Description

Thesis

DIRECTV (DTV) sells pay television subscriptions delivered via satellite to end consumers.  The company has a steady and relatively mature business in the United States and an extremely well-positioned and rapidly growing business in Latin America.  Both businesses have very good returns on capital: 2011 aggregate pretax ROTIC was over 50%. Management is very strong operationally and is pursuing an aggressive capital return program, upping leverage to a steady 2.5x EBITDA and repurchasing shares with all excess cash.  Share count has shrunk by roughly 12% per year for the past few years.  Management is on the record as stating they think the stock is very cheap.

Current stock price is $48.69/share and I think the company is worth over $70/share in 2014.  I look at the valuation a few different ways:

EPS basis - The U.S. Business should grow modestly this year and next and then be flat or decrease slowly from there.  The Latin America business should have very strong growth for the next 5+ years.  I believe that DTV will earn mid $6/share in 2014 and that earnings will grow from there.  Moving forward from 2014, decreases in EBIT from the U.S. business should be more than offset by increases in EBIT in Latin America.

SOTP basis - At a 6x EBIT multiple on U.S in 2014 ($4.2b x 6 = $25b) + $2.3b for other pieces (3 regional sports networks = $600m, Sky Mexico piece = $2.1b, Game Show Network = $400m, less Corporate OH = $800m) + $6.9b cash build, you are paying $10.8b for Latin America at that point, which I estimate will be earning $2.8b EBITDA and $1.5b EBIT then.  Management has indicated that in 2016, its goals for Latin America are $10b+ revenue and $3b+ EBITDA.  I think it could be closer to $4b EBITDA.  EBIT at that point should be roughly 67% of EBITDA.  Valuing Latin America at 9x EBITDA in 2014 (or 16x EBIT) = $25b = $71/share stock price.  Valuing the Latin American piece is a bit of an art as the business is growing very quickly and has a long runway.  This valuation does not add in benefit of share repurchases between now and then at prices below this value, which could provide significant juice.

I think that the market is worried about competitive threats to the U.S. business but that a decline in this businses will be relatively slow and that it will be swamped by Latin American growth.  

Business Description

DTV sells pay television subscriptions to consumers that it delivers via a satellite network.  The company has two main segments: the United States (2011: 20m subscribers, $22b revenue, $5.3b EBITDA, $3.7b EBIT) and Latin America (2011: 8m subscribers, $5.1b revenue, $1.7b EBITDA, $0.9b EBIT).  The Latin American segment is comprised of 3 subgroups: Mexico (Sky Mexico, 41% owned, partner Televisa, accounted for under equity method), Brazil (93% owned, partner Globo), and Panamericana (100% owned, covers rest of Spanish speaking Latin America: big 3 countries are Argentina, Colombia, Venezuela).  In addition, the company has a few other pieces: 3 regional sports networks (Seattle, Denver, and Pittsburgh), the Game Show Network, and Corporate OH.

United States

In the United States, there are roughly 97m pay television homes.   Cable has 55m homes, Satellite has 34m homes, and Telecom (AT&T and Verizon fiber) have 8m homes.  The satellite market has two players: DirecTV 20m subs, Dish 14m subs.  Historically, DTV has focused more on the higher end and Dish has focused on the lower end.

Satellite, and specifically DTV, have been gaining share over the past 5 years at the expense of cable.  For instance, since 2007, DTV subs have grown from 16.8m to 19.9m, or 18% while Comcast video customers have shrunk from 24.1m to 22.3m, or -8%).  DTV’s subscriber numbers, ARPU, and EBIT growth have been very strong over that period.  I believe this is a result of DTV offering a high-quality video package and executing extremely well.  DTV focuses on the high-end customer, as shown by its $93 ARPU.  They state that 36% of their customers account for 64% of their profit.

Management guidance for U.S. is for mid-single digit revenue and EBITDA growth in 2012 & 2013.  The outlook has weakened slightly in the past year as programming expenses have been higher than already high expectations, and I think that results will likely be below these targets  The driver is that the large media companies keep demanding higher fees for their existing cable channels and added carriage of more channels.  Regional sports channels are a big factor here.  Historically, the cable channel owners have had a large amount of leverage due to their ability to bundle channels and the presence of multiple competing pay television distributors in each market.

Management is pursuing a few incremental business lines that will help manage margin pressure in the core consumer business.  These are local advertising, commercial customers, and video-on demand.  They believe there are several hundred million dollars of opportunity in each of these areas.

The big picture risk in the U.S. business is that the cable companies are competitively advantaged to satellite television providers because of their ownership of the broadband internet pipe.

I am comfortable with this risk for the following reasons:

1) This has been true for the past 5 years and during that period DirecTV has been outperforming cable by quite a bit.  I think this is due to a combination of a compelling content offering and user experience, good price, and availability in many parts of the country where cable & telecom offerings are relatively weak.

2) DirecTV has very high customer satisfaction ratings.  I think people really like the video service they get from DirecTV and will be reluctant to switch.  They are much more likely to just add high-speed internet to their existing DirecTV package.

3) I think that DirecTV will continue to maintain an advantage in offering high-quality sports programming.  The company is in the early stages of offering ultra-high-definition television, which should roll out in the next 5-10 years.  Satellite has a structural advantage to cable in offering that kind of service, as it is very good at broadcasting high volume, high-definition content.

Latin America

DTV has an extremely strong hand with its Latin America segment.  This business is conceptually similar to that of the United States, only the competitive position is much better for a number of reasons.

1)       Coverage - Satellite has almost 100% geographic coverage with uniform high quality.  Cable networks in Latin America are not nearly as widespread as those of the United States and are generally in much worse shape.

2)       Timing of launch - In the United States, cable launched in the early 1970’s and satellite had a 15 year delay.  In Latin America, both were launched at the same time in the mid-1990’s.  As a result of this, and combined with the first point, DTV has much larger relative market share.

3)       Scale player - DTV covers the continent and is by far the largest pay television provider in the market.  In each individual market, DTV competes with a larger cable player.  However, DTV aggregates scale across 9 different countries, plus its U.S. bsuiness  This gives it a number of advantages with regards to technology development and content development.  This scale benefit is growing over time.

4)       Programming – Content owners have a much weaker hand in Latin America and thus programming costs are lower.

5)       Penetration – Pay television penetration in Latin America is still very low and their is a clear runway of growth for at least another decade.

In 2011, Latin America subscribers grew 36%, revenue grew 42%, and EBITDA grew 43%.  At the 3/29/12 Latin American business Investor Day, management put forth a “5 year vision” that had subscribers, revenue, and EBITDA doubling for the business, and I think this is probably a low bar.  The middle class in Latin America is exploding, and DirecTV is tapping into this with a very well positioned product.  There is an excellent presentation from the recent Latin America Investor Day that covers each market in detail.

Notes

• Businesses will remain together - There is no plan to split the U.S. and Latin American businesses as there are large synergies to keeping the operations together.  In addition, there is a good deal of sharing that goes on between the two businesses.
• Wireless broadband - Management is launching a wireless broadband pilot in Brazil.  This is a modular type investment that involves buying spectrum and doing buildout market-by-market.  Through 2014, they expect to invest $150m, and the business will do $150m revenue and 45-50% EBITDA margins at scale.  Expected IRR’s are mid-20% range.  In addition, they believe there will be large benefits to the core television business via reduced churn.
• Note that EPS estimates provided by street are based off average sharecount.  Using year-end sharecount, which I think one should do, provides a nice boost.
• Management communications are very good and there are numerous presentations and conference calls where they review operation and strategy in depth.

Catalyst