01 Sept 2007

If you've ever shopped in the high street bargain basements then you'll know that sometimes there is an item that is so cheap that you can't resist it. Right now, the value of Virgin Media has slumped so low that a potential buyer of the unlucky cable company could soon be paying in loose change rather than having to get out a cheque book.

Before problems in the US sub-prime mortgage market triggered a global credit crunch, a bevy of private equity houses, led by Carlyle Group, had been lining up to take a look at Virgin Media, with a mooted valuation of US$23bn (€17bn). The company, quite rightly, decided an auction was the best route.

But the landscape changed and the credit crunch forced Virgin Media to postpone the auction. In any case, several of the potential bidders had already stepped back to re-evaluate. In an easy credit market it is a lot simpler to buy a company that is not firing on all cylinders and has a ton of debt. After the company's poor quarterly results on August 8, Moody's Investors Service lowered its outlook on Virgin Media and its US$12bn debt from "stable" to "negative". By August 16, the share price had reached a 52-week low at US$21.56.

And no wonder. The company posted a net loss in its subcriber base for the fifth consecutive quarter with annualised churn growing to 22% from 19.1% quarter-on-quarter. Telephony subscribers also fell - particularly worrying because telephone represents 55% of consumer cable EBITDA and Sky and others are undercutting pricing. The competitive UK environment and Virgin's unwillingness to reach an agreement for the inclusion of Sky's basic channels on cable means that any cost savings from the merger of Telewest and NTL are being chewed up by marketing costs.

Virgin Media is facing an effective triple-whammy consisting of Sky's superior TV product, low-cost bundles of broadband and telephony from the likes of Sky, Carphone Warehouse and Tiscali, and the increasingly attractive Freeview offer. In broadband, both Sky and BT are marketing aggressively against Virgin Media.

In fact the only good news from the recent results seemed to be on the video-on-demand and PVR front. Some 1.4m of Virgin Media's three million subscribers are using VOD at least once a month, with average monthly views per user up from 9.6 at the start of the year to 13.7 in the second quarter. The good news is that people who use VOD are half as likely to churn as non-users. The bad news is that the service is largely free content or add-ons to packages, so the revenue is not big. In fact Virgin Media won't even quantify it. As to PVRs, Virgin Media says 53,000 signed up for the V Plus PVR service in the second quarter, brining the total to 167,000.

The deal to offer some Premiere League football games should help make up for the loss of the Sky basic channels and also attract some subscribers to upgrade their TV service package, but according to Enders Analysis, the estimated cost of acquiring the games from Setanta Sports makes it "sceptical whether the Setanta investment will pay for itself".

All this means that the price Virgin Media will command in a sale is already less than the mooted price in July. A continuing credit crunch will exacerbate the downward price pressure and if the operating results of the company do not improve, then the market will shove the share price even lower. Does Virgin Media need to sell? One could argue that it would be wiser to hold onto the business rather than sell at a depressed price, but the problem is that Virgin Media is struggling in a highly competitive market where it needs to upgrade its offer, lower its prices and improve its customer service all at the same time as keeping its quarterly numbers up. This is proving hard for the company to do.

The boon of a private-equity sale is that the company can be pulled off the public market, out of the glare of quarterly results. But with the credit markets in their current state the private-equity guys are going to drive a tough bargain if they bid at all. In the midst of all this is of course Liberty Global, the international cable company controlled by John Malone, one of the smartest investors there is.

Malone has already said he is interested in looking at Virgin Media and he is one of the few strategic operators with proven ability to compete against a strong Murdoch-controlled satellite TV player. Virgin Media might be a nice complement to his European cable business and Liberty told investors recently that it has about US$5bn to spend on acquisitions. But Malone is always looking for properties with a lot of upside. Hence Liberty's recent moves into central and eastern Europe. Liberty will be more interested in bidding for Virgin Media if the price falls even more. According to CEO Mike Fries, Liberty would look at markets "where historically sellers have been rather aggressive about valuation". Virgin Media needs to be aggressive about its operating business, but to achieve success it will likely have to be less aggressive about how high a price tag it sets for the business.