Street Capitalist: Event Driven Value Investments

Sir John Templeton said something like: the best time to buy is at the point of maximum pessimism. A few months ago, I wrote a post (Special Situation: IACI Interactive Break-Up) detailing the prospects of a breakup of IAC/Interactive (IACI). At the time, I detailed how a number of the business units could be highly attractive on their own. Right now though, the certainty of such a break-up is extremely unclear, however IACI still offers an attractive return, even without the balance sheet event.

Usually, whenever news comes out about a potential break-up, the price of the company spikes. IACI was no different in this sense, it appears as if the company traded around $27 to $28 per share prior to the news release, and eventually spiked to $31. Now, IACI is trading for as little as $19.46.

I believe IACI offers a good margin of safety with great upside. The company is trading at levels that haven’t been seen in 5 years. The current price is barely above its 52-week low. The trigger for this is most likely a result of two factors

1. The company’s quarterly earnings failed to meet analyst expectations, a large loss on behalf of the Lending Tree segment resulted in an EBITDA of only $210 million versus the projected $257 million.

2. The protracted court struggle between Barry Diller and John Malone means that any ruling on a potential value creating break-up wont come for a while. The near-term prospects of Lending Tree don’t look good which is one of the reasons Diller is trying to argue in favor of the spinoffs.

Many of the other business units of IACI have been performing relatively well. For Ticket master, revenue is up 27%. In spite of a questionable consumer environment, HSN (Home Shopping Network) reported a 3% increase in revenues, and “New IAC” which would be home to internet properties such as CollegeHumor.com is showing a 21% jump in revenues. Best of all, Interval International, the time-share vacation property segment, grew revenues at a rate of 35%. With business segments growing at these rates, the -55% drop in revenue from Lending Tree seems to be mitigated and an investment in IACI could be opportune at this moment.

Valuation

If you look up IACI on a financial screener, you will see that the company is “trading below book” at 0.65. However, for companies like IACI, this isn’t the best of measures. A liquidation scenario would not work properly due to the lack of hard tangible assets, a lot of IACI’s depends more or less on an increased use of their online services.

Now that we’ve established a fault in the P/BV system, we can try applying a more effective method, Enterprise Value / EBITDA. Using this we will obtain a multiple, and then we can compare it to the levels of companies within a similar industry. Since IACI is so complex, yet holds a number of media assets, a good choice would be a comparison with Newspapers which hold non-traditional assets, a good choice of comparison for multiples would be the EV/EBITDA of the New York Times or Washington Post.

Current Share Price: $19.43
Shares Outstanding (Diluted): 335.29
Market Cap: 6524.74

+ Debt 946.42
- Cash $1585
-Minority Stakes $293.2

EV = $5,592.96
Est. 2008 EBITA: $960

Now, if we take this new EV and utilize an estimation of the 2008 EBITDA of IACI, and then take $5,592.96 and divide it by the 2008 EBITDA estimation, we see that IACI may be trading at a low level of 5.8X. This is quite low when compared to more traditional newspaper EV/EBITDA multiples which range from 8x-9x. If IACI traded at these multiples, its shares would range from $26.80 to $30.20 or a potential 37% - 55% return.

This does not really take into account some of the revenue potential of newer business segments in IACI, such as the new websites like CollegeHumor or the growth of the company’s real estate segment.

Either way, at its near historic lows, from this valuation IACI seems to have a significant upside.

Court Case

The current legal maneuvers seem to be indicating that it is not Liberty Media’s intention to block the company from breaking apart all together. Most likely it is that John Malone is hoping to pick up the HSN business segment without having to compete with private equity bidders or make a bold and pricey tender offer to buy the HSN in the public market.

It is hard to argue with John Malone here though, it seems clear that as per Liberty and IAC’s agreement, both parties need to agree before making any changes which could disrupt the ordinary course of business. In any case, with the current valuation of IACI as just one sole entity, there is still significant upside, meaning that any balance sheet event - such as a break-up and spinoff of all the units would result in an extra benefit. Each individual business unit would be able to trade at a greater multiple because they would not be discounted for slower growing or declining business segments.

Outlook

During this last quarter IACI missed earnings estimates mainly due to LendingTree. As a result of the growth from newer business segments, I feel like the current market reaction is overblown and the business is still undervalued. In addition, an end to the current legal troubles would at least reduce uncertainty and help IACI’s price.

Waiting for Buffett’s letter to shareholders was a little exciting, and I’m not even a Berkshire Hathaway shareholder. I enjoy reading what Buffett writes and now more than ever I was looking for some of his insights on what has been happening in markets today. Here was his answer to the CNBC question:

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double- digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently
direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

This is why I like Buffett so much, who else can use a children’s story and use it as a means of attacking a group of highly paid professionals? Not many I’d think.

I don’t entirely agree with Buffett’s assertion. I’ve interned and been around financial advisers, and for the most part the ones I met were good. They didn’t seem to go out to their way to peddle poor products onto novice investors, they weren’t coaxing them into buying the latest investment craze. Maybe they really did learn from the dot com bubble.

But still, there can be some problems. Inherently, the financial advisory industry is built around commissions based on products sold. The problem is, they’re not paid according to how those financial products actually perform. They could have sold you a mutual fund that specialized in sub-prime mortgages and they would have made something up front before you made anything.

Ultimately in this situation the type of fees the adviser is extracting is probably small, the bulk of the fees will be taken by the mutual fund itself, but still - isn’t it still wrong for you to profit by selling a product that fails for the person you’re advising?

I think the most logical thing would be to put an emphasis on properly educating the advisers on the type of products they’re peddling so that they can accurately describe their intricacies to their clients/investors. With the trend in finance, new products keep being invented and they keep becoming more complex. Eventually, we will see a major issue where a party was not properly advised on the type of products they were purchasing and a major legal conflict will arise out of it. Arguably, we’re already at that period.

Some non-profits and municipalities claim they were duped into purchasing mortgage-related products that were thought of to be as safe as treasuries. Who know where we’ll be five years from now?

As long as the big banks spend more time educating their advisers on the products they’re selling and more importantly, how to explain those products to clients — things should be fine. I used to think that advisers should be paid more or less based on how well the products they sell their clients perform, but I think this is actually a bad idea. In client driven industries, they are going to be instances where “the client is always right”. i can really imagine that there will be points in time where a client wants to do something that goes against common sense, or is not prudent. It is his money and it is his choice to make though. Those are the kinds of instances where you should not be penalized for your client’s poor performance.

Advisers aren’t the only ones who face these kinds of incentive issues. Hedge fund and private equity managers can create issues through the kinds of fees they charge. Specifically with management fees, if a fund is charging 1% or 2% as a management fee, and manages $5 billion, right off the top you’re skimming $50 to $100 million dollars. If you’re employing 100 people that’s $500,000 dollars per person at the short end. Not to mention, some well-known firms employ even less employees. This has the ability of taking making the management fee a good safety net against performance going bad, which hampers the whole incentive aspect.

An interesting system could be a management fee that has an inverse relationship with assets under management. This way, a certain target fee would be extracted to cover the expenses needed to run your operation, yet not overcompensate you so that when your performance falls your compensation actually represents a significant fall.

Lastly, some fault should go to investors. They too have their own issues. A lack of pessimism or unending optimism during periods when the market is performing really well is usually a recipe for disaster. They need to act as a skeptic once in a while, to at least question their adviser’s rationale, like Buffett mentions. If not, investors/clients leave themselves open to going along with what their adviser or investment manager tells them, even when it goes against common sense.