Virgin: stop whinging and deal with the debt
Sky battle self-inflicted
Analysis Virgin Media used its quarterly conference call last week to throw another tantrum at Sky. What's ridiculous is that most of Virgin Media's current problems are self inflicted. The dispute with Sky involves a few tens of millions in fees: that's dwarfed by the amount of debt the group now carries. Without new capital, the cable giant's future looks bleak.
Let's have a look at the balance sheet.
The cable industry loves leverage: this has been the case since the early days of US cable, and the model was perfected by John Malone at TCI over many decades. The theory goes that the interest payments eat all the profits, and therefore no tax needs to be paid over to the government. The cash flows guarantee the debt, and the cash flows steadily rise over time given that monopoly rents can eventually be extracted. The leverage leads to greater shareholder returns on a percentage basis than a non-leveraged business model, especially as the business is valued on multiples of cash flow.
The corollary of this is that in times of falling cash flows or rising interest rates the equity can easily and quickly be wiped out and the debt holders take over. This is what effectively happened in the UK cable industry a few years ago: ntl ran around buying as many cable systems as possible using bondholders' money and then didn't generate enough cash flow to keep the bondholders happy. The bondholders effectively took over the company, installed new management, bought the only other UK cable system of any serious size, bought a MVNO to give it an ultra-fashionable quad play, and more importantly a fresh brand.
So at the end of Q1, Virgin Media had net debt of £5.7bn, with a weighted average cost of debt of 7.9 per cent. This equates to around £454m of annual interest charges. Most of the debt is in US Dollars and floating rate, which probably means the skills of the Virgin Media Treasury department in predicting future interest and exchange rates are far more important than any contract negotiations with Sky.
Cable: where's the investment?
Virgin Media loves to use operating cash flow (OCF) metrics, which it claims is a good measure of the underlying performance of the business.
However, I'm old fashioned and prefer to look at the cash flow statement, which shows net cash provided by operating activities of £106m, whereas net cash used in investing activities is £147.9m. This implies a cash outflow from the business of £41.9m, although this includes interest charges of around £110m.
This is really, really important - because if things continue as in Q1, Virgin Media will not be around for much longer without generating some cash or changing the capital structure of the business. Of course, the extremely poor Q1 cash flow could simply be due to seasonal factors. However, Q1 2006 net cash generated by operating activities was £207.3m and capital expenditure was lower than in 2007. So Q1 2007 was not a blip.
The Virgin Media capex statement in itself is extremely interesting because it shows that it is capitalising the cost of customer premises equipment, (CPE) or set top boxes. CPE accounted for £62.5m out of total quarterly capex of £152.9m . Another way of looking at this is that CPE costs do not feature in the Virgin Media OCF calculation as they are depreciated below the line.
As far as I'm aware, BSkyB immediately writes off the cost of CPE as part of subscriber management costs and, in fact, ownership of the box transfers to the customers. It is hardly surprising that BSkyB charges for its HD and Sky+ boxes, whereas Virgin Media gives them away like candy.
Even more interesting is that Virgin Media only spent £3.5m on upgrading or rebuilding systems, with an additional £15.4m spent on "scalable infrastructure". This is hardly the spend of a cable company busy upgrading its systems getting ready for DOCSIS 3.0 and 50meg to the home. In fact, it smacks of a company spending the absolute minimum to keep things going.
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