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DIRECTV – Exceptional Execution, Diligent Capital Allocation

I came across DirecTV (DTV) two years ago when I started reading about Ted Weschler and Todd Combs, the two portfolio managers that had been hired by Warren Buffett in 2011. Berkshire Hathaway (BRK.A)(BRK.B) initiated a position in DTV in the third quarter of 2011 around $45, presumably by one of the two new portfolio managers. Learning more about the company I came across the name John Malone and read about his history of value creation in the media businesses with TCI from 1973 to 1997 and subsequently with the Liberty Media companies up to today. One dollar invested with John Malone’s TCI in 1973 was worth $933 in 1999. I was also intrigued to note from Pat Dorsey’s informative book, “The Little Book That Builds Wealth,” that most companies with economic moats from the Morningstar coverage universe are in the media sector. These factors inspired me to dig deeper into the story of DirecTV.

JohnMalone_TCI_Performance

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Moats by Sector_Morningstar

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I) The Record

DirecTV has experienced explosive growth in the last decade. Revenue and earnings have increased at a double-digit rate over the last eight years. The U.S. subscriber number has grown to 20 million and stabilized. Latin America subscriber number has doubled in the last three years and stands at 16.5 million as of 2012 end. U.S. OPBDA (operating profit before depreciation and amortization) was $5.7 billion on revenue of $23.2 billion with ARPU (average revenue per user) being $97 per month (4% year-over-year increase). Latin America consolidated OPBDA was $1.9 billion on revenue of $6.2 billion. EPS was $4.58 in 2012, up from $3.47 in 2011 and $2.30 in 2010. Net debt increased from $9 billion ($10.24 per share) in 2010 to $17.5 billion ($23.76 per share) in 2012 end. Shares outstanding reduced from 876 million in 2010 to 644 million by year-end 2012. As of April 17, 2013, shares outstanding are at 571 million. In the last six years, DTV has bought back shares worth $25.7 billion, which compares very well against today’s market cap of $31 billion and enterprise value of $48 billion.

01_DTV_Subsc_Growth_Consolidated

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02_DTV_Revenue_Opbtda_Growth_Consolidated704141483.jpg04_DTV_EPS_Growth_SO_Reduction

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II) Business and History

DirecTV traces the origin of its satellite television service to 1994 as part of the Hughes Corporation. DirecTV has experienced explosive growth in the last decade since 2004 when News Corp. acquired a controlling interest from Hughes Corporation unit of General Motors. Liberty Media controlled by John Malone received an 18% stake in News Corp. for financing part of the deal thus acquiring indirect interest in DirecTV. In 2006 Rupert Murdoch transferred its 38.5% controlling interest in The DirecTV Group and few other assets to Liberty Media in exchange for Liberty's 19% interest in News Corp. In 2009 Liberty Media merged some of its entertainment assets with DirecTV and distributed the shares to its shareholders. As per last known information, John Malone still owns just above 3% of DTV stock which would be worth approximate $1 billion today.

As per DirecTV's website:

“DIRECTV (DTV) is the world's leading provider of digital television entertainment services. Through its subsidiaries and affiliated companies in the United States, Brazil, Mexico and other countries in Latin America, DIRECTV provides digital television service to 20.08 million customers in the United States and 15.48 million customers in Latin America.

DIRECTV reported revenues of $8.05 billion in the fourth quarter of 2012. DIRECTV is composed of two main operating units - DIRECTV U.S., and Latin America, as well as DIRECTV Regional Sports Networks.”

III) Operations and Competitive Advantages

Information from DirecTV website:

“DIRECTV is committed to our company values: leadership, innovation, decisiveness, agility, teamwork and integrity. We believe that the successful execution of our stated operating strategies will create significant shareholder value over the long term by delivering sustainable, profitable growth through brand leadership, innovative excellence, world class customer service, increased productivity and disciplined expense management, while also returning excess cash to shareholders.“

DirecTV U.S

“Our vision is to provide customers with the best video experience in the United States both inside and outside of the home by offering subscribers unique, differentiated and compelling programming through leadership in content, technology and customer service. Due to the rising cost of programming as well as higher costs to acquire new subscribers in an increasingly mature and competitive industry, it is even more important to distinguish and elevate the DIRECTV experience with a focus on delighting our new and existing customers. To fulfill our goals in a profitable and sustainable way we developed a strategy to (1) transform the customer service experience, (2) advance the entertainment experience both inside and outside of the home and (3) strike a balance between growth and profitability.”

DirecTV Latin America

“Our vision is to provide customers across Latin America with the best video experience by leveraging DIRECTV Latin America's key strengths while continuing to distinguish our service from our competitors by offering subscribers unique, differentiated and compelling programming through leadership in content, technology, customer service and targeted marketing strategies. Our strategy involves (1) profitably expanding our leadership position across all demographic segments, (2) enhancing productivity and effectively managing costs and (3) leveraging DIRECTV Latin America's brands and customer base to introduce complementary services.”

DirecTV is the second-largest premium Pay TV provider in the U.S. with 20.1 million subscribers. Comcast has 22 million, the largest number of subscribers, and Dish has 14 million. Netflix has 27 million U.S. streaming subscribers who pay $7.99 per month and have access to content that I consider not premium content when compared to the other three providers. In total we estimate the U.S. to have 100 million households.

These are some of the competitive advantages:

1. DirecTV has a duopoly in the U.S. direct broadcast satellite (DBS) space with Dish Network. The cost of starting a new DBS company is prohibitive due to cost of obtaining the space orbit licenses, cost of launching satellites, etc. Incumbents have economies of scale advantages. The high fixed costs inherent make it impossible to compete for anyone new and this all but eliminates possibility of a new entrant.

2. Multiple System Operators (MSOs) like Comcast provide competition to DirecTV in U.S. and have certain advantages like bundling of services. DirecTV, however, has some cost advantages due to the lower cost nature of the satellite based delivery as opposed to MSOs having to spend heavily on their network infrastructure. This advantage has somewhat narrowed as Comcast has been expanding with acquisitions over the last many years.

3. DirecTV because of the satellite based delivery can offer service to customers all over the U.S., whereas MSOs can offer service only to customers in areas where they have a network.

4. DirecTV in the U.S. deals directly with customers and price based on market whereas MSOs have to contend with local governments who are incentivized to control costs to the users.

5. DirecTV in the U.S. has enough economies of scale which when combined with the fact that most of its customers are premium customers gives them the edge when acquiring content and securing long-term contracts.

6. DirecTV in Latin America has early-mover advantage and economies of scale advantages.

7. DirecTV in Latin America already has the regulatory approvals. Obtaining this for another competitor in the various jurisdictions in Latin America will be time consuming and costly.

8. The cable network infrastructure in Latin America is not as well developed and extensive as in the U.S. This is a tremendous advantage for DirecTV as in many populated cities as Latin America it is not feasible to build out this infrastructure easily due to various factors.

9. The competition with DirecTV Latin America is very fragmented.

10. DirecTV Latin America is uniquely positioned to outbid competitors in acquiring premium sports and entertainment content due to the scale advantages and its existing partnership with content providers.

11. Latin America gives DirecTV a long runway of growth due to the low (15%) penetration rate of pay TV services. This is not available for U.S.-only competitors since the U.S. pay TV market is already saturated.

IV) Balance Sheet and Profitability

Income statement and balance sheet data taken from 2012 Annual Report is below.

Cash flow per share is $7.89. Debt per share is $23.68. Debt to cash flow is 3.0. Debt to OPBDA is 3.0. The share count is down 11.5% in the first 4.5 months of 2013 from 644 million to 570 million. The earnings are very much understated due to the high capital investments by DTV in Latin America to grow the subscribers aggressively. The amortization costs also are a factor in reducing the stated earnings. DTV's strategy to lever up the balance sheet and buy back the shares in this low interest rate environment also helps reduce stated earnings due to interest expenses. The true measure of the earnings power of the business is the cash flow per share which in 2012 was $7.90 as per my calculation.

08_DTV_AR_Select Financial Data_Operating Income

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09_DTV_AR_Select Financial Data_Cash Flows

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V) Management

Mr. Michael D. (Mike) White serves as the chairman, CEO and president of DirecTV Inc. He started as CEO and president of DirecTV on Jan. 1, 2010. He served as the chairman of PepsiCo International Limited, a subsidiary of PepsiCo Inc. since February 2003 and CEO from February 2003 to September 2009.

Mike White has demonstrated based on his actions over the last few years that he is a shrewd capital allocator. He is adapting the strategy similar to what John Malone adopted with TCI to generate exceptional results from 1973 to 1997.

Here is Mike White from the 2012 Annual Report:

“Our commitment to [b]profitably grow our businesses while keeping a sharp eye on achieving operational excellence through disciplined expense management and productivity improvements was clearly a highlight in 2012 as operating profit before depreciation and amortization grew 8 percent to finish the year at $7.5 billion.”

“Finally, by leveraging these outstanding results with the continuation of our share repurchase program, earnings per share increased by 32 percent to $4.58. These achievements were also reflected in a 17 percent gain in our stock price for the year, out-pacing both the S&P 500 Index and the NASDAQ.”

Capital Allocation Philosophy:

“Content, technology and service are the pillars around which we’ve built our best-in-class video service that we deliver to our customers; and increasing the value of DIRECTV is the commitment that we are making to our shareholders. As you know, we’ve been clear about our desire to continuously explore opportunities to create more value by further strengthening our business position in both the U.S. and Latin America. If opportunities do not arise that meet our rigorous strategic and financial hurdles, we will continue our capital allocation strategy with share repurchases—because we believe our stock remains significantly undervalued—and this strategy, coupled with our strong balance sheet and operating performance, provides us the flexibility to be selective and opportunistic in considering strategic opportunities as they arise.”

On March 15, 2013, the following was announced:

“DIRECTV says it is not proceeding with its bid for Vivendi-owned Brazilian telecom GVT. DirecTV, already a major player in terms of Brazilian DTH broadcasting, had been looking to GVT as a way of boosting its presence in the dynamic country. The company “has decided not to move forward in its pursuit of GVT and has withdrawn from the process,” a DIRECTV spokesman said. Last week, the company’s CFO Patrick Doyle said at an investor conference that GVT was not a must-have for DirecTV, and that DIRECTV would only go forward if “the economics are compelling.”

VI) Value and Price

DirecTV is currently trading in the $48 to $55 range. I believe this price is below the intrinsic value of the company when considering the growth prospects and competitive advantaged of DTV Latin America. The U.S. strategy to focus on premium customer retention and cost reduction to grow ARPU and margins is also a prudent strategy.

05_DTV_SharePrice_History_3

1804643074.jpgProjected price in 2017 is expected to be $140 to $164 based on assumption that DTV with stable operations in U.S. and growth in Latin America can increase cash flow by 10% per year and continue on the strategy to lever up the balance sheet and buy back shares. The projection assumes that DTV will increase debt by 15% for year 2013 and maintain Debt/CashFlow of 3.5 from 2014 onwards and will be able to buy back 15% of shares per year. This strategy is feasible as long as interest rates stay low and DTV continues to generate significant free cash flow.

10_DTV_MritikCapital_Price_Projection

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VII) Catalysts

I believe the following will act as catalysts over the next three to five years:

1. DTV will continue to execute on its strategy of focusing on retaining the existing 20 million premium users in the U.S. and increasing ARPU at a rate above inflation.

2. DTV Latin America will continue strong growth due to the low penetration of Pay TV in Latin America (15% only) and competitive advantages of the satellite TV model and the economies of scale.

3. The upcoming Olympics and Soccer World Cup in Latin America will provide added momentum.

4. The strategy to lever up the balance sheet and buy back shares aggressively as long as DTV trades below intrinsic value while interest rates remain low will accelerate the per-share intrinsic value.

5. DTV will continue to secure long-term contracts on premium content including sports content and market will recognize this in due time.

6. Latin America in the coming years will generate significant free cash flow and this will allow for value creation due to intelligent capital allocation.

7. U.S. household growth in the coming years may surprise to the upside allow modest gains in U.S. subscriber count.

VIII) Specific Risk

As in any investment there are risks associated with an investment in DTV. Following are some of the risks:

1. Emerging digital media competition could prove to be more significant than anticipated. This does not seem likely in the near term. For example, currently Netflix (NFLX) has 27 million U.S. subscribers paying $7.99 per month ($96 per year). Assuming that NFLX has no costs (which is impossible) it will generate $2.6 billion per year from its customers which I don’t think is enough to secure the premium content to challenge DTV, CMCSA and DISH.

2. Interest rates dramatically rise in the near term which will require DTV to adjust as its strategy of levering up the company at the rate of the last few years will not be feasible.

3. Content costs may rise more significantly than anticipated.

4. There is regulatory risks associate with FCC and Latin America regulators.

5. Risks related to Tax Sharing Agreement between Liberty Media and DTV.

6. Satellites are subject to significant launch and operational risks.

7. MSO consolidation in the last decade has increased the scale for companies like Comcast allowing them to compete better. MSOs also have the advantage of bundling services and providing one bill for phone, cable and Internet services. This allows them to use bundle discounts to dissuade users from dropping the cable service.

8. There is some risk of so-called "cutting the chord" whereby users drop premium cable and switch to low-end services like Netflix, Hulu and Amazon Prime. This has not manifested as of now but change in user preferences cannot be ruled out if there is severe recession.

IX) Why Is This Cheap?

I believe the market is undervaluing DTV for the following reasons:

1. The high debt load of DTV, which is an intentional strategy to reduce earnings and taxes and employ leverage due to the low interest rates, is a deterrent to many market participants.

2. There is concern that Internet video providers like NFLX or innovation in the TV space like a possible Apple iTV are a competitive threat. I believe these threats are overstated and DTV management is securing long-term premium content agreements to mitigate this risk.

3. There are concerns that the content providers (owners) will exact a higher and increasing price for content licensing in the coming years. I think this will reach an equilibrium and DTV should be able to mitigate this factor by raising prices and controlling costs.

4. The stock does not pay a cash dividend and this is a deterrent for investors needing income and chasing yield.

5. There are concerns about the possibility of DTV acquiring GVT Brazilian Telecom unit of Vivendi SA at an expensive price and needing to issue shares or reduce or suspend buybacks. This is no longer an issue.

Disclosure

I own shares of DTV.

Comments and questions welcome.

Read more:

1. DTV 2012 Annual Report

2. Pandora Group DTV Strategic Review 2006

3. Comcast 2012 Results

4. Dish 2012 Results

5. Netflix 2012 Results

Note:

I have used information from DTV investor relations website, investor presentation and financial statements. I have referenced information from DTV Stratgic Review by Pandora Group.

About the author:

MritikCapital
Mritik Capital Inc. is a financial advisory firm with focus on identifying quality businesses with durable competitive advantages that are undervalued. Our first goal is to preserve the capital of our clients and look for strategies for enhancing their net worth based on opportunities that present compelling risk adjusted reward.

Please note that investing offers both risks and rewards. Before investing do your own due diligence and consult your financial advisor.

Visit MritikCapital's Website


Rating: 4.5/5 (51 votes)

Comments

stevenramsey
Stevenramsey - 1 year ago
Great analysis. I totally agree. John Malone, I believe, still owns his shares, which is also a positive. We would do just great if we followed Malone's ideas blindly.

You've focused on the right things and I believe, when those forces are added up, you've got the "lollapalooza" effect.

My question is not if DTV is a great idea. It is. And Ted Weschler won't even consider putting money into an idea unless he spends at least 500 hours of research. Berkshire added to their stake according to the most recent 13Fs. So there's that.

My question - Malone's growth/strategy in Liberty Global (LBTYA, LBTYK, etc) is the same formula as TCI. It looks like that's what he is about to embark upon at Liberty Media (LMCA) through his 27% stake in Charter (CHTR). As for Liberty Global, Dan Loeb believes the company can earn $6 per share in FCF in 2014 and it now sells at $68, for a 8-9% FCF yield. And I see nothing slowing the growth down.

So, how would you compare Liberty Global vs. DirecTV?

With both, you have leverage, scale, great content, growth, and massive share buybacks....just tossing that out. Once again, good write-up.
MritikCapital
MritikCapital - 1 year ago
Hi Stevenramsey, Thanks for the feedback and you great insight into John Malone's recent moves. Actions of John Malone to me are similar to those of a chess grandmaster who thinks many many steps ahead and I can visualize him working on the different pieces of the global telecom puzzle.

I think Liberty Global will do really well in the next decade. I plan to do a detailed analysis on it and will write it up if I feel that it is still trading at a compelling valuation. This low interest rate environment where Malone can borrow for 30 years at 5% and invest in depressed assets which are contractual cash flow generating assets with returns of 10-15% or more must be a no-brainer for him. They have the operating expertise to execute exceptionally and ability to structure the companies to minimize taxes. His focus on Europe I think is due to depressed valuations there and also the possibility of enhanced gains when currencies of Northern Europe re-adjust against USD in the future (either Euro or local currencies).

In terms of growth prospects I like DTV for possibility of better subscriber growth due to low penetration rates of pay tv in Latin America. LBTYA also has great prospects though but most gains will likely come from the expected wave of consolidation leading to greater economies of scale.

I think the bet on CHTR via LMCA is more a bet on the Jockey than the horse. Tom Rutledge is a very shrewd operator and I suspect with Liberty's involvement and capital he will be able to consolidate the remaining smaller cable operators who are getting squeezed due to rising content costs. I think it will play out well in the long term. I prefer to play this via LMCA indirectly rather than CHTR directly as it gives the investor more diversification with SIRI, LYV, BKS and other assets.
stevenramsey
Stevenramsey - 1 year ago
I totally agree on the Liberty Media-Charter front. I have added to 'Media' recently. The scenario I envision playing out for Media, over a time-frame of 3-7 years:

1 - Currently, LMCA gets driven primarily by SiriusXM results. Sirius is a monopoly on satellite radio, with a subscription model, high FCF, huge NOLs, and a long runway as the average age of cars is 11+ years old and new opportunity in used cars. This provides for large share buybacks along the way....meanwhile, Charter grows the way Malone did with TCI, but has smaller effect on LMCA's value.

2 - Sirius gets spun-off via RMT. (And Malone's spinoffs always do very well (see STRZA & LVNTA charts), so probably a good idea to just buy Sirius when that happens, no matter what.)

3 - Liberty Media then is primarily driven by Charter. By this time, Charter has more cable systems, more scale, more FCF generation, and has even more momentum. And Liberty has increased it's stake to more than ~30% or so....

That's a path to value I see (for two of the businesses), but it's a wild-card with Malone. And that's a good thing!

Sorry, that's all a sidebar to your idea on DTV. I agree 100% on DTV's prospects. They're effectively doing an LBO of themselves through arbitrage. Their buybacks almost rival the Henry Singleton spree of the 1970s.

Thinking big picture, by owning LMCA, LBTYK (these shares are cheaper and the CEO Fries said on CNBC in February they're buying back these shares over the A or B shares) and DirecTV, you effectively own dominant, cash flow companies with superb management on three different continents.
MritikCapital
MritikCapital - 1 year ago
Makes sense Steven. I will keep my eye on Liberty Global.
trinathdasari666
Trinathdasari666 - 1 year ago
Great analysis.The article has been very detail ... Great work
quixote1
Quixote1 premium member - 1 year ago
Great stuff.........we´ll keep an eye on all of this.Thank you.
vgm
Vgm - 1 year ago
Exemplary analysis and commentary. And additional insightful perspective from Stevenramsey.

Thanks!

Long DTV
MritikCapital
MritikCapital - 1 year ago
Hi Trinath, Vgm,Quixote1,

Thanks for your comments and feedback. I appreciate it.
ramos285
Ramos285 premium member - 1 year ago
I like a lot this article, but I have a doubt how to calculate the value of ev? can you explain?
MritikCapital
MritikCapital - 1 year ago
Hi Ramos,

Thanks for reading the article and commenting on it.

I hope I am understanding your question correctly.

http://en.wikipedia.org/wiki/Enterprise_value

Enterprise Value (EV) is the value of the business in its entirety (see link above for clear definition). In my analysis I am projecting the growth of cashflow of the company and increase of debt of the company (to buyback shares) where by management will try to keep a certain relationship between debt and cashflow (as long as interest rates remain low).

In my analysis EV = Debt + MarketCap where MarketCap = NoOfShares * SharePrice.

ramos285
Ramos285 premium member - 1 year ago


Thank you for having responded to me, but you can explain how for example in 2012 the ev / cf = 6.08 how to calculate this number, and why in 2014 until 2017 this value is constant 5:16 (v / cf)

MritikCapital
MritikCapital - 1 year ago
Hi Ramos,

Thanks for catching the issue in the xls formula. [color=#333333; font-size: 12px; line-height: 18px]For the year 2012, [/color]EV/CashFlow (EVCF) should be = (644*48+ 15300)/5085, which should be 9.09.

Shares Outstanding: 644M.

Average Share Price for Year: $48.

Net Debt: 15300M.

CashFlow of $5085M taken from 'operating profit before depreciation and amortization' of 'Select Financial Data - CashFlows' from 2012 Annual Statement.

My intention of keeping a stable EVCF from 2014 was to imply that DTV may stop further increasing leverage going forward in anticipation of interest rates going up. Thus by keeping the EVCF at 9 now (same as 2013 going forward), I am projecting the Price based on formula as below:

Pc=(EVCF * CashFlow - NetDebt)/NoOfShares.

I have also updated Debt/CashFlow to stabilize at 3.5 from 2014 onwards. The formula correction brings down the projected 2017 fair price to $139.

I am unable to edit the image on the article so I will need to contact the GF editor on updating the screenshot.
ramos285
Ramos285 premium member - 1 year ago
I now understand better, the article you wrote is great thanks again
MritikCapital
MritikCapital - 1 year ago
Hi Vgm,

Thanks for posting this link. I did note this and some of the points Bill Nygren raises are indeed valid. Sometimes we need to look at long term total return and not just the current cash dividends.
Cogitator99
Cogitator99 - 1 year ago
Well, it's a little hard to believe that it will triple from here, but who knows. But it seems to me like it should be worth at least $100 in 2-3 years.
MritikCapital
MritikCapital - 1 year ago
Hi Cogitator99,

Thanks for reading the article and your comments. Even I was not expecting for a triple when I started analyzing, but using the assumptions listed that was the evaluated projection price. We need to factor in continued return of capital to shareholders via buybacks and also company is locking in 30 year debt at low interest rates so these factors when done well accelerate the returns.

The key is whether DTV moat holds over next 5 years and whether interest rates stay low. Let us wait and watch.
Cogitator99
Cogitator99 - 1 year ago
Good point. I think the low multiple of the business revolves more around fears that the business model will become obsolete in a few years. Think when the market realizes that this concern is overblown the stock will move up.
sersoylu
Sersoylu - 1 year ago
To be the devil's advocate, I'm not 100% convinced that Directv's business model is completely worry free. What is of particular concern to me is the highly respectable Chairman of DISH Mr. Charlie Ergen's recent hunt for the wireless carrier Sprint (and the extremely valuable spectrum of Clearwire that it has control of). I think Directv's US business may suffer in the long term if Dish can make this first ever Wireless-Pay TV model happen, because as much as I love Directv as a loyal customer, I don't necessarily love the monthly bill I pay and a bundle of discounted services from another satellite carrier sounds attractive to me. This doesn't impact the great prospects Directv has in South America, but it might have a drag on overall numbers when combined with horrendous rise in programming costs.

The other thing that confuses me about Directv is this leverage approach. I understand the idea of low cost borrowing to finance a higher ROC business, but isn't it a bit extreme to do this to a point of creating negative equity ? I think this strategy works as long as the firm's moat remains in tact but what happens if membership drop seen for the first time in 2012 returns in 2013 ? Due to this $17 billion debt, DTV has terrible Piotroski and Altman Z numbers. Can the growth in SA single-handedly carry DTV forward ?

Too many smart people are behind this stock so probably it's me who's missing the boat here, but I just don't fully understand this levered buyback approach.

MritikCapital
MritikCapital - 1 year ago
Hi Sersoylu,

Thanks for commenting on the article. You raise some valid points. Charlie Ergen is a visionary and I won't be surprised if his vision of wireless pay TV becomes reality in the coming years. It is hard to predict the pace of innovation but I suspect we are a few years away from that happening in the US. The challenge for DTV is to evolve and respond to this threat. As you say Latin America is the anchor and the growth driver we can count on.

As to the financial engineering I think we will only know how all this turns out 5 years from now. For 2013 Q1 DTV borrowed 792M and returned cash to shareholders of 1378M via share buybacks. It will be interesting to see the approach of the management since share price has appreciated to $61. Net debt/liability is currently 18.5B and expected cash flow in 2013 is above 5.5B.

stevenramsey
Stevenramsey - 1 year ago
The levered buyback approach is a unique and aggressive way to shrink the equity, but it's basically arbitrage:

1. Borrow money at 3-5% rates

2. Use that money to buy back your own stock that has a current 7% cash flow yield

DirecTV, as seen in today's Q1 report, continues to shrink the equity dramatically ($1.4B in Q1'13) and has an adequate cushion of cash flow to cover the interest expense on the large debt load. Another important benefit to this is that the higher interest expenses limit the amount of income tax that DirecTV has to pay.

This form of returning to shareholders is substantial. An illuminating way to look at this is if DirecTV were to borrow this money and pay it out as a dividend, the yield would be in the double digits.

I suspect that the company will continue to shrink the equity at a rapid clip. If DTV management has a somewhat similar outlook to Mritik on the intrinsic value of the shares ($130+), then I have no doubt they'll continue to gobble up the shares at a massive rate, indefinitely.
MritikCapital
MritikCapital - 1 year ago
Hi Steven,

Whats your take on Liberty Global results. I did some initial analysis and come up with a fairly wide range for fair value based on different assumptions and outcomes. I like the consolidation efforts and the way operations are progressing. I am looking for a pullback on this one.
stevenramsey
Stevenramsey - 1 year ago
I don't have anything of value to add to the quarter's results. I take Pabrai's approach of following what the great investors do and to look at the "cannibals". That being said, Dan Loeb believes LGI will do $6/sh of FCF in 2014 and can grow at 20% annually. If Loeb is right, then purchasing at ~$70 gets you an 8.5% FCF yield on '14 results, and it grows from there. Malone and Mike Fries are so laser focused on creating value by any means necessary, I think the odds are good for solid results over the long-term.

I would also say that Liberty Global is strikingly similar to what TCI was for Malone in the 1970s, 80s, and 90s. There is definitely complexity with the various holdings in other cable companies, various tax assets, and a white canvas for consolidation due to the various countries and cable systems within them. Then you throw in the large buyback program (though not as significant as DTV's as a percentage of shares outstanding). I've re-read Malone's chapter of "The Outsiders" many times and this fits right with that story.

And I'm not so sure that the price/value dissonance is as wide as DirecTV's, based on your analysis. I will say, that since last year, I've been long DTV and haven't done anything with LGI at this point.

You agree? What differences draw you to DTV over LBTY(A, K, B)?

MritikCapital
MritikCapital - 1 year ago
Hi Steven,

I agree that LGI allows more scope for value creation with consolidation. I am still doing my analysis on this. I notice they have not only announced the Virgin Media deal but also acquired 18.5% of Ziggo NV for $1.2B. They have also raised $3.6B via senior notes in last 2 months which they plan to push down to Virgin Media level upon completion of the acquisition. So this is going to provide more cash to deploy as they lever up Virgin operations.

For DTV I can project some growth and assign a moat to the Latin America business so I saw value which was being enhanced by the leveraged buyback.

For LGI I think everyone is betting on the fact that Mike Fries and Malone will create value through their product innovation and capital allocation. I opened a small position few weeks ago in LBTYK around $68 so that I can track the company better. I will wait for a pullback on this one.
sersoylu
Sersoylu - 1 year ago
Thanks for the responses guys.

What DTV is doing is arbitrage alright, but it's an arbitrage undertaken with debt. Wasn't it Warren Buffett telling us all along to never bet with debt ?

If a firm's stock is significantly undervalued, it's normal for management to take measures to levitate the stock. We all remember Berkshire was in a similar situation not too long ago, when Buffett had to institute a first ever share buyback program (which he normally hates). I think, at that time, Berkshire stock was way more undervalued than DTV is today, but we didn't see Buffett borrowing like crazy. So why do this so aggressively with so much debt ? And how come does this debt not bother Buffett, as he preached to us over and over that we should always prefer companies with low debt/equity ratio for long term investments ?

I guess when a firm is run by a CEO that comes from the LBO industry, this kind of financial engineering becomes business as usual. I'll stay on the fence for now.
stevenramsey
Stevenramsey - 1 year ago
You're right that Buffett prefers low leverage. But something people often overlook about Warren is that he lives and invests by wisdom, NOT rules. He said at the meeting Saturday that he does not invest by a set of financial metrics. And you're also right in that Buffett sees buying back Berkshire stock as a last resort. However, nearly all of the companies he buys into repurchase their own shares aggressively.

It would not be smart if DirecTV stayed at a low debt ratio. DirecTV's operating cash flow covers interest expenses by ~6x, so they are still being fairly conservative with their debt. The best businesses are highly leverage-able, free-cash flow generators with very stable revenues. A subscription model business like DirecTV (others that come to mind: Liberty Global, SiriusXM, franchise/royalty-type like BKW and DIN) allows for a higher debt load.

And it has to mean something when John Malone, Lou Simpson, Ted Weschler, and Todd Combs are all invested in the company.

And I'll close by saying that I don't want to pressure you into the investment. I'd just say that some of this is worth considering for DirecTV, or other similar situations.

**As for Liberty Global, my dilemma is that it isn't as cheap as some others. But the great businesses with great management (Malone and Fries are unbelievably good I would say, top 0.25% of business managers in the world) give me more freedom on the price to pay. Getting an 8% FCF yield with those managing partners seems like a great offer. Mritik, do you like that bet or agree with that perspective?
vgm
Vgm - 1 year ago
"If a firm's stock is significantly undervalued, it's normal for management to take measures to levitate the stock." Sersoylu

In buying back stock, the rationale of a shareholder-friendly management is not "to levitate the stock", but to reduce the number of shares outstanding, and thereby increase the piece owned by each shareholder. In fact, the optimal situation is that the stock price languishes during the buying period, since thereby more shares can be bought in per dollar spend. Buffett describes this in considerable detail for IBM in his 2011 Letter (published Feb 2012).
sersoylu
Sersoylu - 1 year ago
Stevenramsey,

Thanks for your response. Like I said, you and all the other great investors buying into DTV are probably right, and I'm wrong. I just like to follow my principle of understanding the business and its financials first before investing (in this case, possibly at my own peril).

Vgm,

I don't think management of a company has a motive or mandate to increase the piece of the business each shareholder owns, or increase their control of the company, etc. Management has a duty to provide highest value to shareholders. We see many companies do buybacks even though the stock is not undervalued. or at times overvalued. Buffett says that's a wasteful way of capital allocation and he wouldn't support it even though it may increase his share of the company. He'd like to see capital allocated where there's highest return for him. If a company has a durable 40% ROC, he'd like to see the money invested back in the business and turn into higher earnings.

The primary reason for buybacks is actually to increase the share price and thereby increase holders' holding value. If the stock price is unreasonably low, it is also a measure against takeover attempts (hostile or otherwise) at such a price. While this may increase each patient holder's share, I don't think it is the primary intent. These are not mutually exclusive events, and I think what you're saying is a biproduct of share buybacks.
Cogitator99
Cogitator99 - 1 year ago
Sersoylu,

You might be missing some nuances here. Buffett is not necessarily against debt and buybacks. These things are situational and can make sense in one context and be absolute madness in another.

And no offense -- I also think you have not taken the time to look very closely at the business and understand the model like Steven or Mritik. When people start throwing around Piotroski and Altman-Z numbers, it's almost always because they haven't taken the time to look under the hood and are relying on the headline figures to form their conception of the company. So I'd encourage you to read the filings over the last 5 years to gain more perspective.

As Steven points out, DTV has been borrowing at low rates and buying back undervalued shares. For much of last year, for instance, DTV was trading at a 10-11x P/E. This for a business that owns a leading brand, can still grow EPS at 15%, and earns 30% on capital. When the shares fell to 48 early this year, DTV was trading at its lowest-ever multiples relative to earnings, cash flow, etc. -- the 2008-2009 crisis included. In other words, as long as you believe that the business wasn't going to disappear over the next few years, it was quantifiably cheap -- which is the best reason for a company to buy back its shares.

So in my opinion, DTV's buyback is rational for as long as they can produce cash flow in a sustainable manner, borrow at low rates, and purchase shares below fair value.

Keep in mind that DTV is reinvesting into the business, mostly in Latin America, where they are still spending quite heavily. However, if you have the opportunity to borrow @ 3-4% (a situation which won't last forever) and can buy shares that you fully understand and control that have a 7% FCF yield, why wouldn't you? If, for instance, you believe the shares are worth $90 and you can buy them for $55 (a ~64% return) isn't that a smart capital allocation to make? You'd be hard pressed to find many projects with such an IRR, and after all, they are not mutually exclusive -- they can reinvest and take advantage of a temporarily low interest rate regime and share price to create value for existing shareholders.

I would recommend you read the book that Steven mentioned -- The Outsiders -- because I think it will change the way you look at buybacks...your views on this seem a little skewed to me.
vgm
Vgm - 1 year ago
Sersoylu,

Increasing the piece owned by each shareholder when undervalued shares are being repurchased IS increasing value. (We were talking only of buying back shares which are undervalued.)

Here's what Buffett wrote in the 2011 Letter on buybacks:

"Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $11⁄2 billion more than if the “high-price” repurchase scenario had taken place."

sersoylu
Sersoylu - 1 year ago
Cogitator99,

I have the utmost respect for Steve and Mritik, as well as other great investors who are behind DTV at the time. That's why I noted I'm likely to be wrong in being suspicious about DTV. I've only been familiar with value investing for the last 3 years and I don't hesitate to disclose that. I consider myself a beginner. I also don't do this full time, so I set up a system for myself to maximize my efficiency in reviewing stocks, because I simply don't have as much time as I'd like to have to review companies (unfortunately). Per this, I use an elaborate spreadsheet to review certain key numerical metrics on a business, and if there are red flags in this quick screen, I pass. Only on companies that pass the quick smell test I dedicate my time to dig in deeper. DTV was one I had passed due to high debt, but I came back to it for a few reasons, one of which is this great article and the other is the great set of investors behind this stock. I wish I had the time to read 5 years of annual reports on all stocks that trade in the US market, but unfortunately I don't. I only read the last DTV annual report. So you don't need to beat on me for this point. I'm not trying to debate investing decisions with people with better skills and more time. Just trying to understand the reasoning behind DTV's hyper-aggressive buybacks and learn from an educating exchange.

I think both you and Vgm are misunderstanding my point. I don't argue that if a company with good ROC that trades well below IV (by all valuation metrics and beyond any doubt or variance) buys back stock, that's the wrong way of allocation capital. My question was HOW FAR do you go in doing this ? In the last 5 years, DTV's long term debt increased 3-fold, from $5.7 billion to $17.2 billion. The company carries a negative BV of $5.4 billion. Steve made a good point that operating cash flow still covers interest expense by about 6 times, which is important, but this is certainly a lot of debt for a company with net income under $3 billion.

In 2012 shareholder letter, Buffett says; "In re-purchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value. Directors and I believe continuing shareholders are benefited in a meaningful way by purchases up to our 120% limit (of BV)". Now, DTV has a negative BV so Buffett's metric of optimum share buyback threshold cannot even be calculated. Let's just assume DTV had not engaged in this aggressive debt-funded buyback program, and grew BV at a rate in line with earnings growth the last 5 years. At best the BV would still be below $10/share based on some rough calculations. So the stock is nowhere near being undervalued by Buffett's own principle in share buyback limits. I looked at other metrics for IV, including DCF, Graham Value and Earnings Power value, and my own intrinsic value calculation does not indicate as high a margin of safety as you indicate. In fact, the DCF showed the stock is fairly priced.

I understand Berkshire and DTV are two completely different companies, but let me ask a question in a different way; If Buffett were the CEO or Director of DTV, do you think he would allow buybacks to the extent of creating negative BV, or would he support buybacks in a more limited fashion ? My guess is probably the latter, because he may not feel it's prudent. Now, it's different to be managing a company vs. being a shareholder, but I think some principles should be somewhat in line.

There are many other companies in the market today that trade well below IV, they dominate their market, and hold CROIC figures similar to DTV. I'll give you Cisco Systems as an example, which is a powerhouse in switches and routers. Many of these companies engage in share buybacks, but not many that I follow do it as aggressively as DTV with such leverage. These are the points that make me struggle with DTV (although the recent quarterly announcement was quite impressive, particularly what's going on in South America).

And my last humble point about Vgm's IBM buyback case numbers; I had read that section by Buffett and I'm glad you brought it up because it reveals an important nuance from what I can see. Buffett likes to invest in wonderful businesses an hold them forever. This is one way of value investing as we all know, among others like cigar butts, net-nets, BV discounts, etc. etc. Since I have such small amount to invest with, I'm in the camp that buys smaller cap deep discounts, as well as good, large, but temporarily undervalued businesses, but I don't hold any stock forever. I like to hold them until they reach IV and I sell at that point and move on to another, preferably within 1-3 years (most similar to Pabrai style). In this sense, I don't care what % of the company or its earnings I own. I only care about the value of my holdings, and how quickly I can recover a gain from the stock appreciating to IV. When you look at the IBM case, a languishing stock price would increase Buffett's holding % of outstanding shares, true. But when you invest with my strategy (IBM is not undervalued in my view, but for talking purposes), when you buy in at $200, you want to see IBM reaching $300 (or whatever the IV value is) as soon as possible. At the end of 5 years, Buffett may own 7% of IBM at $200/share, where his holding would be worth $12.7 billion. But if the stock goes up to $300/share, yes he'd own 6.5% of the company but his holding would be worth $19.1 billion. That roughly 50% increase is the actual goal for some investors, not the % you own. So as a shareholder, I primarily like the share buybacks by IBM to the extent that it acts as a catalyst in raising the stock price to where I think it should be, so I can sell. So shareholders may be looking at it from different points of view, and that's what I was trying to elaborate in my previous message. In IBM's case, I think aggressive share buybacks currently is not the best capital allocation in my view because the stock is not cheap. In DTV's case, we'll see if this leveraged buyback strategy will pay off and raise the stock well over $100.

I appreciate the feedback from all of you guys. I'll definitely get that book, the Outsiders.

MritikCapital
MritikCapital - 1 year ago
Hi Sersoylu,

I appreciate you expressing your thoughts candidly. Each of us have their own investment goals and strategy. It is best to stick with what works for you. Best wishes.
vgm
Vgm - 1 year ago
Well said, Sersoylu. I can understand where you're coming from. I think we all learn from a discussion like this. I certainly do. Good luck!
vgm
Vgm - 1 year ago
For what it's worth, another credible value investor enthusing about DTV along similar lines to Bill Nygren:

http://finance.yahoo.com/video/market-wizard-shares-market-wisdom-121700099.html
Cogitator99
Cogitator99 - 1 year ago
Sersoylu,

Thanks for expressing yourself. Had no intention of beating on you so I apologize if it came out that way.

The point I was trying to make is that when evaluating capital allocation decisions you have contextualize. The all-important criteria is that buybacks are done at a rational price.

The point about negative equity shouldn't matter at all; it is an accounting entry that in this case signifies nothing at all about the value of the business. I disagree with the premise that Buffett wouldn't allow for massive buybacks if he so believed that the shares were undervalued. If you look back, he has always favored companies that were engaged in repurchases on a massive scale for as long as they made sense. In many cases he encouraged his investee companies to do so, as was the case in Geico, WPO, KO, DIS, etc. BNI was a large repurchaser of its own shares before the BRK purchase as well, and of course IBM is engaged in a similar activity.

You probably also shouldn't fixate on Buffett's P/B of 1.2x for BRK shares. There's nothing magical about it; he just wants a demonstrably cheap price for the buyback and as it happens, he's long used book value as a metric to evaluate BRK's progress against the broader markets. It may or may not be applicable to other companies. Again, it's all about context.

MritikCapital
MritikCapital - 1 year ago
Berkshire has increased its stake in DirecTV by 9.5 percent to 37.3 million shares. At recent price of $65 this is valued at $2.42B which represents 2.85% of the $85B portfoio as of 31 Mar 2013.
sersoylu
Sersoylu - 1 year ago
Apparently Seth Klarman opened a small position on DTV as well in Q1 2013. The weight of gurus on the long side is becoming overwhelming, I must say.
MritikCapital
MritikCapital - 1 year ago
It is good to see Sersoylu, I admit. But as someone said "you are neither right because everyone agrees with you, nor wrong because everyone disagrees with you. You are right only if your analysis and thought process is correct". Let us wait a few more years and see how this investment pick turns out.
sersoylu
Sersoylu - 1 year ago
Mritik,

right you are no doubt. On the other hand, Klarman is really piling on BP big time. Something to look into further.
MritikCapital
MritikCapital - 1 year ago
Hi Sersoylu,

I have had my eye on BP. It seems like a good time to plant the BP dividend tree. Same for CHK in which Bruce Berkowitz whose analysis I highly respect has started a position in Q1 2013. Carl Icahn, Southeastern Asset Management, Longleaf Partners are already major holders of CHK as well. I usually don't like cyclical businesses but there comes a price when the risk/reward looks attractive.
sersoylu
Sersoylu - 1 year ago
Fully agree on CHK. I have been waiting on point to buy into CHK but I haven't been able to capture a good enough discount to BV so far. It looks like Berkowitz is less conservative and more optimistic on the prospects of CHK. Mohnish Pabrai also has a large position on CHK. A great play for the game changing oil & gas boom in the US, in my view.
MritikCapital
MritikCapital - 1 year ago
DTV is looking to bid on Hulu (once more). Lets wait and see how this goes. I think it is highly likely that DTV won't win the bidding as the crowd is getting too big. I hope they won't make any deal that won't make economic sense. It will be interesting to see sale price of Hulu with 3.5 million paid subscribers. NFLX has 33+ million subscribers and is valued currently at 13B. The current bidder list includes YHOO, KKR, Silver Lake, DTV, TWC, Guggenheim Digital and Chernin Group LLC.
vgm
Vgm - 1 year ago
Mritik, Sersoylu,

Totally agree on CHK. In the past few days CHK chairman Archie Dunham made a personal buy of 450,000 shares at a cost of $9.4M

http://blogs.barrons.com/stockstowatchtoday/2013/05/23/finding-insider-buys-in-a-sea-of-sales/?mod=yahoobarrons

I loaded up on CHK during the swoon a year ago.
MritikCapital
MritikCapital - 1 year ago
Hi Vgm,

Very interesting info about the insider buy. I have sold puts on CHK and will wait for being assigned. They have good assets and now they have good share holder friendly management. Nobody can predict the commodity price though. You acted bravely when everyone was fearful last year. Great for you and wish you success with your investment.
MritikCapital
MritikCapital - 1 year ago
It looks like a merger between DTV and DISH could be a possibility. In all fairness with all the online options evolving for digital video and price pressures on content the arguments used by justice department in 2002 blocking the merger do not ring true today.
MritikCapital
MritikCapital - 1 year ago
Mike White's thoughts on competitive threats to DTV and strategy from May 2013 interaction with Bloomberg.
sersoylu
Sersoylu - 1 year ago
I think Charlie Ergen's primary strategy is to become a spectrum holder and get into wireless. I've been watching the bidding war between him and Sprint on Clearwire (I'm a happy clearwire shareholder, which became my best investment ever). He seems intent on getting at least some portion of Clearwire. if not all of it and he's been planning his moves very intelligently so far. Can he still merge with DTV on top of that, sure why not. Who would not want to eliminate competition ? The way I see it is the need for satellite TV providers is to offer bundle services.

I recently moved and after all these years I had to sadly drop my DTV subscription for cable. The price is superior and I don't think the quality difference is noticeable (so far). To be able to get high speed internet, landline and TV service from one provider is definitely preferable. You can add the cell phone service to this as well.
MritikCapital
MritikCapital - 1 year ago
Hi Sersoylu,

You really did great with the Clearwire pick! It reinforces the fact that sometimes one needs to look at not just the earnings of the company but also the assets. Charlie Ergen is obviously a very smart person so it will be interesting to look back in a year and see what his strategy was and how it panned out.

I agree that the bundling of services is an advantage. It is the reason why I like Rogers and Bell in Canada and also Liberty Global's moves in Europe. As for DTV I still believe the long runway for growth in Latin America adds value and US business will still be a cash generating business for the next few years allowing management to deploy that capital and re-position the business. Obviously all market participants don't agree on DTV, hence it trades for a 12 P/E after having grown earnings at double digit pace over last 5 years and being in the Media Business,
MritikCapital
MritikCapital - 1 year ago
John Malone's thoughts on Cable and Satellite industry outlook and trends including musings on DTV, CHTR, DISH.
sersoylu
Sersoylu - 1 year ago
Ergen lost the battle for Sprint and Clearwire. Softbank closed the deal on Sprint, and Sprint did the same with Clearwire. If I were AT&T or Verizon, I'd be very worried right now.
MritikCapital
MritikCapital - 1 year ago
It will be interesting to see what Ergen's next move is.

Maybe he goes after TMobile now. I think all eyes are now on Sun Valley Conference to see what will be strategy going forward for media and telecom companies.
MritikCapital
MritikCapital - 1 year ago
In this Bloomberg interview Malone suggests DTV DISH Merger.
MritikCapital
MritikCapital - 1 year ago
Malone suggests cable companies should make joint bid for Hulu.
MritikCapital
MritikCapital - 1 year ago
According to data compiled by Bloomberg John Malone is the largest individual shareholder in DirecTV with 27.7 million shares, or 5 percent.
vgm
Vgm - 1 year ago
Thanks Mritik for keeping us up to date. Getting John Malone's insights is like hearing the word of God in media!
MritikCapital
MritikCapital - 1 year ago
Hi Vgm,

Totally agree. It is interesting to note that parents of Hulu were listening when Malone spoke. Looks like DTV will need to find other avenues for growth in North America or continue with the share buyback.
sersoylu
Sersoylu - 1 year ago
I saw today that DTV took a nose dive after the quarterly announcement due to a miss on Latin America subscriptions. I couldn't read the details. Major headache or a temporary issue ?
MritikCapital
MritikCapital - 1 year ago
Hi Sersoylu,

I did not notice your comment and hence the late reply.

In my opinion Latin America will get more competitive going forward but DTV is well positioned to compete and grow there.

However the risk adjusted reward and margin of safety for DTV at $59 is not the same as it was when DTV was trading at $50.
MritikCapital
MritikCapital - 7 months ago

DTV almost a double in 1 year on chatter of merger with AT&T.

My only complaint is that AT&T could have acted before the one year aniversary of this article!

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