In some respects, cable TV/Internet businesses ought to work like utilities. It takes a lot of capital to build the infrastructure, but once it's in place customers send in monthly checks like clockwork. It's never quite worked out that way, however, as seemingly never-ending capital demands have prevented many of these companies from turning into steady dividend-generating machines.
Virgin Media (Nasdaq:VMED) is an interesting case study. On one hand, the company's high-quality network is valuable and the company has consistently delivered on ARPU. On the other hand, the company faces competition from conventional competitors such as British Sky (Nasdaq:BSYBY) and BT Group (NYSE:BT), as well as content rivals such as Netflix (Nasdaq:NFLX), Amazon (Nasdaq:AMZN), Google (Nasdaq:GOOG) and Apple (Nasdaq:AAPL). Worse still, the company's huge debt load crushes a discounted cash flow model - leading to the question of how much debt should matter to investors.
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A Brief Overview
For those readers not familiar with Virgin Media, it is the major player in the U.K. broadband, pay TV, mobile and fixed-line telephony markets. It is the sole distributor of TiVo (Nasdaq:TIVO) in the UK and it owns the largest fiber optic network. While Virgin Media does owe its name to its acquisition of Virgin Mobile (and a decision to license the "Virgin" name), and Sir Richard Branson's Virgin Entertainment Investment Holdings does own a sizable amount of stock, he is not actively involved in the management of the company.
Although British Sky is larger in the U.K. pay TV market and BT is larger in fixed-line telephony, Virgin Media has held its own, largely on the strength of its broadband offerings and triple-play packages. Over 30% of VMED's customers have access to speeds of 30Mbps or greater and 6% of its customers subscribe to its triple-play package (though British Sky recently pulled ahead in total triple-play subscriptions).
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Can VMED Leverage its Network?
The central question in my mind is whether Virgin Media can generate strong cash flows from its existing network. Over the last four or five years, the company has done a good job of reaping more cash flow, with this margin exceeding 12% in 2011.
But there are certainly challenges here.
For starters, BT has gotten a lot more aggressive with its own broadband offerings - its Infinity service passed roughly 20% of VMED homes two years ago, but that percentage has risen to 50% recently. What's more, VMED leads British Sky and BT in ARPU and there may be a limit to how much the company can continue to raise primaries (a primary source of revenue growth recently).
Perhaps the bigger threat, however, is control of content. Companies such as Amazon, Netflix, Google and Apple are all starting to offer content in a way that lets users pick and choose on an a la carte basis - something that consumer advocates have long (and unsuccessfully) pressured cable companies to do. Now the threat is that these providers can dominate the content and leave companies like Virgin Media as just a commodity purveyor of the pipeline.
This isn't to say that Virgin Media can't fight back. Exclusivity with TiVo has helped retention, and future offerings like "quadruple-play" and/or a la carte content could preserve that cash flow.
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The Bottom Line
The central problem with valuing Virgin Media is its huge debt load. A free cash flow growth rate assumption of 5% suggest a negative $10 per share value, while 7.5% growth still produces a negative number (and implies free cash flow margins in the high teens).
Perhaps it's worth asking if the debt should really be held against the company. Debt investors have never been especially bothered by high debt levels in the utility sector, and utility companies have generally had little trouble refinancing and rolling over that debt. Moreover, Virgin Media's strong free cash flow should allow the company to pay down that debt over time. If you just ignore the debt, then the fair value of Virgin Media appears to be in the low $30s on the basis of that 7.5% growth rate.
I'm personally not terribly enamored with debt-heavy companies in highly competitive industries, particularly those that require ongoing capex to maintain competitiveness. So while I can appreciate the virtues of Virgin Media's cash flow potential, this won't be a name in my portfolio any time soon.
At the time of writing, Stephen D. Simpson did not own any shares in the companies mentioned in this article.