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Longleaf Partners Comments on DirecTV
Posted by: Holly LaFon (IP Logged)
Date: April 18, 2014 05:19PM
During the quarter we exited DIRECTV (DTV), a highly successful core holding in our U.S. and Global accounts for over a decade. We discuss our DTV experience not to showcase one winner, but because the investment illustrates the process and approach we follow for holdings across all mandates and highlights some of Southeastern's unique research strengths.
History of DTV Investment (based on Longleaf Partners Fund) Sometimes we can own a company in indirect ways that create part of the discount to intrinsic worth. In the case of DTV, we owned the underlying business via three different stocks over our thirteen-year holding period as shown on the chart that follows. Initially, in 2001 we bought GMH, the tracking stock that General Motors created for the Hughes division that included all of its satellite businesses. By early 2004, the company had been spun fully out of GM and renamed DIRECTV Group. Over the following four years, we opportunistically added to and trimmed our position.
In early 2008, John Malone exchanged Liberty Media's (LMDIA) News Corp shares (NWS) for the 40+% of DTV that NWS owned. We previously had purchased Liberty Media Corp, the precursor to LMDIA, and the 2008 transaction increased our underlying ownership in DTV. Throughout 2008, we swapped DTV for LMDIA which traded at a steeper discount to underlying value. In the financial crisis, although DTV's business remained remarkably stable, LMDIA shares became severely discounted when debt at other Liberty affiliates cast a shadow on LMDIA. We made sure we understood the obligations of each Liberty entity and John Malone's intentions, and then took LMDIA to a "double weight" (10%) position while maintaining our direct DTV stake. In 2009, LMDIA and DTV merged. Over the next four years, the intrinsic value of the company grew as did the stock price. We trimmed our position as the price-to-value (P/V) gap closed and completely exited in the first quarter of 2014 when the stock reached our appraisal. Because of the strength of DTV's franchise and management partners, value could continue to build unabated. We followed our discipline to exit when the price reached our appraisal, leaving no margin of safety in the stock.
In every new investment, we analyze why a stock is cheap and how our view of the business differs from the market's view. Initially, DTV's core strongholds were rural subscribers with no cable alternatives and premium subscribers willing to pay for the technologically superior digital picture and recording as well as exclusive sports programming. The most valuable DTV subscribers were immune from the market's concern - the "triple play threat" of a single provider for video, voice and broadband. Subsequent subscriber growth and pricing power as shown through rising ARPU (average revenue per user) were proof of DTV's advantages.
When we own a name we evaluate how the business evolves and adjust our assumptions about competitive advantages and value growth. Over time, DTV's U.S. subscriber base grew to more than 20 million, and growth inevitably slowed. Cable providers developed better picture quality and digital recording, and "cord cutting" (leaving pay-TV for video delivery alternatives) also received increasing attention. Verizon invested heavily to become a competitor. Satellite provider DISH's Hopper grew more competitive due to combining cord cutting with high definition recording. NFL programming became less exclusive. As the competitive landscape changed, at three different points over our holding period, we appointed an analyst to serve as "Devil's Advocate" (DA) to challenge the entire investment case and appraisal. Although DTV's U.S. ARPU continued to increase, we reduced our appraisal multiples to account for the increasingly competitive U.S. environment. Management also recognized the U.S. evolution and developed Latin American markets where the lack of infrastructure minimized cable competition. Over the last five years, we adjusted our appraisal as DTV transitioned from a primarily U.S. provider to a company with almost half of its value attributable to its Latin American operations. However, we recently lowered our appraisal of the Latin American business based on currency fluctuations and other geopolitical developments. While shorter-term conditions made a lower appraisal unavoidable, we remained very bullish on the company's long-term prospects in Latin America.
The operating expertise of two successive CEOs, first Chase Carey and then Mike White, kept the company competitive over the long run, even as the landscape morphed. In addition to improving service, containing costs, and providing exclusive programming, management upgraded customer quality ahead of the recession, removing subscribers with lower credit and poor payment history. This move paid off handsomely as subscriber retention gave
DTV an edge through the financial crisis. Many CEOs have strong operating abilities, but what sets apart the all-stars is a deep understanding of building value per share through wise capital allocation. Our successive DTV partners clearly understood the risk/reward calculus when they deployed the company's resources. They successfully invested for growth by comparing subscriber acquisition cost (SAC) to the value of the cash flow stream from the incremental new subscriber. They also returned enormous capital to shareholders, repurchasing over 60% of the company's shares over the last 10 years when prices were well below intrinsic value.
We conduct a comprehensive assessment of management at the outset of every investment. At DTV, we did this a second time in 2010 when Mike White came from Pepsi to be CEO after Chase Carey left for NWS (which became 21st Century Fox). We quickly called upon our broad network of contacts, including some who had worked directly with Mike, to gain insight into his skills, character, and record, and we received positive feedback.
Deeply Discounted Price
How can strong businesses with good management become deeply discounted? Four common ways that we find a cheap stock applied at DTV. First, a mismatch between real or perceived threats and when or how they will impact value creates opportunity. In some cases, short-term challenges have little impact on long-term value. In the case of DTV, the stock price was over-discounting the near-term "triple play threat," even though longer-term technology changes did alter the competitive landscape.
Second, we see many external reports that determine price targets by simply putting a multiple on earnings. Our due diligence breaks down business segments, evaluates free cash flow versus earnings, and differentiates between capital spending to maintain the business versus to grow it. We analyze growth spending as a choice that must be weighed against capital allocation options. At DTV, management's investment in U.S. SAC lowered short-term profits, but when U.S. growth spending slowed, the cash flow from those subscribers continued to roll in, generating a high long-term return. A similar dynamic continues today with the build out of Latin America.
Third, we often find a "sum of the parts" discount when we can own a business indirectly through another stock. Our appraisals break down the value of each underlying piece of a company. The most extreme example at DTV came in December 2008 when we could own a share of DTV through LMDIA for less than half the price of directly owning DTV. Fourth, controversial management can generate a discount. When we doubled down on LMDIA, skepticism about John Malone played a part in the price decoupling from the value. Although accurately assessing executives is difficult, we spend immense time reviewing operating and capital allocation history, understanding incentives, interviewing others who have interacted with the person, meeting with the CEO, and researching professional and personal backgrounds.
From Longleaf Partners first quarter 2014 commentary.
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