DirecTV (DTV) reported strong second quarter results Thursday morning. Revenue increased 7% year-over-year to $7.7 billion, just a bit shy of consensus expectations. The disappointment in the period came from DirecTV Latin America, where revenue still advanced 12% year-over-year on a reported basis (constant currency revenue surged 26% year-over-year). Currency issues can be short-term headwinds, but we think the issues will even out in the long run. Earnings per share increased 8% year-over-year to $1.18, falling well short of consensus estimates. Again, we think this was largely due to currency issues. Free cash flow increased 15% year-over-year to $1.2 billion, equal to 15% of total revenues.
In the US, revenue increased 5% year-over-year to $5.9 billion driven largely by an increase in average revenue per user (ARPU) of 4.5% compared to the year prior. Subscriber churn remained low at 1.53%, which management explained was slightly higher than normal because of more involuntary churn. Operating profit before depreciation and amortization (OPBDA) increased 4% year-over-year to $1.65 billion as OPBDA margins declined 30 basis points year-over-year to 27.8%. There were a few issues related to the Genie box and increased content costs. President and CEO Michael White added some commentary on the issue during the conference call, saying:
"ACPU [average cost per user] was a touch better, but it's not so much better that I'm going to have a party, to be honest with you. It's still an enormous headwind for the business overall. It just happens to be a little better than we expected. But I'd say, structurally, it's still at a heightened level and continues to look to be that way, not just this year but in the years ahead. So I wouldn't get too excited about that. But we're taking the opportunity to fine tune some of our tools and still feel comfortable we can deliver our full year guidance."
To combat rising content costs, it is clear, in our view, that some industry consolidation must occur, and that could be a merger between DirecTV and Dish Network (DISH). We previously addressed the merits of a merger between the two satellite giants, and now that Dish Chairman Charlie Ergen is done pursuing a merger with Sprint (S), we think the time is ripe for the two companies to join forces.
Former DirecTV Chairman and industry pioneer John Malone recently implored Ergen to join forces with DirecTV (of which Malone owns 5% of shares outstanding) in order to combat rising content costs and to save hundreds of millions of dollars via operational synergies. Ultimately, we think a deal could occur in the not-so-distant future, and at the very least, we think Ergen is contemplating the idea of merging with his number one competitor.
As for the Latin American business (DTVLA), revenue increased 12% year-over-year (26% excluding currency) to $1.7 billion as the subscriber base swelled. Subscribers in Latin America now stand at 11 million, up 22% from the year prior. OPBDA margins suffered as a result of currency issues (and lower ARPU), higher content costs in Brazil, and higher customer acquisition costs, falling 250 basis points year-over-year to 27%. Churn appears sky-high at 3.1%, up substantially from the 1.8% the region experienced a year ago, but this was almost entirely due to correcting previously overstated subscriber numbers. As DirecTV Latin America CEO Bruce Churchill stated on the conference call:
"Our higher churn in Brazil unfortunately offset very low postpaid churn in PanAmericana, which is 1.33%, down from 1.4% last year on churn improvements in Argentina and Venezuela. With regard to our prepaid subscribers in PanAmericana, we saw an increase of almost 70% of our on subscribers compared to last year, reflecting our strong sales and continued improvement in reconnection rates."
Other than the issue in Brazil, DTVLA performed relatively well during the second quarter, and we continue to believe it will be a long-term driver of free cash flow growth for years to come.
Speaking of free cash flow, few firms are committed to putting excess capital to work to the same extent that DirecTV is. Management repurchased 10 million shares for $620 million during the second quarter, and since beginning its share repurchase program in 2006, the firm has retired 63% of shares outstanding. Shares have largely traded at a discount to intrinsic value during this time period, so the repurchases have greatly benefitted shareholders.
Results in the DTVLA division were largely impacted by extraneous factors, and we think it is important to look at the broader picture: the satellite industry in Latin America is still young and experiencing secular growth. Ultimately, this segment could be as big, if not bigger, than DirecTV's core US business.
Without question, several challenges lay ahead for DirecTV, namely in the form of content costs. Again, if we look at the industry landscape, we think there are a few factors at play that will benefit DirecTV. For one, content costs are starting to reach the point of diminishing returns (where companies are starting to demand lower prices because it simply isn't worthwhile to acquire programming at such high costs). Content competitors such as Netflix (NFLX) and even Amazon (AMZN) won't have the financial strength to continue bidding higher amounts for content without risking financial insolvency.
Additionally, we think the rise of online content consumption has left the cable and satellite industries well-positioned to consolidate, even though we think the "cutting the cord" trend is a bit exaggerated. We suspect regulators will overestimate the competition, allowing a mega merger along the lines of DirecTV and Dish, which may not have been fathomable in the past.
All things considered, we're happy to keep holding shares of DirecTV in the portfolio of our Best Ideas Newsletter. The firm is a cash cow, has a strong Latin American business, and its US content distribution business will hit an inflection point in the next few years (where consolidation may improve the profitability of the entire industry).
Additional disclosure: DTV is included in the portfolio of our Best Ideas Newsletter.