On December 15, Nomura analyst Mike McCormack downgraded his recommendation on DirecTV (DTV) to reduce, with a price target of $32.00 per share (versus the close of $45.36 per share on December 14). After reading the report, the analyst outlined an unjust premium valuation to peers, muted share repurchases post 2012, a mortgaged Latin American business and deteriorating domestic fundamentals as the argument calling for an almost 30% decline in the share price.
While I generally admire an outside-the-consensus call, I can't agree with the rationale behind why such a dramatic decline should be expected on fundamentals alone in DTV shares. Despite the assertion that DTV should trade in line with peers, the reality is that the company's underlying fundamentals and the track record of the management team delivering for shareholders highlight a stock that should trade at a premium valuation to peers overall. Let's consider the following reasons why the Nomura call is badly missing the mark:
- Since 2005, DTV has returned capital to shareholders in the form of repurchases, taking the share count to 732 million as of September 30, 2011 from 1.4 billion as of December 31, 2005 (the high tick on the share count) using a combination of leverage and FCF. While that is backward looking (and management should only receive credit for buying the stock low and taking extraordinary action to support the equity through a tumultuous period for equities broadly), DTV is expected to continue to retire shares through 2012 at an accelerated pace (a point noted by Mr. McCormack).
Further, management has indicated the potential for incremental leverage in 2012 could be undertaken to support the return of capital to shareholders. I concur on $2.0 billion of FCF available for share repurchases in 2012 from operations as highlighted by Nomura, and assuming the company is buying back stock at the current price of $43.63 per share, the roughly 6% of shares outstanding is right.
But what if management does a $2.0 billion bond deal to fund further repurchases? This is not unrealistic by any stretch, considering the track record of the company, and if undertaken, we are now talking about 12.5% of outstanding shares. That is a pretty considerable return of capital (and consistent with the recent pace), as DTV continues the levered recapitalization of the business taken on since 2005.
- Mr. McCormack talks about leverage, both on Latin America (how the EBITDA has been levered) and eludes to leverage in regard to share repurchases. First, the Latin American business is not levered as the US business can support the debt. Let's assume that the US business has $5.5 billion of OPBDA at year-end 2011. Against consolidated leverage of $13.5 billion, the Debt/OPBDA ratio of 2.45x is not particularly excessive (and that gives no credit for cash on the balance sheet of $1.3 billion, which will go toward share repurchases which is why we are not looking at net debt).
The growth in Latin America (accounting for OPBDA of, say $1.6 billion, in 2011) is only gravy to support the balance sheet further. Considering the credit markets are pricing DTV as a strong investment grade credit, with 10-year paper yielding 3.827% and 30-year paper yielding 5.409%, it would not appear that the bond market is concerned that DTV has levered future growth. Looking at next year, if DTV ends 2012 with leverage of $15.5 billion (assuming the company does $2.0 billion of further debt to support share repurchase), the consolidated entity is around 2.0x levered using the $7.7 billion estimate by Mr. McCormack and 3.0x levered against the US operations alone, which is not overly disconcerting for a company that will do $2.0 billion of FCF in 2013 and has a generally stable overall business as evidenced by multi-year growth in subscribers in the US and Latin America.
- The Nomura team makes a lot of assumptions about declining operating trends in the US and the high capital intensity of growing Latin America. Yet they still conclude that the company is going to grow OPBIDA by 11% (versus the compounded growth of 13.6% for the period from 2006 to the estimated 2011) and EPS by over 30% (which is before imputing the impact of further share repurchases from the incurrence of more leverage). The Nomura team is concluding that a company that is going to repurchase a minimum of 6% of outstanding shares, with 11% growth in OPBIDA and 30%+ EPS growth will decline almost 30% in 2012, to reflect a multiple move closer to peers? The stock is trading at 5.616x 2012 consensus EBITDA, a discount to the broad S&P 500, trading at 8.25x (and I am a heck of a lot more comfortable with the DTV numbers than the broad S&P, considering the economic backdrop versus the elasticity of the DTV subscriber).
Peers like Comcast Corp. (CMCSA) and Time Warner Cable Inc. (TWC) are trading at 6.037x and 5.434x, respectively, and do not have the same growth potential or track record of returning capital to shareholders in recent years. Without going further, and getting into the over-analysis and various cash flow type of comparisons used by Nomura to prove a point, it does not appear that DTV is a particularly expensive stock relative to peers or the market, and the company is expected to just fine operationally. Expecting a 30% decline in the value of the shares is pretty aggressive, as a result.
- One further point to talk about are margins and the cost of programming. This is not a DTV issue; this is an industry issue. My bet (using common sense and a modicum of knowledge about how economics work): the cost of higher programming will be passed on to the consumer over time, by the entire industry. That's the way life goes, unfortunately for those of us who use and watch television.
As I see it, the call by the Nomura team appears very ambitious and overly punitive. DTV is growing, has a generally stable business, has returned capital to shareholders aggressively -- the only way to make share repurchases relative to a dividend -- and has a track record of success. I am staying long here, and if I wasn't in the stock, I would look to this report by Nomura (and the corresponding market reaction) as an entry point.