Analyst: Plenty of Upside Availble in DirecTV Thesis

By: SumZero Staff | Published: January 02, 2014 | Be the First to Comment

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DirecTV

DirecTV's current valuation at 6.5x EV/EBITDA and 10x forward P/E is too pessimistic considering the potential of a US Cable M&A/consolidation trend, DTV's core advantages, aggressive buybacks and continued growth in Latin America/US. There is also a valuation gap to US cable peers which I think should correct. DTV has acceptable downside at current levels and 10-35% upside considering conservative buyback scenarios and normal EBITDA growth rates. While many skeptics have long predicted the demise of the satellite TV players due to the lack of a competitive bundle and Internet-TV proliferation, DirecTV has been proven remarkably resilient.

Valuation:
Current valuation seems reasonably attractive. 6.5% 2014 FCF yield not bad for a stable business with 5-7% organic EBITDA growth and potential upside for cable M&A/consolidation, continued buybacks and pay-TV penetration growth in Latin America. On an EV/EBITDA basis, it's trading at 6.5x compared to 6.88x past 7-year average and 7.7x peers average (ex-SIRI). Down case scenario looks bad but seems temporary rather than permanent. Management will keep doing aggressive buybacks and the stock hasn't ever traded below 6x except for the brief period during Sept 2008-June 2009 financial crisis.

(+) Stability of revenues and margins: Top line growth and margins have both been relatively stable over the past 8 years. Even in 2008 and 2009 the company grew consolidated revenues at 14.2% and 9.5% respectively. DTV grew revenues every single year, at rates between 16-7%. EBITDA margins have fluctuated between 22.2 and 25.7% since 2006. This is reflected in DTV's A-2 S&P investment grade credit rating. Pay TV is a stable and predictable business -"…once a subscription video service has achieved profitability and scale in a market (20-30% of households), it is very likely to be able to sustain that profit stream for many decades". NFLX Investor Relations Letter, April 25, 2013-. Over 80% of subscribers return each year and programming costs are pre-determined for years forward.

(+) Margins/FCF generation: DTV has a FCF/Revenues average ratio of 46% in comparison to CMCSA's 12%, DISH's 15% and TWC's 10%. Economics of this business are compelling, considering that once the satellites are in place and subscribers signed up, continuing capital expenditures are not significant and profit margins are high.

(+) Management capital allocation track record: Management has consistently returned capital to owners through buybacks (retired +50% outstanding shares since 2006) and made high-returns investments in Latin America, delivering consistent ARPU (average revenue per user) and organic top line growth.

(+) ROIC: DTV has generated average return on capital of 19% in the past 8 years. Economic return is well in excess of DTV's cost of capital.

(+)Organic Growth/longevity of return: Since the 2003, revenue has grown organically at 7-16%/year and EBITDA at a 5Y CAGR of 9%.

(+) Dominant Market share: Largest pay-TV Company in the world with the highest ARPU. DirecTV has exclusive content, extensive HD programming offers, industry-leading customer service and cutting-edge technology (Genie, access to rural areas and interactive features). The company is in a good position to negotiate content deals and offer promotions.

(-) Mature, low growth US market: US pay-TV market is mature (~90% penetration) and highly competitive, with most competitors offering aggressive cash-back promotions and bundle offers. In addition, content costs are rising in average 8% vs. cable ~4% price increases and younger demographics are looking to get content through broadband-only or other means. DTV's US high-end market position has led to above-average subscriber metrics in terms of TV's per household, monthly ARPU and customer churn.

(+) Latin America Business: DTV expanded considerably in the past years, growing revenues at a 3Y CAGR of 29.46% and EBITDA at 38.02%. Long-term growth potential of DTV's Latam business is driven by two secular trends: a growing, young middle class population and a still under-penetrated pay-tv market. Latam also presents several other advantages: exclusive content is easier to access, higher margins and lower competition. Pay-tv penetration rose from less than a third of homes at end-2012 to nearly 45% by end-2013. According to Digital TV Research, by 2018 84% of Latin American homes will have pay-tv and new satellite installations will account for a large portion of that increase. While growth has been lower in 2013 (affected by overall FX volatility and a challenging Brazilian economy), I am optimistic on the long term opportunity. As management said at the last September 11, Merrill Lynch conference: "there is still a lot of juice in Latam."

Management:
(+) Management is very shareholder oriented: management's capital allocation is excellent, careful with acquisitions and focusing on substantial share buybacks. Solid track record of ARPU growth and execution.
(+) Management compensation: CEO received significant $800k stock options compensation that vest mostly in 2015 at strike price of $49. I think he is compensated to keep driving the stock higher.
(+) Smart owners: Berkshire Hathaway ($2.2b position, $47 avg. cost), Passport Capital ($976mm position, $61 avg. cost), Weitz ($51 avg. cost), SAC Capital ($47 avg. cost), Tiger, Soros, Gabelli, Harris Associates, all own stock.

Catalysts:
(+) Continued buybacks
(+) Merger/consolidation with DISH
(-) Latam experiences FX devaluations and macro contraction
(-) Maturing US pay TV market
(-) Rising content costs >8% per year

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