How Much Did DirecTV Really Earn In 2013?

|
 |  About: AT&T Inc. (T)
by: Early Retiree

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 (NYSE:BRK.A) (NYSE:BRK.B) 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.

Before we try to apply this concept to DirecTV (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. As DirecTV has been growing net subscribers (US+LatAm) at an average annual rate of 9%, for the sake of simplicity we will consider 9% of all capital expenditures for satellites, property and equipment as growth 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 loses over time. Thus, we should consider only equipment for net subscriber additions as growth investments.

So now let's translate this into figures:

2012

2013

DTV US

(in 000s)

(in 000s)

Subs

20,084

20,253

Subs new gross

3,874

3,790

Subs new net

199

169

Subs churn

3,675

3,621

- churn % of gross additions

94.86%

95.54%

DTV LA (w/o Mexico)

Subs

10,328

12,600

Subs new gross

4,417

4,382

Subs new net

2,439

1,239

Subs churn

1,978

3,143

- churn % of gross additions

44.78%

71.73%

Total subs

30,412

32,853

Subs new gross total

8,291

8,172

Subs new net total

2,638

1,408

Subs churn total

5,653

6,764

- churn % of gross additions

68.18%

82.77%

- churn % of total subs

18.59%

20.59%

Click to enlarge

Now we know that in 2013 DirecTV spent 95.54% of its consumer acquisition costs in the US and 71.73% 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, 82.77% 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 ratio is 20.59%, after 4.86 years the customer base is 100% renewed.)

How much did the company spend in 2013 for subscriber acquisitions?

($ millions)

DTV US Segment

DTV LatAm Segment

TOTAL

Acquisition costs expensed

2,642

777

3,419

Growth acquisition costs expensed

(US: 4.46% - LatAm: 28.27%)

118

220

338

Click to enlarge

($ millions)

DTV US Segment

DTV LatAm Segment

TOTAL

Cash paid for consumer leased equipment (sub acq.)

666

923

1,589

Growth acquisition costs capitalized

(US: 4.46% - LatAm: 28.27%)

30

261

291

Click to enlarge

($ millions)

DTV Consolidated

Cash paid for satellites and PPE

1250

Growth expenditures (9%)

113

Click to enlarge

Now we can elaborate the income and cash flow statements:

We add $338 to net income to adjust for the growth related 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 net income and then to operating cash flow is $220, 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.

($ millions)

2012

2013

Operating CF consolidated

5,634

6,394

Growth acquisition costs net of tax deduction

+ 348

+ 220

Adj. Op. CF

= 5,982

= 6,614

Capex + satellites

- 3,349

- 3,786

Growth acquisition costs capitalized

+ 495

+ 291

Growth expenditures (satellites + PPE)

+ 103

+ 113

FCF adj.

= 3,231

= 3,232

Shares (average, diluted, in millions)

644

553

FCF adj./share

$5.02

$5.84

Click to enlarge

GAAP-EPS in 2013 was $5.17, but real Owner Earnings were about 13% higher!

That said, we also have to consider that:

1) We have looked only at two years - and 2013 was a year with relatively high capital expenditures and unusually high churn especially in Brazil (due to the fraud issue).

2) By looking only at our calculated owner earnings, we don't attribute any value to the non consolidated subsidiaries. To be precise, as the cash flow statement includes a $198 million adjustment for non-cash earnings from unconsolidated affiliates, owner earnings per share would have been even higher by $0.36 if we had considered those unconsolidated affiliates.

3) Overall, our assessment of growth vs. maintenance costs is probably very cautious:

a) As stated in the Q1/2013 conference call, in 2013 DirecTV continued "to build a world-class infrastructure to support explosive growth momentum which is expected to continue for the foreseeable future".

b) We consider all costs for subscriber retention as maintenance, but ARPU is actually increasing, hence profit is growing even from the stable subscriber base.

All in all, we could expect somewhat lower capital expenditures in the years to come and a lot less churn. This means that DirecTV should be able to grow free cash flow at least by the multi-year average growth rate of about 9%, while share repurchases should boost EPS growth even further. The current repurchase program would allow to buy back 9% of shares outstanding. Hence, I'd project 2014 owner earnings to reach at least $6.50/share.

(This is an update to my previous article on the same subject. It uses a slightly different calculation method: growth and maintenance costs for the US and the LatAm segment are now split and advertising costs are not double counted anymore. Thanks to Seeking Alpha users fatbaboon and ValueThis4 for their comments!)

Disclosure: I am long DTV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.