddy job of using them).
I will attempt to put some of his capital allocation techniques, which can be, admittedly, a bit difficult to understand, in a more understandable context.
Imagine Malone sitting in his office in Denver, looking at tons of opportunities in which to invest, and just trying to figure out which ones he should use his limited capital to invest in, and how he can get more capital to invest in as many opportunities as possible.
This may be difficult to picture, because most big company CEOs today are struggling to find opportunities in which to invest to grow their revenue, and often they either invest in low-return projects (which is the wrong thing to do), or they buy back shares at a high stock price (which is also not ideal), or they pay out dividends (which isn’t a hyper-efficient use of their shareholders’ tax dollars either). But Malone, he has a lot of opportunities. And that is special. It’s the type of situation that Warren Buffett talks about when he looks for companies that can invest $1 of Retained Earnings in opportunities that will create more than $1 of future value, and Buffett says it’s rare to find companies that can do this.
So Malone, who, as Joe mentioned on the audiocast, often says “creating a profit is not the same thing as creating wealth,” says to himself, “I have all of these great opportunities. The more of them I invest in, the more wealth I’ll create for my shareholders (and myself) over the long term. Forget about next year’s profit, let’s maximize the capital we can invest so we can do as many projects as possible!”
Charlie Munger refers to one of his biggest investing mistakes as when, before he met Buffett, he was presented with an opportunity to buy rare shares in an investment opportunity that was an absolute no-brainer, but he didn’t because he didn’t have the capital. The mistake, he says, was not taking on some debt to buy those shares. The company’s stock quadrupled in value over the next two years and, had Charlie taken on a little debt to buy the shares, he would have made several million dollars. (A quick disclaimer, I’m not suggesting you take on debt to buy stock; this was Charlie Munger, one of the best investors of all time, talking about an opportunity that was one of the top four he’s ever seen, so you can imagine how low risk this opportunity was).
So how does Malone find as much capital as he can to invest in the great opportunities he sees, and thus grow wealth really quickly? He takes on cheap debt (maybe the cheapest he’s ever seen over his long career, and definitely cheaper than the debt that Charlie Munger should have taken on), and he minimizes taxes. The former, I think, makes sense, and it also drives the latter, but the latter is a bit harder to understand, so let’s talk about the tax situation.
Let’s use a simplified example and say Liberty Global makes $100 of profit before they’ve paid depreciation and amortization (i.e. before they’ve paid for projects) and taxes. They can either invest that $100 in projects and opportunities (and pay associated depreciation and amortization costs), take an operating loss for the year and pay no taxes, or they can take the profit and pay around $35 of taxes on it, leaving themselves with $65 of profit to retain and invest in opportunities next year. So, if I’m John Malone, I want to take the $100 and invest it in the great projects I see this year, rather than take $65 to invest in projects next year. That’s almost 2/3 more projects that Malone can invest in! And he does this a lot, and he will continue to do so, and take a loss, as long as he has those great opportunities that other CEOs would kill for, because 2/3 more to invest means he can grow revenue at a much faster rate than if he were taking a profit each year. And this effect can occur because he uses debt to finance a lot of the projects, because the more debt he uses, the more interest he pays, and interest is tax deductible, which helps him pay low or no taxes. And imagine the impact of that occurring year after year after year. The more projects he can do, the more subscribers he gains, and the more subscribers he gains, the lower his cost structure will be because he can negotiate lower costs from his content suppliers (think the likes of ESPN and HBO in the US. Note, this phenomenon is more important in the US market because content costs in Europe are lower). So why would other CEOs not take this same strategy, you ask? Well, there is one who takes a similar strategy (Bezos at Amazon), but for the others, there are many reasons, and one is that they want to show Wall Street a profit. Another is that they don’t have the large, certain cash flows that Liberty has, which makes it safe for Malone to take on a lot of debt because he knows he’ll always be able to make his interest payments. John Malone just doesn’t care what the analysts think, and that freedom allows him to make better long term decisions for shareholders.
Where does he get all of these opportunities? The European cable market is different from today’s US cable market (which has a few big players), but similar to yesterday’s US cable market (which had many small players, and in which no one had the scale to negotiate low costs out of their content suppliers). While at TCI, Malone generated his enormous returns by pursuing scale, through the use of as much capital as he could employ, as quickly as possible. Because the cable market in Europe is fractured, there remains opportunity to acquire other companies. There also remains a lot of opportunity to build great “pipes” to peoples’ homes so they can consume content at fast broadband speeds. Both of these opportunities, when financed with debt, allow Malone to shelter more investment cash from taxes. It’s a virtuous cycle that speeds shareholder wealth creation.
Writing down my thoughts helps me think through my investments. I figured it might be useful to share, so I hope it was of some help. Fool on!