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  • DIRECTV - A SHARE CANNIBALIZER 0 comments
    Oct 28, 2013 10:31 AM | about stocks: DTV

    Introduction

    As a background to this post, I first discovered DTV after reviewing Berkshire's public holdings, and after noticing that both of Berkshire's new fund managers Todd Combs and Ted Weschler held rather large positions in DirecTV, I decided to dig deeper. Weschler has been a long-time shareholder of DTV, having held shares comprised of roughly 25% of the long-side in his hedge fund if you look at Peninsula Capital Advisors' SEC filings dating back to inception. We think Weschler is an extremely talented investor in his own right, having returned 1236% over a roughly 11-year period running his hedge fund. We like to track the holdings of great, long-term investors that tend to have extremely concentrated portfolios with high conviction ideas as a source of idea generation. Although we do not need confirmation from great investors for the development of our own investment theses and conviction, we still take comfort that other great investors may be seeing the same value as we do. Weschler also appears to be a big fan of John Malone, and he has consistently invested in Liberty Media shares in the past and for Berkshire currently. As a side note, we believe that he is well capable of becoming the next "Buffet", and certainly is qualified to takeover the investment duties at Berkshire as a successor.

    Now back to DTV. The DTV story is interesting, as the company was originally part of Hugh's Electronics Corporation, a subsidiary of General Motors. John Malone's Liberty Media eventually acquired a controlling interest in DTV, after negotiating a swap for their 19% interest in News Corp. Shortly after, DTV was spun off in a Reverse Morris Trust transaction in 2009. Despite much of the recapitalization process being completed, we still believe DTV shares are attractive going forward. The business has demonstrated that it offers a superior video product to subscribers and the large share gains mostly taken from cable that it has achieved over the past decade support this case. Today, the company sits on a crossroads amidst industry shifts in how consumers are viewing their content, and management have elected to focus the company on its core video business, which is a stark contrast to Charlie Ergen's DISH focus on entering the wireless industry. Despite Malone's public comments on the importance of broadband and high speed data for the future (which we agree with), we believe DTV will remain a significant player in the Pay-TV industry and will position itself has being broadband agnostic as the company has national scale with exclusive content and an ubiquitous presence.

    Company Overview

    DirecTV is one of the fastest growing Pay-TV operators in the world with a ~$32B market cap. DTV is comprised of two business segments: a mature, free cash flow generative U.S. business which is currently the second largest Pay-TV operator in the country with 20MM subscribers and a fast-growing Latin America business with ~13MM[1] subscribers. The Pay-TV industry in the US is largely mature (~87% penetration) and is most likely in a slow, secular decline. There are currently ~100MM Pay-TV subscribers in the US and ~50MM in Latin America.

    Thesis:

    1) DTV's U.S. business should remain sustainable for the long-term despite gross margin compression. The market currently under-appreciates the resilient cash flow generative capabilities of the highly recurring, (customer contracts are fixed 2-year terms with high renewal rates), stable US business segment. DTV benefits from a higher-end customer base vs. competitors (DTV's entry-level subscription package is $61 vs. Dish's $25), holds the premiere brand and leading technology offering ("TV everywhere" and advanced HD set-top boxes with time-shifting functions for eg.), and award-winning customer service (DTV has won more industry customer service awards than any other competitor). Despite the pay-TV industry slowly shedding net subscribers, DTV should be able to at least maintain their 20% market share largely from maintaining their respective share in new housing starts and benefitting from a rather sticky customer base. By my conservative estimates, the US business will only start slowly losing net subscribers after 2015-2016 and has demonstrated real pricing power by raising prices 3-4% annually and growing ARPU[2] steadily (nearly 5% CAGR over past 7 years). Moreover, DTV holds exclusive content (NFL Sunday Night ticket for eg.) which has been a large differentiator in terms of offering a premium video product and this should help reinforce the upward trajectory in ARPU growth within low-to-mid single-digits longer-term. Despite the fact that cable has long held the advantage of offering a competitive triple-play (video, voice, broadband) bundling package, DTV has still been able to steadily grow its market share by 200 bps from ~18% in 2008 to 20% today. I believe this can largely be attributed to cable focusing on cross-selling to its existing subscriber base, rather than stealing share from competitors, but it is also a testament to DTV's superior video product and competitive positioning. I believe churn[3] will also remain stable given DTV's top-tier customer service and higher customer loyalty resulting from increasing sales of advanced products such as HD DVRs, pay per view, and premium channel programming.

    2) Latin America remains largely under-appreciated by the market. The region has an extremely long runway for growth as Pay-TV penetration is still very low at ~34.1% region-wide and should reach closer to 60% by 2020 powered by a growing, middle-class. I believe Pay-TV service is one of the core, basic entertainment services that is purchased by consumers as they advance within the socio-economic ranks given its superior value proposition vs. other basic entertainment options. As the premier Pay-TV brand in Latin America, DTV has a superior competitive positioning all across Latin America including Brazil, Pan America, and Mexico with market shares ranging from 11-44% depending on the country. The business has sustainable competitive advantages due to regional scale (which provides the company with considerable bargaining power when it comes to securing the best content and hardware equipment on favourable terms), the premier brand, superior customer service, exclusive content and technology that have been easily leveraged through the successful practices developed in the US business. This is in contrast to many cable operators in the region that are limited in their operations at the country-level, thus limiting their scale. Several key factors also differentiate the L.A. competitive landscape from the US one which should benefit DTV in the long-run.

    1) Direct-to-home satellite operators were early entrants in the region along with cable and telecoms, unlike being a late-comer in the US after cable enjoyed a multi-decade runway of growth establishing subscriber bases. I think this is rather significant as video is typically a sticker service relative to voice or broadband given the more differentiated nature of the product. Market share trends in L.A. have been extremely favourable as DTV and satellite in general continue to steadily take share from cable which mostly offer lower-quality, inferior analog video services. Moreover, there are no meaningful fiber optic overbuilds in the region, thus eliminating an additional competitive threat.

    2) Programming fees are more controlled because of the lower-quality cable networks in the region. There is also the absence of broadcast retransmission fees and RSNs (regional sport networks) which have been a major source of programming cost inflation in the US.

    3) Despite dominating the high-end, DTV provides services across the entire customer spectrum in L.A. and have implemented a successful segmentation strategy that has been yielding subscriber-level IRRs between 40-70% depending on the segment. Competition mainly focuses on the low-end but DTV has successfully responded with a competitive pre-paid package offering as evidenced in Mexico.

    4) Broadband service is underpenetrated in Latin America and competition remains weak, providing DTV a market opportunity to establish a competitive broadband and video bundle longer-term. DTV has been opportunistically deploying fixed-broadband service based on LTE technology in selective underpenetrated areas in Brazil that should yield high returns on capital. All these factors mentioned have led to a higher-margin (30% EBITDA margins vs. 24% in the US) L.A. business that should be able to comfortably continue taking share in a rapidly growing market.

    3) Share buybacks are key. Since 2006, management have opportunistically employed a leveraged buyback strategy of repurchasing over ~$26B worth of stock and plan to buy back $3.5-4B a year going forward while maintaining a 2.5x gross leverage ratio[4]. In my model I conservatively forecast continued buybacks going forward at a 20% yoy share price appreciation assumption while maintaining the 2.5x gross leverage ratio. I believe the buybacks are currently the optimal capital allocation decision in light of other strategic options available and are tax-efficient compared to dividends. Put another way, DTV is currently borrowing at a rate of less than 3.0% (DTV recently issued $650MM of 2.75% senior notes due in 2023 in May) to repurchase shares yielding ~9-10% on a 2013 P/E basis; the ongoing buybacks should be very accretive to earnings per share given that shares are trading below intrinsic value. Although interest rates may start moving up over the next several years, I have already assumed a long-term cost of debt of 5% in my model, which should be reasonable given the recurring nature of the business.

    4) Conservative accounting obscures the true free cash flow and value of the business.

    - DTVs' 41.3% equity stake in Sky Mexico is not consolidated in the financial results. I estimate Sky Mexico should generate at least $535 of EBITDA in 2013.

    - Leased set-top deprecation assumptions are rather conservative (4 years for a High Definition set-top box and 3 years for a Standard Definition box). In comparison, Comcast assumes 6 years for their set-top box depreciable life assumption. In economic reality, churn in the US business has been averaging 1.55% monthly implying an average customer economic life of greater than 5 years.

    Market Consensus/Bearish Views:

    Bearish Argument 1) Programming costs are rising faster than Pay-TV companies' ability to pass on these extra costs to consumers, thus squeezing their gross margins.

    Mitigant: Although I agree that programming costs will continue to increase at high-single digits for the next several years (I conservatively estimate US gross margins will actually compress to 34% by 2018 vs. 46% today), the large source of programming cost increases over the past few years has primarily been sports-related content which has been increasing at 9-10% annually for DTV. ~33% of all programming costs are on account of sports with the ESPN channel accounting for 75% of that. Given that ESPN already receives $5.04/sub/month vs. $0.24 for the weighted average of all other channels combined, upside in the future may be more limited and commentary from Disney's CEO has confirmed this view as bidding for sports rights become more competitive for ESPN in the future. Several Pay-TV operators have already begun to hedge their contest costs such as Comcast by purchasing RSNs for example. Moreover, the large programming cost increases over the past several years were implemented by cable networks that negotiated for higher affiliate fees to help offset the cyclical downturn in their advertising fees experienced in the 08' recession. Thus, I believe part of the large increases in programming fees recently were a response by the cable networks to cyclical weakness in advertising revenues and future increases may become more limited in scope versus consensus expectations.

    Bearish Argument 2) Web-based video such as Over-the-top[5] (OTT) will be a major disruptor to the traditional Pay-TV model[6] as consumers continue to "cord-cut".

    Mitigant: I believe this is by far the most overblown fear for several reasons:

    1) DTV's customer base is skewed towards an older, higher-income demographic that are less likely to "cord-cut" versus younger, lower-income subscribers that have been fueling OTT adoption.

    2) The economics of online advertising are simply not as attractive; the online model has yet to prove that it can command the large advertising fees necessary to secure high-quality, premium content in order to attract large masses of subscribers. Live sports content continues to command premium advertising rates over television and is unlikely to move 100% online given the current economics. Moreover, given the large amount of online inventory, all forms of media have historically faced deflationary advertising pricing pressure as they've moved online and this is unlikely to change.

    3) Cable channels with premium content are incentivized to not disrupt the traditional Pay-TV ecosystem given the large affiliate fees that they receive from Pay-TV operators; Pay-TV operators also have considerable bargaining leverage over cable networks in terms of competing against new entrants. For example, Pay-TV operators can demand similar rights to air content on mobile platforms such as tablets and smart phones if new entrants try to secure similar terms, thus preventing OTT entrants online exclusivity on certain mobile platforms. Moreover, the scale required to build a profitable OTT business is enormous, and even for Netflix which currently has the largest online subscriber base is trapped in a low-margin business as it continues to pay enormous costs to secure exclusive content while having limited pricing power.

    4) As the insatiable demand for bandwidth continues broadband providers can eventually move to a usage-based pricing model which will limit the rate of OTT adoption.

    5) The issue of channel bundling is a large one as consumers currently pay for hundreds of channels that they may not even view, but if consumers want to watch the best content online via an a-la-carte model as opposed to viewing it on a channel, they will most likely have to pay more for one-time deals for premium, high-quality content vs. paying a monthly TV subscription fee for viewing the same content; I see this as unattractive for the consumer. Moreover, Pay-TV operators are improving and enhancing their user-interface platforms as they are moving towards cloud-based platforms, improving the customer experience by capturing viewer habits and developing more sophisticated platforms in general that would be competitive vs. OTT platforms such as Netflix, Hulu, or YouTube. One last point is that even if the Pay-TV model eventually becomes extinct in the future, the rate of decline will most likely be slow.

    Bearish Argument 3) The mature market in the US will get increasingly competitive as Cable continues to upgrade their systems from analog to digital to HD and Telcos continue to roll-out their fiber overbuilds. DTV also has no broadband exposure which leaves them at a serious competitive disadvantage as consumers continue to consume more data online.

    Mitigant: I agree that a lack of exposure to growing broadband is a major disadvantage and have already assumed declining net subscribers in my DTV US estimates; however, DTV's competitive advantage in video should remain given their exclusive content and leading customer service and scale. Also, partnering up with the Telcos remains a viable option for DTV customers that want a broadband service. A large % of the US customer base (~40%) are located in rural areas where there is less competition from fiber. Also, the Telcos have largely completed their fiber builds with the exception of AT&T U-Verse adding several million more homes over the next couple of years with the long-term goal of having 50MM US homes passed nearly completed. I believe that despite the enormous financial resources that the Telcos possess, a nationwide fiber build is unlikely given the lower returns offered in more rural areas which compound the issue of already questionable returns on current projects. Therefore, as long as DTV can successfully position itself to remain broadband agnostic, high-quality satellite TV should remain relevant in the long-term competitive landscape.

    Bearish Argument 4) Adverse foreign exchange and churn pressures in Latin America will dampen the growth outlook in the region.

    Mitigant: This has been a legitimate concern, especially since the company has over $400MM trapped in Venezuela which illustrates some of the political uncertainty in the region as well, but longer-term these shorter-term pressures should stabilize as the region (ex Venezuela) is growing healthily and has a bright outlook. I believe the Street has also overplayed the recent higher levels of churn in L.A. and especially in Brazil. In the short-run, higher levels of churn may persist given the recent expansion into the pre-paid market and a mix-shift towards lower-income, middle-market subscribers. However, over the longer-term, churn should stabilize as DTV implements their best practices in customer loyalty and retention and ARPU should trend higher as DTV up sells advanced services to its subscriber base like it has historically.

    Valuation:

    DTV is one of the fastest growing Pay-TV companies that should compound EPS by at least ~15% a year for the next several years powered by aggressive share buybacks and solid growth from Latin America which will help offset slowing growth and margin compression in the US. Most sell-side analysts value DTV on an EBITDA basis. I believe this is the wrong metric as shares should be valued on a FCF basis with maintenance CapEx as the true proxy for capital expenditures needed to maintain the business' competitive advantage going forward. Currently, I estimate growth CapEx comprises ~50-60% of total CapEx for 2013 due to the large spending in subscriber acquisitions in Latin America (~44% of total CapEx). DTV's CFO has stated in the latest investor day that ~80% of DTV L.A.'s CapEx is growth-related. However, I also acknowledge the fact that some CapEx related to subscriber acquisitions should be considered maintenance CapEx as there is regular churn in the subscriber base and DTV needs to constantly add gross subscribers simply to offset these losses. Since scale is an overwhelming competitive factor in the Pay-TV business, maintaining a strong, stable subscriber base is key to having a sustainable competitive advantage. For the sake of conservatism, I have assumed that 70% of total CapEx is maintenance CapEx for my FCF calculation despite the fact that current CapEx is elevated and disconnected set-top boxes and satellite dishes can be recovered.[7]

    Merger with Dish?

    Although a rather low probability, there is also available the free option of a merger with DISH which would be massively accretive to earnings due to the realizable synergies simply from cost savings. I have not incorporated the upside of this scenario in my valuation as I believe regulatory hurdles will remain substantial. However, longer-term if satellite and cable video quality converges along with a wider adoption of online video, the more likely it is that regulators would approve a merger between DISH and DTV. The main justification for a merger would be the emergence of an additional competitive wireless broadband offering which would leverage DISH's terrestrial spectrum rights to compete against the incumbent cable and telecoms offerings. The increased scale would also help constrain programming price hikes that are currently being passed on to the consumer.

    Management Assessment:

    Management appears to be quite shareholder friendly given their track record of repurchasing shares largely at accretive valuations. The CEO is honest in recognizing the current competitive pressures and external threats the industry is facing in the US. Despite a challenging environment, I believe the management team have done a terrific job operationally controlling costs and churn in a competitive US market by focusing their strategy on customer loyalty and retention while rapidly growing the Latin America business sustainably by executing on distribution and marketing. -Compensation: longer-term compensation is primarily based on achieving realistic yet challenging targets in net revenue, operating cash flow, and EPS growth

    -Track Record: DTV generates high returns on capital and has averaged 20%+ ROIC over the past 2 years which has been among the highest in the industry

    Why are shares Mispriced?

    Partly because of the bear arguments outlined above, but I believe the company is trading on a depressed multiple because it has elected to buy back shares over paying a sustainable dividend which does not attract yield-oriented investors. DTV also doesn't have a natural shareholder base that are either value or growth because of the two separately growing businesses - a mature, free cash flow generative US business and a fast-growing Latin America business. For catalyst-oriented investors, an initiation of a dividend or spin-off of the Latin America business can unlock substantial shareholder value. However, I see both options as unlikely for the time being given management's clear preference for share buybacks and the expected loss of some synergies that the two operating segments currently share if a spin-off were to occur.

    Another way to look at valuation is to look at a break-up value of the entire business. If you assign a ~12x EBITDA multiple to the Latin America business which I believe is reasonable given the DTV's superior competitive position and long runway for growth as highlighted above, you're only paying 4x EBITDA for the US business, which is quite attractive. I believe this valuation is unwarranted even under draconian scenarios, and the downside risk here is largely priced into the market.

     

    2013

    2014

    2015

    P/FCF

    13.8x

    10.9x

    8.8x

    FCF Yield

    7.25%

    9.17%

    11.38%

    Additional Risks to Thesis:

    -mostly comes from a higher rate environment as DTV has levered up its balance sheet to a 2.5x leverage ratio; however, virtually 100% of DTV's debt is fixed and more than two-thirds of the company's senior notes mature after 2018

    -a more competitive environment in L.A.; Dish may look to enter into other lucrative LA markets such as Brazil with a low-priced entry level product

    Disclosure: The author of this write-up owns shares in the company mentioned and may purchase or sell shares without notice. This write-up represents only the author's personal opinions and is not a recommendation to buy or sell a security. No information presented in the write-up is designed to be timely and accurate and should be used only for informational purposes. Readers of the write-up should perform their own due diligence before making investment decisions.

    APPENDIX:

    Consolidated Company DCF Valuation: Base Case scenario and 2018 as exit year

    In my financial projections, I differ from the Street mainly in attributing a lower value to the US segment and a higher value on the LA segment. Key business drivers are ARPU, Churn, Net Subscriber Growth, and Programming Costs.

    Sum-of-Parts Valuation: (TEV estimates and multiples based on separate DCF analyses for DTV US and DTV Latin America Segments)

    (click to enlarge)

    Management Track Record:

    I believe operational track record is important in assessing management's capabilities. Below is CEO Michael White's track record during his tenure as President of Pepsi International:

    (click to enlarge)

    U.S. Pay-TV Industry Data:

    Top 10 Pay-TV Providers in the U.S.
     YE2012 Subscribers (in thousands)
    Comcast

    21,995

    DIRECTV

    20,084

    DISH

    14,056

    Time Warner Cable

    12,218

    Verizon FiOS

    4,726

    AT&T U-verse

    4,536

    Cox

    4,412

    Charter

    3,989

    Cablevision

    3,197

    Brighthouse

    2,020

    DTV Latin America Market Data (excluding Mexico):

    DTV Latin America Market Data YE2012 
    CountrySubscribersMarket ShareCountry Pay-TV Penetration
    Brazil

    5,037,523

    31.10%

    27.00%

    Argentina

    2,000,000

    24.10%

    67.40%

    Venezuela

    1,566,000

    46.10%

    47.10%

    Columbia

    683,178

    15.80%

    33.80%

    Others

    400,000

    20.00%

    25.00%

    Chile

    284,687

    13.20%

    40.40%

    Puerto Rico

    240,000

    34.80%

    51.40%

    Ecuador

    101,540

    20.30%

    14.50%

    Total Subscribers

    10,312,928

    27.70%

    34.10%


    [1] Includes DTV's share of Sky Mexico Subscribers

    [2]ARPU: Monthly Average Revenue Per Unit

    [3] Churn: Subscriber disconnections, usually measured on a monthly basis

    [4] Gross Debt/EBITDA

    [5] Over-the-top is defined as broadband delivery of video and audio without a multiple system operator being involved in the control or distribution of the content itself

    [6] The traditional Pay TV model is based on content creators selling rights to cable networks who in turn aggregate the content into channels and then charge an affiliate fee per subscriber to a multichannel video programming distributor (MVPD) such as cable television systems, direct-broadcast satellite providers, and wireline video providers

    [7] Set-Top boxes should also become less hardware intensive longer-term, thus helping reduce capital intensity

    Disclosure: I am long DTV.

    Additional disclosure: Disclosure: The author of this write-up owns shares in the company mentioned DTV and may purchase or sell shares without notice. This write-up represents only the author’s personal opinions and is not a recommendation to buy or sell a security. No information presented in the write-up is designed to be timely and accurate and should be used only for informational purposes. Readers of the write-up should perform their own due diligence before making investment decisions.

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