DirectTV (DTV) is the largest combined holding of Warren Buffett's two new investment managers (Todd Combs and Ted Weschler). In this article I outline what these two excellent investors might see in DirectTV to take such a large position, and why I believe you should follow them.
DirectTV is the highest conviction stock pick of Buffett's protégés
In the 2012 Berkshire annual shareholder letter, Buffett listed DirectTV on his list of top Berkshire investments, and he noted that this was the first time that he included an investment that was made by someone other than himself. As of the end of 2012, Berkshire Hathaway owned 3.8% of DirectTV stock worth $1.15 billion dollars. To put this holding in perspective, Buffett has said that Todd Combs and Ted Weschler each managed 4 billion dollars at the end of 2012. Accordingly, the DirectTV investment constituted approximately 14.4% of the joint portfolios of Buffett's hand-picked protégés, and the stock is their highest conviction pick. Warren Buffett had nothing but praise for these two investors in his recent shareholder letter, saying "Todd Combs and Ted Weschler, our new investment managers, have proved to be smart, models of integrity, helpful to Berkshire in many ways beyond portfolio management, and a perfect cultural fit. We hit the jackpot with these two. In 2012 each outperformed the S&P 500 by double-digit margins. They left me in the dust as well." In addition to Weschler and Combs, another former Berkshire Hathaway investment star, Lou Simpson, also has a high conviction about DirectTV with approximately 7.2% of his hedge fund's current portfolio invested in DirectTV. Obviously the Berkshire Hathaway investment brain trust likes DirectTV, and in the remainder of this article I examine DirectTV's current business outlook, recent financial performance and aggressive capital allocation strategy to understand why DirectTV is primed for outperformance.
Business Overview and Future Outlook
DirectTV's primary business consists of providing satellite television service in the United States and Latin America. DirectTV is the second-largest pay TV provider in the United States (after Comcast) with 20.1 million subscribers at the end of 2012. DirectTV also provides satellite television throughout Latin America through its subsidiaries of PanAmericana, Sky Brasil, and Sky Mexico. As of December 31, 2012, DirectTV had 15.5 million subscribers throughout Mexico and South America.
The company's business strategy moving forward is to focus on high value customers in the U.S. and grow customer subscriptions rapidly in Latin America. The pay TV industry in the U.S. has seen slowing growth as the market becomes saturated and as some customers decide to cut the cord. DirectTV's strategy in the U.S. to focus on profitability and building greater relationships with higher value customers (over growth of subscribers) is a good one as the lower tier of pay TV customers decide to live without cable or satellite. DirectTV's exclusive arrangement to offer the NFL's "Sunday Ticket" has been very successful in attracting higher value customers, and DirectTV has the exclusive rights through the 2014 NFL season.
The most exciting story for DirectTV is in the Latin American region where growth in subscribers has been rapid in recent years. DirectTV has a significant competitive advantage in Latin America because the cable infrastructure is not well developed and DirectTV's satellite operations allow it to provide excellent quality television without the expensive installation of cable infrastructure. Current CEO, Michael White (who used to be the number 2 executive at PepsiCo), recently had an question and answer session with an industry website where he said that the reason the Latin American operations have been growing so rapidly was a combination of a great management team, rapidly growing demand from an expanding young workforce in countries like Brazil and Columbia, and the structural competitive advantages of satellite TV over cable in Latin America. When asked about DirectTV's competition in Latin America, White said the following about the advantages of satellite over cable in the region: "when you look at building out that infrastructure in Latin America it's a lot more challenging. And the satellite technology is more leverageable once you've built your broadcast center and have satellites in the sky and have call centers. I feel strongly that it's still a wonderful asset and still has growth potential even after the last couple of years of growing aggressively."
Overall, DirectTV's portfolio of businesses is very attractive: a profitable U.S. business focused on high end customers and a fast growing business in Latin America.
Recent Financial Performance
DirectTV has had outstanding financial performance over the last five years. The company has increased its revenues from $17.2 Billion to $29.7 Billion (an increase of 72.6%), increased its net income from $1.45 Billion to $2.95 Billion (an increase of 103%), and increased earnings per share from $1.37 to $4.62 (an increase of 237%).
Dr. John Malone's Aggressive Capital Allocation Key to Financial Performance
In his annual shareholder letter, Buffett recommended the book "The Outsiders" by William Thorndike, Jr. The book is excellent and holds some key insights as to how some CEOs have delivered amazing shareholder returns by maximizing capital allocation decisions. An understanding of how Dr. John Malone, one of these Outsider CEOs, has brilliantly allocated capital in the past while running a variety of cable and media businesses illustrates why DirectTV's current capital allocation decisions will continue to make shareholders richer over time.
John Malone is a billionaire who made his fortune in the cable television industry and now heads Liberty Global, which is a conglomerate of media companies. Malone and Liberty Global have been intimately involved with the strategy and direction of DirectTV in recent years as Malone was chairman of DirectTV's board of directors and controller of 24% of the voting interest in DirectTV from 2008 to 2010. Although Malone stepped down as chairman of DirectTV's board and exchanged his voting shares in DirectTV for common shares in 2010 due to an agreement with the FCC, he and his family held 26,547,627 common shares of DirectTV as of April 6, 2010. Considering how Malone despises taking capital gains without a tax efficient exit (as detailed in the Outsiders), we can guess that he still holds these shares, which would be worth approximately $1.4 Billion today.
According to the Outsiders, one of Malone's key insights in the cable business was that to be successful a company needed leverage with content producers and the way to get that leverage was to rapidly grow the number of subscribers. Another key insight was that best way to grow subscribers was to take on lots of debt to build out infrastructure, aggressively depreciate the costs of construction, and reduce taxes through the depreciation deduction and interest expense deduction. This strategy allowed Malone to fund his rapid subscriber and revenue growth through increased debt and tax savings. Additionally Malone repurchased stock of his companies when he believed them to be undervalued by the market. The combination of (I) using debt and tax savings to expand operations, (ii) using the increased customer base size to negotiate better deals with content providers, and (III) repurchasing equity at opportunistic times has worked extremely well for shareholders in Malone's companies.
All of these lessons are being implemented again at DirectTV. From 2006 to 2012, DirectTV has increased its long-term debt from $3.4 Billion in 2006 to approximately $17 Billion, (ii) significantly increased its depreciable capital investments, and spent $26 Billion on share repurchases, retiring 60% of the outstanding shares since 2006. DirectTV has taken on debt to grow its revenues in the U.S. and Latin America and decrease taxable income through increased interest and depreciation deductions. Because the tactics of increased debt and capital expenditures mask the true earnings power of the business, DirectTV's P/E ratio of 12 is not reflective of the true cash flow of the business. DirectTV's management has been using the measure of cash flow known as OPBDA (operating profit before depreciation and amortization) to determine the true cash flow generation of the company. The OPBDA of DirectTV at the end of 2012 was $7.5 Billion and has been growing steadily over the past few years. Using this measure, the company's enterprise value is currently valued at only 6.26 times OPBDA, and seems unreasonably undervalued at current share prices.
Conclusion: Buy DirectTV
The combination of excellent business performance and future prospects for DirectTV in the United States and Latin America along with John Malone's aggressive capital allocation strategy make DirectTV a long-term buy for savvy investors. Berkshire's investment group certainly understands that shares are currently undervalued when looking at the metrics that matter, and I believe investors would do well to follow their lead.