DIRECTV – Exceptional Execution, Diligent Capital Allocation

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MritikCapital
Apr 18, 2013
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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, Financial)(BRK.B, Financial) 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.

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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.

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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, Financial) 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.

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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.

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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.

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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, Financial) 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.

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