Qurate Retail Group

AN IMPORTANT NOTE TO ANY READER: THIS IS NOT INVESTMENT ADVICE. IT IS IMPERATIVE THAT YOU DO NOT READ ANYTHING WRITTEN HERE AND MAKE AN INVESTMENT BASED ON THE DISCUSSION BELOW. QURATE RETAIL GROUP WILL BE A VERY LEVERED ENTITY AND THE STOCK IS BOUND TO BE EXTREMELY VOLATILE.

2020 has been an interesting year. In a time of many unexpecteds, this may take the cake. Sullimar Capital Group decided to acquire a minority interest in Qurate Retail Group (hereafter “Qurate”); the entity that owns QVC and HSN. Yes, you read that correctly.

Tech stocks are racing. The world is moving to the future. Our accountant is even commenting about all the money to be made in the stock market. And our path to wealth rests on QVC & HSN; both tied to a legacy TV distribution machine. Meanwhile, people are “cutting the cord” en masse. Given my recent pronouncements that I would focus on quality businesses with the potential to grow, communication is warranted.

Summary of Conclusion:

We purchased a minority interest in Qurate Retail Group because:

  • This is one of the most habit forming retail businesses we’ve ever seen.
  • There is a complex financial transaction that will make the common equity simply too cheap on a proforma basis. Proforma equity, while highly leveraged, will trade at 3-5x free cash flow available to common equity. The leverage is a concern, but this business will be able to service its debt obligations going forward. Further, the recent refinancing of the notes due 2022 is evidence that the 2023 notes will also be able to be refinanced. That mitigates some of the near term concern for free cash flow uses.
  • Qurate Retail Group has a capital allocation dream team. Greg Maffei controls the capital allocation. He is one of the best capital allocators alive and this financial transaction is the most shareholder friendly move we’ve ever seen.
  • Analysts that cover Qurate Retail Group point to a lack of buybacks as evidence that Dr. John Malone, the controlling equity owner, doesn’t believe in the entity. Those analysts are misinterpreting the current situation.
  • The entity has an incredibly resilient, and adaptable, business model.
  • This business is cheap, misunderstood, and carries a fair amount of leverage. Moreover, even investors that understand the business are afraid of the stock because they’ve been burned over the past 3 years. If we are remotely correct in our analysis our downside is very limited and we have a decent chance to make very satisfactory return.
  • The entire thesis rests on the stickiness of the business. This business has users that absolutely love the product. They use it as habitually as many consumers use far more well known brands. The issue here is the user base is generally women, aged 50 and older. They are the retail equivalent of Fly Over Country. Thus, Wall St. ignores them.
  • The market is worried about Qurate’s terminal value. At this valuation, that question is not the primary concern for entering shareholders. If this business is stable entering shareholders will do just fine. And, it is stable. Importantly, the financial transaction referenced above is evidence that EVEN IF Qurate is an ice cube, Greg Maffei, the man who controls Qurate’s capital allocation, will return capital to shareholders. Therefore, the potential for large losses is mitigated.
  • This is a low downside, high upside bet. The market thinks it is the opposite. And that’s exactly why the odds offered are so attractive.

Risks And Mitigants

  • Primary Risk – Leverage creates a fragile financial position under a business that is, at a minimum, not currently growing. Future cash flows have to be diverted to debt paydown and free cash flow available to common equity is minimal. This scenario would extend the investment duration into an uncertain (at best) future. This risk is mitigated by the:
    • Quality of existing customer relationships, especially among best customers. Even if the business did not grow going forward, these customers’s habits put a floor under how poorly the existing business can perform.
    • Debt market’s insatiable appetite for yield. Qurate recently refinanced it’s debt maturities due in 2022. According to trusted colleagues, the appetite is there to refinance the 2023 notes as well. However, the timing is not ideal because the notes trade at a premium to par and the underlying business is sound. Qurate will refinance at the right time.
    • Greg Maffei controls the capital allocation and knows what he is doing.
  • Secondary Risk – Qurate is disintermediated. In the short to medium term this risk is overstated. Qurate needs to navigate a shift to online. As of today, that migration is beginning but leaves a lot to be desired. Nevertheless, the company has an intimate relationship with its best customers and has continued to demonstrate an ability to acquire new customers with reasonably good economic characteristics. Further, Amazon tried, and failed, to recreate the Qurate experience. Long term, this is a risk to watch but the immediate threat is minimal.
  • Tertiary Risk – Qurate is a “melting ice cube.” This risk is mitigated by an objective analysis of the data as of today. More importantly, Greg Maffei controls Qurate’s capital allocation. He and his team just announced a financial transaction that strongly indicates they will get our money back to us if Qurate, is indeed, a melting ice cube.

Investment Case:

Who Qurate Serves

Qurate Retail Group’s 2018 and 2019 10-Ks claim 55% and 44%, respectively, of the company’s customers were women aged 35-64. Reports, though dated, suggest the average customer is ~50 years old. https://digiday.com/marketing/nrfdigitalsummit2015-how-qvc-got-its-customers-to-shop-on-mobile-and-tablet/#:~:text=QVC’s%20core%20customer%20group%20ranges,age%20clocking%20in%20at%2050. Based on what the 10-Ks don’t say, it’s probably fair to guess somewhere around 40% of customers at any given time are women older than 64.

Many people perceive the QVC customer to be somewhat unsophisticated. According to the slide below, she is far from an unsophisticated consumer:

Image used to demonstrate customer sophistication.
Source: 2018 Investor Presentation

At the May 22, 2018, investor day, Mike George, Qurate’s CEO, described the Qurate customer as “above average income, above average household wealth, [she has a] very engaged life….[she is] more likely to be involved with [her] community, church, hobbies; [she’s] just a very engaged person. And not surprisingly, she’s an avid shopper.” See Bloomberg (hereafter “BBG”) transcript of May 2022 Investor Day @ page 7.

Shows consistency of customer behavior
Source: 2018 Investor Presentation

Her relationship is deep and predictable. She consistently returns to watch her favorite hosts. The existing customer data in the slide below gives a sense of the overall stickiness of the customer base.

Image shows importance of existing customers
Source: 2019 Investor Presentation

Qurate does not employ a hard sell strategy; though it does use typical sales tactics to create the pressure to buy. The company’s strategy is to provide her with video entertainment in order to help her discover useful products she didn’t know she needed. By doing so, Qurate adds value to her life by sifting through all the potential options and delivering suggestions to her. And, she appreciates that service. Which is why she returns.

She is likely at a time in her life where she has more disposable income, more time, and enjoys looking for

  • ways to improve her home,
  • gifts to her children/grandchildren, and
  • unique products and deals that make her feel good.

The hosts at Qurate offer her suggestions for how to solve those needs.

Yes, the slide above shows pretty poor conversion from new customers to retained and existing customers. While improved conversion would be very nice, this business doesn’t require strong conversion. Instead, the business requires converting 33,000 of 2,300,000 of new customers (1.5% of total funnel) into best customers. Then it requires retention of these best customers.

Simply put, Qurate’s super users are addicted to the retailer. As of 9/30/19, this population was 17% of Qurate’s user base and accounted for 70% of trialing 12 month (“TTM”) sales. They watch the company’s content regularly and are by far Qurate’s most important customers.

Super user habits drive the business outcomes
Source: 2019 Investor Presentation; NOTE the bottom right of this slide showing conversion from new to best.

It can not be overstated how habit forming 33 web visits per month and 18 visits to a QVC TV property per month are. Is that Facebook, Apple, or Google type habit formation? Clearly not. But it’s not too far off from Starbucks habit formation. And that says something.

As of today:

  • The transition from new to best customer is remarkably stable.
  • Super fans are retained at 99% through 9/30/19, and 97% through 6/30/20. There may be seasonal changes that drive the 2% difference. We will be watching these retention numbers like a hawk. If they change meaningfully then we are wrong.

The reactivated part of the sales/lead generation funnel acts much like new customers (although almost certainly at a lower cost per sale). It may sound odd, but those customers really aren’t all that important to the business. The key to this business is super fan interaction.

The Current Funnel of Customers Is Healthy

Qurate’s legacy lead generation funnel is dependent upon television distribution. Qurate gets distribution by paying cable distributors a commission on sales. Some agreements have commission guarantees. These guarantees are applicable when television operators make concessions such as:

  • committing to deliver a number of subscribers,
  • giving enhanced channel placement, and
  • promising QVC advertising slots.

Generally speaking, QVC’s distribution costs are variable. In this way, Qurate aligns incentives with video distributors. This strategy helped them gain desirable channel placement when bundles exploded with options. Today, they are offering similar win/win solutions in order to help secure distribution with the new video providers.

There’s a credible argument that Qurate’s customer funnel is still tied to the bundle. The current iteration of the business has ~2/3 of customers coming organically and 1/3 coming from performance marketing. Needless to say, the legacy TV bundle is not something with a positive long term outlook. However, it’s unlikely that the cable bundle unravels over the next 5 years. Given the valuation, that’s all we need to avoid a bad outcome (assuming Super User retention is stable).

The common equity is so “cheap” because there is a lot of debt on the balance sheet and the market is fearful that Qurate’s legacy distribution advantage is eroding under its feet. It’s important to note the debt maturities are well spread out and manageable. See the distribution below:

Debt distribution is well engineered
Source: Bloomberg. Note – the orange line represents debt expiring in the last 2060s.

Despite the structure of the debt, the market is wary Qurate can service it’s obligations. Further concerning the market, the company’s performance since the HSN integration has fallen short of expectations. QVC acquired HSN in 2017 despite horrible customer attrition at HSN. In our view, Qurate underestimated the problems at HSN and paid too much. In investing parlance, HSN was a value trap.

As if that wasn’t bad enough, Zulily, once considered the future, saw sales decline in every quarter of 2019; resulting in a $1+Bn impairment. Qurate argues these trends are turning; but it did it’s best to serve Mr. Market a healthy dose of confirmation bias. Qurate’s management team points to a healthy customer funnel to rebuke the market’s assessment.

Customers "beginning" to trend younger.  Will that translate to a brighter future? TBD.
Source: 2019 Investor Presentation

It should be noted that the slide above doesn’t tell us much about the current customer make up. Notice how the “overindexing” applies to new customers. It would be more useful to see current customer distribution. From this, all we can really infer is ~22% (2.3mm new customers out of 10.6mm total customers in 2019) of the customer base is getting younger. This is a bit of a blessing and a curse. On one hand, younger customers have longer customer lives. On the other hand, they are arguably less sticky. Time will tell how they season.

An anecdote further provides some comfort on the quality of the new cohort. According to an expert, interviewed on the Stream platform:

“…[Qurate] is constantly experimenting…they will find ways to continue to be relevant to the audience. It’s interesting because over time, many pundits have said, ‘well, what’s going to happen when all your customers die?’ Well, the interesting thing is that the average age of new customers has never been younger and the average demographic of the customer base hasn’t aged a year...it’s starting to get slightly younger because the business is able to constantly generate a very, very large number of new customers and then get them to behave…largely as older classes of cohorts…have behaved.”

Let’s assume the average customer is closer to 55 rather than the 50 year old number cited earlier. She still has at least 20 years of consumption in front of her. Yes, today’s 55 year old woman is probably more likely to comparison shop than the typical QVC customer was. QVC is trying to combat this pressure with improved merchandising. We think this comment from the QVC message board (discussing whether people price shop QVC) is close to today’s Qurate customer’s “truth:”

“I can be a little picky about what I buy as far as size, color, fabrication etc etc so when I find my exact item, I then don’t spend time with price comparison. I shop mostly outlets. But if I find something I really want on Q, I’ll buy.”

While the cable bundle may unravel over the next 20 years, there is a reasonable possibility Qurate is able to pivot. For instance, skinny bundles would help Qurate immensely. The Roku app is showing signs of promise; though not enough to satisfy the market. But, given the behavior of Qurate’s customers, the probability of a near term unraveling of the customer base is very low. Therefore, Qurate has time to introduce her to its new technologies while she visits her favorite hosts.

Note: Mike George cited the average customer relationship as 35 years at the May 2018 Investor Day. See BBG transcript; 2018 Investor Day; @ pg 7). 35 years feels high but demonstrates the stickiness of the relationship. It is our view that Wall Street overlooks this customer base because it isn’t sexy. These 33,000 women per year are the retail equivalent of Fly Over Country. We are happy to partner with a company serving them.

What About The Future

The issue on everyone’s mind is whether Qurate can (a) continue to acquire customers and (b) pivot to the future. In a world that’s ever changing perhaps it’s just better to look at what is happening rather be definitive about what may. To that end, customers have come into Qurate’s funnel in the recent past:

Lead funnel is consistent
Source: 2018 Investor Presentation

But isn’t Qurate dependent upon the bundle to deliver new leads? In the short term, yes, Qurate depends on the bundle. Over the long term, the picture is less clear.

The most obvious question to ask is whether Facebook and Amazon can disintermediate Qurate. Isn’t the world moving to a world where influencers aggregate attention and link to products? Won’t they simply displace the need for Qurate? Moreover, isn’t Amazon the place to go to purchase everything? Why does Qurate need to exist?

Qurate needs to exist, for a small percentage of the population, because they love it. And, within the niche customers, they don’t want to leave. According to the same Stream interview cited above:

“What’s absolutely impressive to me, as somebody that’s been inside the business, is the parity of customer metrics across market[s]. The average age swings a little bit…but it’s relatively tight. But as far as the customer loyalty metrics and average number of units purchased…its just amazing to see how constant those numbers are across markets...It’s just one of those things in the model and how QVC operates to build that customer loyalty and takes a customer-centric view…[that] engenders great loyalty once they decide that QVC is a place they enjoy spending time with. A retailer they enjoy spending time with in discovering great products, new products, new inventions, and really spending time with. Interestingly enough, the customer views QVC as a part of their family.”

Think about that. Part of her family. Last time I checked a family can have more than one member in it.

In fact, one could argue Qurate will be even more important to her as her attention becomes even more disaggregated. Qurate’s average customer already shops at Amazon. She goes there when she knows what she wants. But, she is also smart enough to know that Amazon is The Everything Store. Sometimes “Everything” takes way too much mental effort to siphon through. Sometimes she just wants to be entertained and discover something.

She also goes to Facebook’s properties. But again, she is bombarded with choice. She is intelligent enough to know that an influencer will sell anything. And, while she may buy things from influencers, like with Amazon, she still enjoys frequenting her trusted “family” at a virtual department store/entertainment experience. This habit occasionally results in a $50 purchase.

Importantly, that $50 purchase can come with an installment plan priced at 0% interest. So, she can burn some time, peruse some items, feel a connection, be entertained, and part with a mere $10 today. Note – Qurate sends the product as soon as the first installment is made. Some customers refer to the plan a layaway without the wait.

Will she buy more on the internet in the future? Undoubtedly. Does that mean she will stop using Qurate? Doubtful.

It’s noteworthy that Amazon attempted to recreate Qurate and failed. Amzon’s attempt, called Style Code, was a daily online show. Interestingly, the “channel” used celebrities and influencers to aggregate attention. But, it seems as though recreating a home shopping network may be harder than it is in theory. See https://econsultancy.com/why-did-amazon-s-online-video-shopping-channel-fail/. Might Qurate be a strategic asset for Amazon one day? Stranger things have happened.

Facebook May Even Be an Opportunity

Let’s take a step back for a moment. As stated above, Qurate is looking to convert ~33,000 people every year into best customers. As of today the conversion ratio is a paltry 1.5% of new customers. What if Facebook and Google improve the customer funnel and help Qurate increase conversion?

Potential conversion ratios

It’s impossible to predict where the ultimate conversion factors end up. Thus, it’s hard to know how many leads will be needed in order to generate the necessary annual super fan cohort. But, it’s also impossible to deny that the consensus opinion is Facebook, Google, and Roku are going to help deliver targeted, measurable results.

Mike George highlighted Qurate’s performance marketing strategy in the 2019 Investor Day.

Performance marketing is more of a focus

Market participants don’t seem to care very much about this slide. They are focused on the legacy bundle distribution. But if Mike George isn’t outright lying when he repeats, over and over again, that Qurate is able to target these cohorts with a payback period of only 1 year, then this could be quite an opportunity for them. That said, the size of the opportunity may be inherently limited by the niche nature of Qurate’s offering.

Mike George’s answer on the 2q19 earnings call acknowledges how niche his offering is: “I guess a pretty tight set of return metrics to that [performance marketing] spend, has to kind of pay back within a year and we are focused on sort of needle in the haystack of how do we find customers that could become really great core QVC customers as opposed to one and done…There are pockets of these digital customers, especially those who come in on more engagement platforms like social media, media marketing that are coming into the ecosystem and becoming pretty high value pretty high frequency customers right away.”

To be clear, changing the top of the funnel will add additional variable cost to the business as Qurate has to compete for eyeballs. However, it’s plausible that performance marketing ultimately enables a higher quality customer to enter the funnel. At this valuation we don’t need much to go right to make a satisfactory return. We do, however, need cohort stability.

The Future of Distribution

Qurate knows it is going to have to pivot the business over time. For now, the business appears to be making progress on its eventual pivot:

Engagement increased despite customer attrition concerns
Source: 2019 Investor Presentation

According to the slide above, 2.5 million Roku installations resulted in 480 million hours streamed; or 200 hours/install. It’s unlikely that all users stream equally. Therefore, it stands to reason at least some super users have turned to Roku. Moreover, COVID accelerated installations. As of August, Qurate announced they had a total of 3.6 million Roku installations. That’s 50% ytd growth on an OTT platform! Given how this business works, dismissing those installs as a transitory benefit is a mistake.

The following claim is unbelievable. It simply can’t be true. But it’s also way too important to leave out of a writeup. A different interview on the Stream platform contains the following statement:

“QVC…has got to be entertaining. It’s got to be able to bring the viewer back again and again. Mike once said to investors, it’s a hundred hours of viewing before somebody makes their first purchase. How many websites are you willing to sit on for 100 hours before you buy their product?” Emphasis added.

The idea that someone is actively watching QVC for 100 hours before a purchase is simply unfathomable. But, it’s likely that QVC is running in the background while she is at home. And if that’s the case, QVC is a part of the customer’s life. So, while we agree customers have had more time at home, we reject the premise that COVID is some one time bump. Quite the contrary, COVID was the catalyst to introduce a larger cohort into a life long relationship. That is, unless human behavior changes going forward, which is unlikely given the amount of data supporting habit formation and inertia.

Importantly, when these new cohorts come to Qurate, they are more likely to make a purchase on a digital platform. 81% of customers now purchase via e-commerce. See BBG transcript; May 2018 Investor Day; @ 7). That is (a) an incrementally positive sign and (b) probably a function of the current cohort of 50+ women being more and more comfortable with internet purchases. This is critical because Omni-channel customers spend far more than Digital and Traditional customers.

Habits of users

Over time, the business should continue to trend towards digital, but it will probably take longer than Mr. Market would prefer. Especially since ~32% of sales are still completed via telephone.

A Glaring Wart in The Business

It’s very important to be honest and acknowledge how atrocious HSN’s social media presence is. The only kind words to say about HSN is they partnered with Guiliana Rancic. That’s something, but not much. On average, their hosts have a mere 12,335 followers on Facebook and that is heavily skewed by Colleen Lopez. Take her out and they have an average of only 6,247. Instagram is even worse since Colleen doesn’t have much of a presence on The Gram.

By contrast, QVC hosts average 71,384 followers on Facebook. 4 of them have in excess of 100,000 followers. Moreover, QVC has relationships with Martha Stewart, Rachael Ray, RuPaul, and others. While they may not be the influencers to millennials, those people matter in the attention aggregation game.

This should have been a MUCH greater focus for the company already. That said, Qurate has been dealing with digesting a very complex integration with HSN. QxH, the division that houses QVC and HSN, reorganized recently and hired Leslie Ferraro as its group President in September of 2019. She has an impressive resume (below) but it’s unclear (a) why she left Disney and (b) whether her experience will enable her to execute Qurate’s pivot to the future.

CV of QxH President

Going forward we would really like to see Qurate fully lean in on social. We honestly believe Qurate could be the shopping method of the future. The business’ core competence is screen based sales. It gives entreprenuers an incredible distribution platform at a time when they are otherwise playing an ecommerce game that results in minimal return.

There is no reason why Qurate, with its rabid fan base, should not have a robust online community that acts as a meeting place. But, it must become a top priority. Thus far, Qurate looks to be moving too slow in that realm. It’s possible Qurate’s focus on profitability today will preclude the company from a true pivot to tomorrow. That outcome would not be ideal, but would also limit our downside in this investment IF our assessment of cohort strength is accurate.

2019: A Year To Forget

2019 was a bad year for Qurate. There’s no two ways about it. That said, throughout the year Mike George was candid about the issues the business faced.

In 1q19 Mr. George commented about the HSN integration taking focus off the merchandising teams. He also mentioned beauty weakness, which is something to monitor going forward. Critically, engagement on the QxH platform increased 4% in 1q19. Thus, customers stayed engaged. That will forever be the most important metric we look at because at its core this is an investment based on habit.

In 1q19 operational difficulties and pullbacks on promotion slowed sales. Large merger integrations are very, very difficult. This one is no different. Therefore, as long as customer engagement is increasing, short term business results are of limited concern.

2q19 was solid but 3q19 saw more problems. In 3q19 Mr. George walked through product mix issues and highlighted the closure of an HSN product line. He also mentioned a concerning 3% customer attrition rate. However, as shown above, new and reactivated customers are not this business’ engine. They are important to feed people into the best customer funnel, but losing some moderately interested consumers is not the end of the world.

To reiterate, the key here is determining whether the super fans are leaving. Losing 3% of “window shopping” customers is not good, but it isn’t horrible either. While customer count did decline, through TTM 9/30/19 Qurate saw increases of:

  • 7% in TV viewership,
  • 105% in digital livestream sessions, and a
  • 30% increase in HSN digital livestream sessions.

Thus, it stands to reason that the quality of Qurate’s customer base actually improved in 2019. But, it is odd that improvement didn’t result in higher sales despite the industry headwinds. The market doesn’t need much to spook on Qurate retail’s stock. 2019 gave it plenty of reasons to do so.

The COVID Bump – A Sustainable Boost

Fast forward to COVID-19 and Qurate is benefiting immensely. Why? Because people are stuck and home and have to watch TV. They can’t go anywhere so they are discovering Qurate en masse. Yet, the market discounts this as well. Sure, ecommerce is growing but that’s because people have no other option!

But here’s the thing, Qurate has actively avoided getting into price matching. Why? Because they are playing the long game and looking to cultivate strong, long term, super fan customer relationships. COVID enabled them to have more chances to convert women into super fans.

Total active users increased 14% at QxH. That’s ~5mm customers. Apply the 1.5% conversion factor to that number and you have 2+ years of super fan growth today. On the 2q20 conference call Mike George indicated the COVID cohort is behaving exactly as expected. That’s big news.

Even more impressive, the customers piled in despite Qurate pulling back on offering Easy Pay (the payment installment plan) in order to manage bad debt risk. To be clear, they still offer Easy Pay on all items but they were more stringent about who they extended the terms to. People that are dismissing this as just another ecommerce company benefiting from COVID are not deeply thinking about the relationships being built.

Qurate also demonstrated the model’s merchandising adaptability. They were able to quickly pivot and showcase items that were relevant to her. They ditched apparel, beauty, and jewelry programming and aired home, home office, and leisurewear programming instead. Thus, the pandemic provided a huge opportunity for Qurate to prove they put her needs first. Especially when it mattered most. It’s hard to dismiss that as a transitory benefit.

The pandemic also provided management with an opportunity to showcase prudent operations. They were cautious with their buying and managed supply chain complexity. That was no easy feat given how fast everything was changing.

Two Glaring Capital Allocation Questions

Qurate Retail Group acquired 100% HSN and Zulily to bolster scale, offerings, and tech competence. Neither acquisition has been a good one thus far. Strategic rationales at the time included increased scale for the HSN acquisition (TBD on synergies) and differentiated core competence at Zulily (recently written down).

Regardless of the Zulily outcome, it’s important to note that Qurate was attempting to pivot into a new, forward looking, business line. While bears may argue the failure (as of now) is evidence of a classic incumbent mistake, the effort is at least evidence that Qurate understands where the puck may be going. It would be easy for most public management teams to milk today’s cash cow and avoid tangential, riskier, business propositions.

The “why’s” behind Qurate’s missteps differ:

  • HSN – It’s still too early to call the HSN acquisition a failure since the business is not fully integrated into Qurate’s supply chain. That said, HSN had major customer declines at the same time Mr. Maffei cited valuation as a reason to make the acquisition. There is a real case to be made that Qurate purchased a value trap (bears would argue that’s exactly what we are purchasing today).

    Regardless, the objective truth here is QVC and HSN merging is not an easy integration. As of today, projected synergies are $400mm annually. If those are realized, the proforma market cap is < 10x incremental synergies. Meanwhile, Qurate is incurring integration costs, which are depressing current cash flows while the market doubts it’s future. That fact pattern on a leveraged capital structure equals multiple implosion.
  • Zulily – Zulily may not fit within Qurate. While this might be hindsight speaking, it was also somewhat foreseeable. Fundamentally, Qurate is a relationship driven business. Zulily, on the other hand, is more transactional because it drives behavior through promotion. Promotion is inherently price sensitive and less sticky. Thus, it’s plausible Zuilily was a big swing and miss; evidenced by Qurate’s $1.0Bn 2019 Zulily impairment.

    On the other hand, the acquisition did add some important technical expertise. Further, the Zulily team brought an innovative eCommerce ethos into Qurate. Going forward, Zulily has a pretty impressive new management team and has refocused it’s marketing efforts. So, maybe Zulily can turn around and the impairment was overly conservative. Regardless, as long as Zulily doesn’t drain cash flow that acquisition won’t matter at this market capitalization.

Capital Returns

Many analysts point to Qurate pausing it’s buyback as evidence that Dr. John Malone and Greg Maffei don’t believe in the entity. I have a very different view. If you’d like to see a management team that believed in the entity way too much look no further than Bed Bath and Beyond.

From 2012-2017 Bed Bath and Beyond repurchased ~$7.0Bn of stock. The current market capitalization is $1.6Bn. Look at the market capitalizations of Bed Bath and Beyond throughout that buyback:

Bed Bath and Beyond destroyed shareholder value.

Above is an example of completely atrocious capital allocation on behalf of minority shareholders. Yes, there is some Monday Morning Quarterbacking in that statement. That said, it wasn’t hard to see Bed Bath and Beyond lighting minority shareholder capital aflame for at least some of that time period.

On the other hand, think about what Greg Maffei has done within Qurate over the past 18 months. Mr. Maffei talked candidly about the business uncertainty and capital return decisions over this period:

  • “We’re going to hold off or be timid at least for a period, [on share repurchases], and try and gain visibility and certainty around the success of [investments in the QxH integration, reassessment of fulfillment centers, and internal purchasing departments] and the ongoing direction before we lean in on some of these things like share repurchase...I think we favor the public, one keeping them as our partners and leading them with share repurchases. As you have noted, we have large free cash flow, we have balance sheet capacity. So the opportunity to do share purchase when we see visibility and confidence in the results is there.” See 1q19 Earnings call.
  • “The reality is that our power is that TV channel…those traditional customers, we’ve probably had less viewership reduction than many might think. Cord-cutting is less relevant to our customers…[which] is not to say we don’t suffer from it, but [our customer base is less impacted]. Nonetheless finding growth in that environment is not easy.” -MoffettNathanson 6th Annual Media & Communications Summit; May 2019. Note – Mr. Maffei was likely referring to gross viewers since engagement has actually increased according to the 2019 Investor Presentation.
  • In 2q19 Mr. Maffei said “We are going to be opportunistic on our share buybacks, we had increasing confidence during some of the results of the quarter as Mike and Jeff outlined and I would note there was a substantial pull back in the share price during the quarter, which made the share repurchase a more attractive option.” See 2q19 Earnings Call. Note – The average purchase price in this quarter was $12.94.
  • “We have been tried to be consistent over the last several quarters with the view that our capital allocation philosophy, which has been primarily focused on share repurchase over the last several years. It has been somewhat disappointing in light of the results we’ve had in the performance of the stock. So, we’ve tried to become more opportunistic and buy less on an absolute basis and more on a opportunistic basis and try and find attractive entry points for that.” See 3q19 earnings call.
  • “Given the volatility of the stock and the results, we remain cautious on the buyback. While the business is experiencing some headwinds now, we still note it generates strong free cash flow and we will prudently and opportunistically allocate it….As far as returning capital to shareholders, we remain cautious. There is volatility both in the business and in the marketplace, and we’ll wait for the year, as the year goes through on rather what we do with capital on — in that regard.” See 4q19 earnings call.

The following conclusions can be drawn from the quotes above:

  • Greg Maffei looks out for shareholder interests
  • Qurate had an uncertain year in 2019
  • The Qurate team is very transparent about what’s going on at the company
  • Greg Maffei liked the shares at ~$13. He isn’t a short term trader and was making an opportunistic purchase. Today’s shares trade at ~$10.50/sh.

In March of 2020 Mike George alluded to the current capital return strategy when he said:

“We chose to kind of…pause…share repurchases…I don’t want to tip our hand on any specific plans as I would say, we’re looking at lots of options, but you could envision a range of things from flavors of share buybacks…dividends…debt reduction…[or] green energy investments.” See: BAML Consumer and Retail Technology Conference. Note: The green energy investments are not random. They are a meaningful way for Qurate to manage its tax obligations.

Fast forward to August 2020 and Qurate Retail Group announced a transaction that will:

  • Pay $1.50/sh cash dividend;
  • Pay $3.00/sh preferred dividend, yielding 8% for 10 years; and
  • Result in a very levered common equity stub with a proforma market cap of ~$2.5Bn.

What In The World Is This?

With a stock price of ~$10.50/sh Qurate is giving investors the chance to redeem 45% of their capital currently invested in the business (assuming the preferred shares trade at par). Alternatively, investors can sell their common shares, almost certainly realize a tax loss, and purchase the preferred shares with the proceeds. More interestingly, investors could sell the preferred and buy more common shares, which now have even more leverage.

While some investors see as reduced confidence because of buybacks declining, others might look and see an opportunity to reward the true believers. To be clear, Qurate is shrinking the common equity to a proforma market cap of $2.5Bn by offering a preferred stock. This offers common stock investors, should they choose, an extremely huge effective buyback without introducing debt into the entity. It’s hard to fathom a more shareholder focused move.

In March 2020, Mike George talked about the share price performance. He said

“Well, I think when I look at the current share price and generally even the reaction to our Q4 results to me it just reflects this wall of worry that some investors have that we don’t share about whether we can sustain long-term growth in an environment where admittedly linear TV viewing has been declining. And so I think investors have looked at down 3% or so sales performance in 2019 at QxH and wondered if that’s about harbinger of the future.
We’ve also had some a little bit of margin pressure in 2019 but again I think investors have looked at that and said, I wonder if that’s the new normal, I wonder if Qurate but more specific QxH can continue to generate the kind of high free cash flow conversion that historically has had.
Our view is positive on all those questions.”

So, here’s what Qurate is really doing –

Qurate is giving investors the chance to express their views. Investors with doubts no longer have to watch Qurate buyback shares into a falling share price. Instead, they can get cash out today and even sell the preferred shares. Interestingly, the preferred shares are now trading for $106 per $100; implying a healthy appetite for the security.

Alternatively, investors can choose to believe in Qurate and exchange their shares for a highly levered common equity. In our view, the common equity is the best security to own.

Mike George and Greg Maffei have been very honest about Qurate’s issues. Fundamentally, the business is strong but does have transitory problems. Does it grow? No. Is that somewhat perplexing? Yes. But, not growing is also not shrinking. Most importantly, engagement continues to be strong (and growing).

Further, the Qurate team has given people the option to take some chips off the table. Many management teams, like Bed Bath and Beyond’s, would not do that. Instead, they would stubbornly buy in shares while destroying shareholder value. This is extremely positive for minority shareholders.

Why Wouldn’t John Malone Just Repurchase Shares Here

Investors seem to think Malone wants to take chips off the table here. After all, if he believed in the entity why wouldn’t he just keep buying back shares? Here is where some will call me naive: What if, just for a moment, we consider that John Malone is at a point where he doesn’t mind trying something creative to unlock value? What if he needs some cash for somewhere else and he’s concerned about taxes increasing next year? What if he is trying to leave an instrument in his estate that generates some additional cash flow? What if this gives him an even more accelerated path to a buyback if the market doesn’t respect his company?

Prerecap, this company would have taken anywhere between ~8-10 years to retire all the common equity. That’s just been cut in half. These guys play the long game and Dr. Malone just massively shrunk the duration of his equity base in a very predictable business. Moreover, not all that long ago he injected fresh capital into Discovery Communications, a business that claims to have similar dynamics (though we much prefer Qurate). So it’s not as if Dr. Malone believes the erosion of the bundle imminently ruins his companies ability to earn in the future.

Yet, people want more buybacks. Or more insider purchases. The problem isn’t Qurate. The problem is that complaint’s lack of creative thinking.

Here is a snapshot of insider activity since 2018:

Insiders were net buyers.

Yes, it would be nice to see insiders step up here. That said, find another public company has insider transactions that look like the ones above. Further, we will not be shocked to see Mike George rebase his options package shortly after this transaction. Then Malone and Maffei can buy some shares on the open market once the dust settles.

In conclusion, Mr. Maffei is delivering on his promise to increase shareholder choice AND massively shrinking his common equity base. What good would it be for his reputation if he put another $1.3Bn of “leverage” in front of the common equity right before it blows up? People see this move as weakness. They are wrong. It is a huge vote of confidence.

The Opportunity, and Potential Pitfall

It’s undeniable that Qurate Retail Group is in the middle of a massive transition. Long term, the business must pivot to non linear video. Medium term, the business has to integrate HSN into its operations. Short term, the business has to figure out why it has missed some trends and adapt to a faster product launch environment. All that said, the team at Qurate has always been forthcoming with the market.

They’ve pivoted their capital return strategy as the facts changed. Thus, if this entity really is a melting ice cube, as the market seems to think, Mr. Maffei will do everything he can for his shareholders. This is not some value trap where management stubbornly destroys value. This is a good business with an extremely adept capital allocator that is minimizing shareholder downside. The market just can’t see that yet.

Valuation

Given the above, we are betting on an entity we believe can sustainably generate $500mm-$700mm of free cash flow available to common equity. Not all of that free cash flow will come to the common equity because some will reduce debt. However, there will be many options for that free cash flow given the debt market’s insatiable appetite and the quality of this business. If the debt markets substantially tighten up, then we will have a few lean years as shareholders. However, given the habits of the customer base and Qurate’s ability to pivot it’s offerings, we are prepared to hold this equity through a recession.

Hopefully the market continues to doubt Qurate and Mr. Maffei can work his magic on a doubted entity. When to sell will be a more difficult question. Given the lack of growth, we will almost certainly reduce some of the position if the price increases meaningfully. We hope to own this entity for a long long time. If we do this will be a very successful investment.

A Note on Capital Structure Complexity

Qurate is controlled by Dr. John Malone. It’s capital allocation is controlled by Greg Maffei, who was hired by John Malone as CEO of Liberty Media Corporation (“LMC”). LMC acquired Comcast’s stake in QVC in 2003 because it needed cash flow. Prior to 2003 LMC was basically a publicly traded entity that held a bunch of assets Malone had acquired at TCI (AT&T bought TCI then spun out LMC).

As a Malone owned entity, Qurate carries the requisite levered capital structure and typically employs a levered buyback strategy. In plain terms, Qurate has a bunch of debt and as it grows it uses more debt to purchase shares. This financial model is incredibly powerful when an entity is growing. It also spooks the market when an entity stops growing; even moreso when the entity shrinks. And Qurate temporarily shrunk in 2019. Hence the share performance.

Further complicating Qurate’s capital structure is a group of convertible exchangeable debentures (CEDs). These are debt instruments that can be converted into shares of an underlying company rather than settled in cash. The note holder has the option. In Qurate’s case, two CEDs are tied to stocks that are now in the money: Charter Communication and Motorola Solutions Incorported. The note holders currently have the option to “put” their notes to Qurate in exchange for shares.

The Charter exposure is covered by an indemnification agreement GCI Liberty agreed to when it was spun out of Liberty Ventures. The Motorola Solutions Incorporated exposure is being managed via a total return swap and some debt tender offers. Going forward, Mr. Maffei will aggressively manage these obligations.

Looking at this capital structure today it’s easy assume there is some questionable financial planning. However, many of these CEDs stem from a market call LMC made in 2000. That call was hugely successful but created an obligation in 2030. We are now approching 2030. Thus, previous smart actions are beginning to have negative consequences; albeit 30 years later. More importantly, the business quality can support the debt.

This is a high quality business with a highly engaged, recurring customer base. We look forward to watching Mr. Maffei’s next round of financial engineering masterstrokes.

6 thoughts on “Qurate Retail Group

  1. Any concer wtr the following:”KPMG LLP has expressed an adverse opinion on the effectiveness of the Company’s internal control over financial reporting.”

  2. Are you concerned about any potential accounting fraud within the Malone empire? His companies are constantly involved in so many complex transactions, doesn’t it make you wonder how they are able to focus on their core operations when so much time is devoted to all these complex deals? Malone’s empire seems to have all the ingredients for some sort of blowup in the future: 1) Lots of debt, 2) Complex transactions year after year, 3) Related party dealings, 4) Name that garners trust with investors, which causes them to let their guard down

  3. This playout very well. Congrats.
    On the 3Q call, Greg said “During the recent quarter, we were prohibited, as we noted, for some tax reasons for doing buyback”. Any idea what this is about?

    1. They couldn’t buy back shares after the transaction without creating taxable event because of IRS rules. I don’t know the specifics but know that’s the issue.

      FWIW – Not sure buybacks are how capital gets returned here.

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