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According to Warren Buffett, when analyzing a company, you should focus on the earnings a 100% owner of the business would pocket at the end of the year. Furthermore, value investors should not overpay for growth (as the future is always uncertain) and focus instead on the steady state earnings of a company.

In his 1986 Letter to Berkshire Shareholders Buffett explains that Owner Earnings represent:

reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges

LESS

the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.

Note that only maintenance, but no growth investments are deducted. Before we try to apply this concept to DirecTV (NASDAQ:DTV), we should carefully think through how the company makes its money:

DTV has its own satellites and uses them to send TV content it buys to its subscribers all over the USA and Latin America.

In order to be able to receive this content, people need equipment which DTV installs at their homes. Afterwards DTV provides assistance via phone.

That's all.

When we try to figure out which expenditures are pure maintenance we have a problem: on the one hand a new satellite with enhanced technical capabilities certainly helps in maintaining the long-term competitive position and to keep clients happy, but on the other hand it might also be used to enlarge the customer base, i.e. at least partially it represents a growth investment. But for the sake of simplicity we will consider all satellite costs as maintenance expenditures.

On the contrary, the equipment installed at clients' homes seems easy: if it is installed for a new client, it's a growth investment. But wait: not all new clients are net subscriber additions, some simply substitute the ones the company looses over time. Thus, we should consider only equipment for net subscriber additions as growth investments.

The same for marketing and call centre expenditures: everything related to net growth can't be considered maintenance.

So now let's translate this into figures:

 

2012

DTV US

(in 000s)

Subs

20,084

Subs new gross

3,874

Subs new net

199

Subs churn

3,675

- churn % of gross additions

94.86%

  

DTV LA (w/o Mexico)

 

Subs

10,328

Subs new gross

4,417

Subs new net

2,439

Subs churn

1,978

- churn % of gross additions

44.78%

  

Total subs

30,412

Subs new gross total

8,291

Subs new net total

2,638

Subs churn total

5,653

- churn % of gross additions

68.18%

- churn % of total subs

18.59%

Now we know that in 2012 DirecTV spent 94.86% of its consumer acquisition costs in the US and 44.78% of those in Latin America for substitutions of lost subscribers. We exclude Mexico as DTV does not disclose separate figures for this segment (which is treated as an equity investment for accounting purposes).

All in all, 68.18% of the subscriber acquisition costs were maintenance expenditures.

(Interestingly the last figure in the table reveals how long a subscriber stays with DTV on average. If the churn/year is 18.59%, after 5.38 years the customer base is 100% renewed.)

How much did the company spend in 2012 for subscriber acquisitions?

2012

($ millions)

Acquisition costs expensed

3,397

Advertising

514

Cash x consumer leased equipment (sub acq.)

1,493

Total subscriber acquisition costs

5,404

Maintenance acquisition costs - 68.18%

3,684

Growth acquisition costs - 31.82%

1,720

Now we can elaborate the cash flow statement:

We add $1,720 to net income to adjust for these costs that have been expensed in the income statement. Then we reduce net income by 35% of these costs because we have to consider that DirecTV, by deducting these expenses in its income statement, lowers its taxes. Hence the net amount we add to operating cash flow is $1,118, in order to calculate DirecTV's real earning power in a hypothetical steady state where it only maintains its customer base without adding new subscribers.

2012

($ millions)

Operating CF consolidated

5,634

Growth acquisition costs net of tax deduction

+ 1,118

Adj. Op. CF

= 6,752

Capex + satellites

- 3,349

FCF adj.

= 3,403

Shares (average, diluted, in millions)

644

FCF adj./share

$5.28

If we run this calculation for the previous years, we get the following:

 

CAGR

2008

2009

2010

2011

2012

FCF adj. (in millions)

8.62%

2,488

3,225

3,770

3,321

3,403

Shares (average, diluted, in millions)

-12.80%

1,114

992

886

707

644

FCF adj./share ($)

24.57%

2.23

3.25

4.26

4.70

5.28

(Some components of the calculations in previous years have been estimated, as disclosure standards have changed over the years.)

In this respect DirecTV's story is not much different from IBM's (see my article on IBM): Total earnings growth is not spectacular, however smart allocation of the stable cash flows to stock buybacks provides amazing EPS growth rates. In the case of DirecTV management has even taken on additional leverage to buy back stock. If there was no growth whatsoever anymore and DirecTV just kept its existing customer base, presuming a languishing stock price, the company could buy back at least 50 million shares per year without any additional leverage. That's about 10% of the currently outstanding stock!

Now think about the facts laid out by Long Term Hunter in his article which illustrates in an excellent manner DirecTV's current situation and future prospects. Suffice it to say that I share his conclusions.

Source: How Much Does DirecTV Really Earn?