DIRECTV Group DTV
December 03, 2007 - 11:34am EST by
jriz1021
2007 2008
Price: 24.87 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 28,979 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

 
SUMMARY
 
DIRECTV Group, Inc. (“DTV”) is a familiar, yet fundamentally misunderstood company, with attractive near-term catalysts as well as longer-term opportunities and cash flow characteristics that are not being properly recognized by market participants. 
 
On a status quo basis, based on a DCF analysis, I estimate the stock should be worth at least $30 per share as the company exits the “growth” phase of the high-definition (“HD”) television upgrade cycle, and begins to lower its capital expenditures, while generating much stronger average revenue per user (“ARPU”) growth.  As discussed below, at this point in the HD upgrade cycle, I do not view the competitive threat from cable and its so-called “triple-threat” of broadband internet, video content, and telephony to be a serious threat to DTV.  In addition, management recognizes that the company is obviously underleveraged.  The company may increase its net leverage from approximately 0.5x today to 3.0x EBITDA, using the incremental funds to repurchase shares or pay a large dividend to shareholders.  For illustrative purposes, if the company levered up and used the incremental funds to tender for shares at $28, the company would be worth approximately $37.00 per share on a pro forma basis.  Management appears to agree that its shares are undervalued, both through their commentary, and through their actions.  During the last three quarters, the company repurchased approximately $1.5 billion of shares at an average price of $23 per share. 
 
In lieu of an in-depth discussion of well-known industry dynamics with which the reader is likely already familiar, below I discuss what I consider to be the primary concerns in the investment community that will be important to understand before DTV ultimately trades to what I believe is its true fair value.  
 
CONSENSUS COMPARABLE COMPANY VALUATION
 
Consensus Comparable Company Valuation
Share Enterprise Value/
Price EBITDA EBITDA-CapEx P/E
12/3/2007 2007E 2008E 2007E 2008E 2007E 2008E
Cable
Comcast Corp. 20.90 7.93x 7.05x 16.17x 12.61x 27.83x 21.75x
Time Warner Cable Inc. 26.66 7.30x 6.44x 18.07x 13.51x 24.37x 18.95x
Virgin Media Inc. 18.98 6.99x 6.63x 13.07x 12.18x NM NM
Cablevision Systems Corp. 27.08 9.55x 8.65x 15.60x 12.85x 136.08x 48.01x
Charter Communications Inc. 1.30 9.76x 8.72x 22.55x 17.74x NM NM
Average         8.31x   7.50x   15.73x (1) 12.78x   26.10x (2) 20.35x (2)
Telecom
Verizon Communications Inc. 43.15 6.30x 6.67x 15.66x 13.36x 18.18x 15.88x
AT&T Inc. 38.50 5.85x 6.04x 11.05x 9.78x 13.87x 12.17x
Average         6.08x   6.35x   13.36x   11.57x   16.02x   14.02x  
Satellite
EchoStar Communications Corp. 42.67 7.66x 6.70x 15.76x 11.90x 24.48x 18.13x
DIRECTV Group, Inc. 24.87 7.61x 6.52x 18.41x 12.18x 20.83x 17.33x
Average         7.63x   6.61x   17.09x   12.04x   22.65x   17.73x  
(1) Average excludes Charter.
(2) Average excludes Virgin Media, Cablevision, and Charter.  

INVESTMENT CONSIDERATIONS
 
Positives
  • Strong brand name, margins and growing free cash flow
  • Underleveraged balance sheet creates a near/medium-term catalyst
  • Strength of HD channel line-up relative to other providers should provide incremental profitability over the next several quarters, as DTV attracts affluent customers (mitigating domestic economic concerns) who already have HD televisions
  • Digital Broadcast Satellite (“DBS” providers are increasing their market share of video subscribers (relative to cable)
  • Cheaper multiples than cable
  • Extremely low churn rates (2 year agreements; very high customer service level)
  • Remote potential of a merger between DTV/DISH, which would be massively accretive
  • Announced cost sharing between DTV/DISH could lower expenses going forward
  • Unloved space, though sentiment appears to be shifting
  • Launched DTV 10 (June 2007) and launching DTV 11 (First half 2008), increasing HD channel capacity to 100 by 2007, and 150 by 2008 – most cable companies are in the 20-25 range
  • Cable appears to be “upselling” to current customers with its triple-play package, not taking away video subscribers from DTV
  • Over the past three quarters, management has repurchased over $1.5 billion of stock for approximately $23 per share
  • Exposed to the growing Latin American market, with a potential for further growth into other foreign markets
  • The potential for significant cable customer churn upon the anniversary of current triple-play bundle agreements, when prices reset to higher rates
Concerns
  • Long-term dynamics vis a vis cable, and particularly, fiber (FIOS, U-verse) may prove challenging
  • Potential for AT&T to terminate its distribution agreement with DTV (representing approximately 8% of gross additions – however, these lost additions are likely to be made up through alternative channels)
  • Although the company has exposure to a growing foreign market, the majority of its cash flow comes from U.S. operations, which may be sensitive to any domestic economic slowdown despite high-end focus
  • A leveraged share buy-back could push Malone over 50% ownership.  DTV’s bylaws state that when an entity owns greater than 50% of its stock, it must make a tender for all of the company’s shares (no required premium is specified).  However, the company could instead pay a large dividend. 
  • In the event that Malone tenders for the remaining DTV shares he does not own, he could offer some combination of cash and Liberty’s soon-to-be-issued tracking stock (which will house Liberty’s DTV shares), potentially minimizing any control premium (see below for a more detailed discussion)
COMPETITIVE THREATS
 
Cable – Triple Play, On Demand, HD
 
The biggest concern among investors relating to DTV is the threat posed by cable providers and their vaunted “triple-threat” of broadband internet, video content, and telephony.  I flatly believe these concerns are not only misguided, but also, unsubstantiated.  Notably, despite all of the challenges discussed here, both DTV and DISH increased their market share of video subscribers over the past several quarters. 
 
The argument for cable and against digital broadcast satellite companies (“DBS”) goes something like this:  because customers can receive internet/video/telephony all from one cable provider, they enjoy the convenience and “savings” (more on this later) of paying one bill to their cable provider.  The alternative is to deal with DTV for video content and, for example, Verizon, for internet/telephony services.  The argument continues: cable providers can offer some sort of discount for this bundle of services, at a minimum creating pricing pressure in the marketplace and, at worst, taking subscribers away from DTV. 
 
I find this argument specious for a few different reasons.  First, it is questionable as to whether one actually receives a real bundle discount by signing up for a cable’s triple-play service package.  When a customer compares the initial pricing of DTV plus internet/telephony to a cable’s triple-play bundle, cable may seem like a compelling deal.  However, many of these cable contracts provide for price increases after 6-12 months, and customers end up paying materially more over time.  For example, after Cablevision’s one-year triple-play anniversary, prices increased from $117 to $143.  In fact, because triple-play bundles will reset their rates in the coming next few quarters, there may be a huge opportunity for DTV to capitalize on any spike in churn from cable subscribers.  Second, there is a big difference between cable companies upselling to their current customers and actually taking subscribers away from DTV.  In other words, what is good for Comcast may not be bad for DTV (recall DTV/DISH market share gains).  Furthermore, I believe that internet and telephony are both commodity services, whereas video content is actually a differentiable, value-added service.  For example, a customer that signed up for DTV’s NFL Sunday Ticket (exclusive through 2010) is unlikely to switch to cable.  Third, even assuming a triple-play bundle is cheaper than a DTV/telecom combination, a DTV customer would be hesitant to switch away from DTV’s award winning customer service.  DTV has consistently achieved higher customer satisfaction ratings than either DISH or cable providers. 
 
Another area of investor concern relates to cable and its On Demand product offering.  For technical reasons, this product cannot be easily replicated by DTV or DISH.  However, these concerns must be weighed against the substantial technical advantage that DTV has over cable providers in offering HD channels.  With On Demand, a cable customer can view a variety of programs including movies and television shows that aired in the past, commercial-free, and at no additional charge.  DTV and DISH cannot match cable’s On Demand service due to the attendant “two-way” transmissions required between a cable customer and the cable company’s On Demand server.  DTV seeks to mitigate this weakness by offering On Demand services that are delivered through a customer’s broadband internet connection; the programs may then be downloaded and watched on the customer’s television.  Admittedly, this is a cumbersome solution, but technological differences between cable and DBS providers cut both ways.
 
Cable, as a distribution method provides less bandwidth capacity when compared to DBS providers.  This is a serious consideration because HD content takes up substantially more bandwidth than standard definition programming.  To increase HD capacity, DBS providers can simply launch another satellite at a cost in the several hundred million dollar range; cable companies can choose either to tweak their existing technology – which they are attempting to do, with mixed results – or spend BILLIONS of dollars laying new cable, and probably face significant regulatory and municipality hurdles related to the prospect of intrusively laying more cable in targeted communities.  In fact, DTV recently launched a satellite (with another to be launched in 2008) that will increase its HD capacity to 100 channels by the end of 2007, and to 150 channels by the end of 2008 – significantly beyond the capabilities of any cable provider, and more than DISH is currently able to offer – an important first mover advantage.  Those numbers may come as a surprise to any fellow cable customer (full disclosure: Time Warner Cable is my provider as my apartment complex does not allow satellite dishes to be affixed to my building), as my HD television often finds itself stretching, distorting, and otherwise maiming the substantial amount standard definition content that’s piped into my apartment, as there simply aren’t that many HD stations available via cable. 
 
Fiber Optic Technology – Verizon (FIOS) and AT&T (U-verse)
 
Besides cable, another potential competitive threat facing DTV is the fiber optic technology employed by Verizon (FIOS) and AT&T (U-verse).  The advantage of fiber technology is that it can act as a triple-play bundle, has higher capacity and higher speeds than cable, and thus should present a compelling value proposition to customers.  Verizon and AT&T rolled out their services in only a few markets, with what appears to be some success, but it is too early to quantify the effect these entrants will have on DBS and cable participants.  That said, I still believe that content, customer service, and overall value will be king, and DTV remains well-positioned with respect to those metrics.  By at least one measure, DTV is better-positioned than cable providers.  Many of DTV’s customers are in low population density areas (approximately 40%) that are unlikely to be targeted by VZ or AT&T, whereas cable companies will compete head-to-head with fiber in nearly all of their major markets. 
 
At present, DBS providers add a material number of subscribers through distribution agreements with telcos like Verizon and AT&T.  There is concern that if Verizon and AT&T market video services directly to customers, there will be an erosion in DBS gross additions.  But these distribution agreements aren’t free, and it is likely that DTV will spend its advertising dollars on other avenues that will allow the company to continue to grow.  In the past, DTV successfully weathered changes in its distribution channel, such as when it lost an exclusivity agreement with RadioShack several years ago. 
 
One interesting data point, which suggests that DBS will continue to be an important part of the competitive landscape, is the recent market rumor speculating that AT&T may bid for DISH, despite AT&T’s U-verse roll-out.  A discussion of why AT&T might be more interested in DISH than DTV is outside the scope of this analysis, but pursuant to the distribution agreement between AT&T and DISH, their bundled packages operate in a more integrated fashion than do those of AT&T and DTV.  Allegedly the negotiations between AT&T and DISH contemplate a valuation range of between $55-$65 per DISH share.  Applying these implied multiples to DTV’s metrics yields a share price of between $32-$37, and that’s before one contemplates any value enhancing, leveraging event at DTV.   
 
LIBERTY MEDIA SWAP DISCUSSION
 
Pursuant to an asset swap with News Corp. announced Q4 2006, and expected to close Q4 2007, Liberty Media, headed by John Malone, will swap his investment stake in News Corp. for a 38.5% stake in DTV, plus other assets.  On a related note, Liberty recently announced that it will create a tracking stock to house its DTV stock.  Based upon the companies’ respective share prices just prior to the announcement of the asset swap deal, Malone swapped into DTV at $21.61 per share, assuming a $500 million value for the sports networks swapped.  While this share price is substantially below what I believe to be the true value of DTV, I think it’s important to consider the dynamics of the negotiations between News Corp. and Liberty.  It was widely reported that Murdoch was desperate to close a deal in an effort to cut Mr. Malone’s influence at News Corp.  In addition, at the time of the deal, there were more concerns vis a vis cable and the triple-play threat that DTV has subsequently allayed over the past few quarters of earnings results. 
 
Price
Shares 12/21/2006 Value
Murdoch Offers:
DTV 470 $25.00 11,750.0
Cash 550.0
Sports Networks (Analyst Estimate) 500.0
12,800.0
Malone Offers:
NWS 188 $22.40 4,211.2
NWS.A 325 21.53 6,997.3
Total 11,208.5
"Extra" Value Given to Malone 1,591.6
Per Contributed DTV Share $3.39
Then Current DTV Share Price $25.00
"Extra" Value Given to Malone Per Share 3.39
Implied DTV Valuation   $21.61
Mr. Malone is a very aggressive investor, and he is comfortable leveraging his assets.  This, in concert with management’s aforementioned acknowledgement that DTV is underleveraged, provides support for the argument that DTV will likely add incremental debt to its capital structure in order to enhance returns on equity.  I estimate that the company can comfortably support between 2.5x and 3.5x turns of leverage up from its current position of approximately 0.5x leverage.  This would represent approximately $9-$13 billion of net leverage, with the incremental net proceeds used to repurchase as much as 29%-43% of the float at a $26 tender price, or pay a dividend of over $9 per share. 
 
Based on my discussions with DTV management, using this amount of leverage to enhance shareholder returns should be manageable as it will likely allow DTV to maintain its current investment grade debt rating and would still leave some “dry powder” in case DTV needs incremental capital for other market opportunities (perhaps expanding internationally beyond Latin America).  Despite the current state of the credit markets, it is clear that investment-grade rated companies can successfully issue debt. 
 
The company’s bylaws provide that if a shareholder holds 50% or more of DTV’s outstanding shares, that shareholder is obligated to make an offer for the entire company at a price not less than the current market price of the company (note that there is no required premium specified).  As discussed earlier, Liberty Media is creating a new tracking stock in order to house its 38.5% DTV stake, as well as other entertainment assets.  DTV will comprise over 80% of the value of this tracking stock.  If Malone seeks to consolidate DTV into this new entity by increasing his ownership in DTV to 50%, he will need to make a tender for the remaining shares in DTV, possibly through offering some combination of cash and the new tracking stock. 
 
Although this seems like a complex transaction, Malone performed a similar transaction with UnitedGlobalCom (“UGC”) in 2005.  A Liberty entity owned 53% of UGC’s shares prior to the deal.  In this transaction, Malone offered UGC shareholders $9.58 per share in cash (as compared to a share price of $9.64), subject to measures ensuring the amount of cash paid did not exceed 20% of the total consideration, with the remainder of the consideration offered through Liberty tracking stock shares.  Because of the mix of cash and stock consideration offered, and required pro-ration, the transaction ultimately valued UGC shares at $9.42, a slight discount to the then current market price of UGC, at $9.64.  I encourage prospective investors to read easily-accessed news articles regarding the UGC transaction.  While it’s impossible to tell exactly what consideration Malone might offer DTV shareholders in the event he tenders for the company, it’s not hard to see why he might want control of the company.  If Malone controls over 50% of DTV’s shares, he can control its operations directly, have access to its cash, and attempt to leverage other Liberty assets off of the DTV platform.
 
ASSUMPTIONS/VALUATION
 
In analyzing DTV from a valuation perspective, I first analyzed the market consensus, and then identified areas where I think the market is either too conservative, or misinformed. 
 
I believe the street is underestimating the potential of the company to raise prices in connection with the HD upgrade cycle.  Consensus estimates call for between 3-3.5% growth in ARPU for the next several years.  Although difficult to quantify, I think it likely that DTV will be able to exceed these estimates over the next few years, at a minimum. 
 
Another area where I believe the market has it wrong is with respect to future capital expenditures.  The sell-side consensus forecasts approximately $2.2 billion of annual capital expenditures over the next three years.  However, I believe this is a case of the market using recent results as a run-rate, when the true level of capital expenditures going forward should be much lower.  While DTV has invested heavily in the HD upgrade cycle, by mid-2008 I anticipate that capital expenditures will begin to decrease significantly.  For example, the company’s HD-DVR, which cost approximately $450 per box in 2006, may come down significantly, to the $200 range over the next 12-18 months.  I conservatively estimate that capital expenditures can be decreased to the $1.7 billion range by 2009 – and I think they could be far lower. 
 
As a result of these assumptions, and excluding DTV’s fast growing Latin American business, I believe the company can generate unlevered free cash flow growth in excess of 20-30% over the next 4-5 years.  I value the U.S. and Latin American businesses separately, using a 10% and 14% discount rate, respectively, with a 7x EBITDA Exit Multiple for DTV U.S. (which implies a 3.6% Gordon Growth Rate), and an 8x EBITDA Exit Multiple for DTV LA.  I believe these multiples properly reflect the cash flow characteristics of DTV’s mature U.S. business, which should be able to cut its capital expenditures, and the strong growth prospects of DTV LA.  Using these metrics, I arrive at my DCF value of $30.  Again, this excludes the value from any leveraging the company does in the next few years.  In my discussions with various sell-side analysts, none of them put any probability or valuation on a leveraging scenario in their formal price targets, providing further upside for investors.  
 
Summary Valuation
DTV US DTV LA Total % of Total
Discounted Cash Flow 5,491.0 1,050.9 6,541.9 17.8%
PV of TV of DCF 25,761.9 3,599.1 29,361.0 79.8%
Discounted Interest Tax Shield 341.6 0.0 341.6 0.9%
PV of TV of ITS 1,018.4 0.0 1,018.4 2.8%
Corporate Overhead 80.0 (480.0) (480.0)
Total Enterprise Value 32,612.9 36,782.9
Debt 3,400.0
Cash 1,390.2
Net Debt 2,009.8
Total Equity Value 34,773.1
Shares Outstanding 1,157.9
Estimated Share Price         $30.03
Current Share Price $24.87
% Increase 20.8%
Leveraged Buy-Back Scenario
DTV US DTV LA Total % of Total
Discounted Cash Flow 5,491.0 1,050.9 6,541.9 17.8%
PV of TV of DCF 25,761.9 3,599.1 29,361.0 79.8%
Discounted Interest Tax Shield 3,996.1 0.0 3,996.1 10.9%
PV of TV of ITS 0.0 0.0 0.0 0.0%
Corporate Overhead 80.0 (480.0) (480.0)
Total Enterprise Value 35,249.0 39,419.0
Debt 9,990.2
Cash 0.0
Net Debt 9,990.2
Total Equity Value 29,428.8
Shares Outstanding 801.1
Estimated Share Price         $36.74
Current Share Price $24.87
% Increase 47.7%
Leverage Buy-Back Summary
Assumed EBITDA 4,000.0 Incremental Debt Raised 9,990.2
Assumed Net Leverage 3.0x Interest Tax Shield 40.0% 3,996.1
Assumed Debt 12,000.0 Assumed Interest Rate 9.0%
Current Net Debt 2,009.8
Incremental Debt Raised 9,990.2
Assumed Tender Price $28.00
Shares Repurchased 356.8
Current Shares Outstanding 1,157.9
PF Shares Outstanding 801.1
 

Catalyst

1) Company fundamentally undervalued/misunderstood competitive dynamics 2) Company likely to lever up and pay a dividend/repurchase shares
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