Don't Believe the Hype

"A bird in the hand is worth two in the bush." -- Aesop

I think InterActiveCorp (NASDAQ:IACI) is undervalued relative to its future prospects. As such, I have the stock on my watch list and read all of the related headlines.

About two weeks ago, a headline from Forbes knocked me for a loop: "IACI May Buy Back Up to 61% of Shares." My initial reaction was that Barry Diller had lost his mind. Given that he is in the early stages of re-creating his media empire, why would he take on debt and spend such a large amount of cash to buy back so much stock? Sure, he's still making tons of money, but is this the best way for him to allocate it?

But then I looked a bit deeper. Apparently, the headline was derived from a Banc of America Securities analyst's report whose thesis is that if Diller went on a share-buyback bender, then the analyst could raise his target price for IACI by as much as 51% over the $33 he has for it now.

Motivation
InterActiveCorp shares are down sharply from their all-time high and really haven't done much even after the Expedia (NASDAQ:EXPE) spinoff. In fact, the sum of the Expedia shares and the remaining InterActiveCorp shares is less than what the shares traded for when the entities were a single company. Who said markets were efficient? That said, I realize there is value in doing a recapitalization.

But first we need to remember that the headline does not come from anything Diller has actually said. And as far back as mid-2004, Diller has resisted Wall Street's cries for massive share repurchases. So this is not about what Diller wants to do. It's about what the Banc of America analyst suggests that Barry could and should do.

I fully agree that if Diller started buying back shares in bulk on the open market or through some tender offer, the stock price would go up. But just because Diller has the means (IACI has about $9 per share of net cash on its balance sheet, per its last quarterly report) to buy back huge amounts of stock, that does not mean he will.

Admittedly, InterActiveCorp is a difficult company to analyze. It has many working parts, and analysts aren't sure how Diller plans to put them all together because Diller doesn't disclose much about his plans. Moreover, the CEO says he prefers to be "opportunistic," which is a fairly vague description and, accordingly, creates uncertainty. But if you do your homework, buy at bargain prices, and exercise patience, you'll see that the market will eventually recognize the company's value.

Is a buyback of this size even possible?
Since the ticker has changed a few times since the Expedia spinoff, not all of the financial databases have been completely updated yet. But piecing together the data I can from different sources, here is how I see the common stock ownership structure breaking down.

Some of my percentages may be a bit off, but roughly 70% of the shares are held by shareholders who are known to be long-term buy-and-hold types. So if Diller wanted to buy back 61% of the shares outstanding and essentially take the company private, he would have to buy most of those shares from guys who aren't very likely to sell. And if John Malone of Liberty Media (NYSE:L), Bill Miller of Legg Mason, Bill Gates of Microsoft (NASDAQ:MSFT), Weitz, and Davis did decide to sell, I'm pretty sure it wouldn't be at prices near the current market price of around $25.

So let's postulate that Diller makes a tender offer for shares. Or, better yet, that he has an auction for shares. What would the buyout price be? Would it be the analyst's target price of $33? Could it get up to $40? I don't know what it would be, but I think it would be a good deal higher than $25.

Buying back shares starts destroying value when the cost of repurchasing them equals the opportunity cost of not being able to reinvest the capital. If value can be created by repurchasing shares, then do it. But once you reach the break point at which it's better to reinvest the capital, that's when you stop.

I'll bet Diller could come pretty close to buying all of the shares if he offered $50 per share. That might seem to be an unreasonable amount, but it's worth noting that it's the revised target price -- assuming 61% of the shares were repurchased -- set by the analyst whose report spurred the Forbes buyback story. Would paying out $50 per share be a good use of capital? Only if $50 were still a bargain relative to the intrinsic value of IACI. Otherwise, Diller would be destroying value as he took complete control of his company. I don't think he would do that.

How many birds are in the bush?
So if the market is a voting machine in the short term and a weighing machine in the long term, why would you recommend taking capital out of the hands of a known value-creator in the hopes of some short-term price appreciation? This is akin to letting five or six birds from the bush escape just so you could get one more for your hand today. To me, this doesn't make sense.

As I said, IACI has about $9 per share in net cash on its balance sheet. That's at least one bird in the hand. In addition, in 2004, it created about $1.50 per share in free cash flow after considering acquisitions. Given that Diller has a great track record of allocating capital to investments that can generate lots of free cash flow, I am sure there are a bunch of birds in that free-cash-flow bush as Diller keeps growing his war chest. To me, it is better for Diller to keep generating cash and investing it Foolishly when great opportunities arise. Investments may come few and far between, just like those at Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb). But I wouldn't bet against Diller finding better ways to use the capital than to increase his controlling ownership in the company by essentially taking it private.

Leverage is a double-edged sword
The last part of the thesis is that IACI's balance sheet is underleveraged. I agree with that statement, too. The debt-equity ratio is currently about 11% and could easily go much higher without any worry about operating cash flows not being able to cover interest payments. But that doesn't mean Diller should take on extra debt to buy back shares. (As a side note: Is it me, or do leveraged buyouts seem to be quite popular again as private equity firms are looking to juice up returns?)

Yes, trading low-cost debt capital for higher-cost equity capital increases value. And debt capital has the added advantage of creating value through the net present value of the tax benefits. But by spending all of its cash and taking on debt, what would be the implication of missing out on buying opportunities, large or small, when they become available? If Diller has to add debt on top of debt or reissue equity to finance a transaction, then hasn't he tied his own hands for no good reason? Being opportunistic is where Diller shines. So having capital flexibility seems to be an important part of Diller's business strategy.

The Foolish bottom line
The headline did its job. I read the story. But the huge-buyback thesis doesn't tread water with me. Fortunately, Diller has resisted this call from Wall Street before, and I believe he is Foolish enough to keep the cash on hand in order to be opportunistic with it.

While I agree that share buybacks are a great use of capital when shares are undervalued, buybacks should not be made when the opportunity cost of doing so is too high. And I think that is the situation with IACI. Diller is known to be a great capital allocator, and it is in shareholders' best interests to keep the birds in his hands to go after the ones that are likely in the bushes next to him.

Fool contributor David Meier does not own shares in any of the companies mentioned. The Motley Fool has a disclosure policy.