It has been a while since I have updated my thesis on DirecTV. The stock has had a good run since my write-up as the market has re-rated the shares to a more reasonable multiple. The Brooklyn Investor, a high-quality investing blog I follow also recently wrote-up DTV here for those of you who are interested. What caught my eye was the Brooklyn Investor’s point surrounding the cost of distributing content in the current Pay-TV ecosystem.
In all honesty, I had little to no clue how the Pay-TV ecosystem would look like 10 years into the future when I first bought my shares in DirecTV at $50. But did I really need to have a crystal ball to justify buying into a good business that earned returns on invested capital greater than 20%, had high incremental returns on capital and growth prospects in Latin America, was cannibalizing its own shares at good valuations, and was run by a fantastic management team? Oh yeah, it was also selling at around a 10x multiple! Maybe I didn’t know it back then, but perhaps the real reason I should have used to justify buying DirecTV was because of its long-term cost advantage.
Satellite is an attractive business because it’s actually relatively asset-light compared to Cable and Telco fiber. A mini-dish and set-top box for every home, several broadcast stations, call centers and a few strategically positioned satellites is all that is needed to run a ubiquitous satellite TV company. This, vs. a ton coaxial fiber or fiber optic needed for every home or business, that needs constant upgrading every several years in order to remain competitive, and you can see why cable and Telco fiber are much more capital-intensive businesses and why media moguls Rupert Murdoch, John Malone and Charlie Ergen were all bidding for Satellite orbital slots when they first came to auction. They all wanted to own a piece of the new death star which was Direct Broadcast Satellite. As an aside, one relative advantage cable has over telco fiber is that although DOCSIS technology continues to get upgraded for faster bandwidth speeds, the vast majority of the cable industry’s CapEx is front-loaded, so only the “last mile” to the home has to be upgraded, vs. Telcos who have to replace their entire copper-wire infrastructure. This is also why Liberty Global holds a competitive advantage over Telcos in Europe.
So back to DirecTV. Having a cost advantage is enormous in a scale-driven business. Direct Broadcast Satellite technology provides the means to efficiently broadcast several hundred HD channels, bargain for exclusive content such as the NFL Sunday Night Ticket and generate superior unit economics (IRR) relative to Cable/Telco; DirecTV’s subscriber churn is the lowest amongst US peers, its ARPU is the highest, and despite paying higher Subscriber Acquisition Costs (SAC) and programming costs per sub than its Cable and Telco peers, DTV ends up ahead because it has a less capital-intensive business model that delivers superior content to a stickier customer base. Looking back, this should have been the original rationale for buying DirecTV. And I believe Satellite TV’s cost advantage will remain even 10 years from now. Let me explain.
Nearly everyone is worried about internet-TV disrupting the Pay-TV ecosystem and everybody and their mother “cutting the cord”. I suspect when some of these major networks such as ABC, FOX and CBC start selling highly-rated channels directly to consumers, the economics would be questionable. Let’s not forget that the Cable networks will most likely have to charge more on a per-channel basis online in order to make up for their lost advertising revenues that they would otherwise receive in the current ecosystem. So I believe either online advertising rates will have to go up in order to justify a large-scale move into a direct-to-consumer model, or even a wholesale model to broadband providers, but either way, the Cable networks remain incentivized to maintain the current ecosystem and will not want to see their affiliate fees evaporate overnight.
Another phenomenon that I believe most industry pundits and analysts have failed to recognize is that the cable firms have basically been indirectly subsidizing the bandwidth costs of OTC players such as Netflix, Hulu, etc. If you take the view that we are going to fully transition towards an Internet-TV based world, then that would mean that currently Cable TV service revenues are subsidizing their broadband service, and broadband service in turn, I believe, is currently subsidizing online streaming services. Quite simply, broadband providers have yet to fully monetize their broadband service. A lot of people think that US broadband services are a rip off because of the speeds you get relative to the price you pay. But what about the other important component of a broadband connection – bandwidth capacity? As more and more video is consumed online, bandwidth demand is going to explode upward and I don’t think Comcast and company are going to idly sit back and let online streaming providers “free ride” the system. After all, Netflix’s largest operating costs after content are probably their server expenses. I would not be surprised at all if the Cable/Telcos eventually implement usage-based pricing for their broadband service in order to make up for the eventual lost cable TV revenues. Let’s not forget that Americans on average still watch a shit ton of television per day, around 4-5 hours on average I believe. Given the explosion in growth in smartphones and tablets, I think its safe to say that online video consumption will continue to grow rapidly, and someone, probably the OTC guys are going to have to eventually pay that price.
One last point I want to make regarding the Internet-TV threat: I believe the internet-TV industry will remain quite fragmented in terms of content type for some time, and it would be rather difficult for any one player to become dominant across all content categories, yes, even you, Netflix. This is partly due to the nature of the industry, but also because online rights will remain competitive. Online streaming services don’t have the luxury of scale to buy up every single content category like Satellite/Cable/Telcos do. This is not only due to a lack of scale but a tradition of content producers and distributors securing long-term, content deals. Netflix may be wise to strategically pursue exclusive original content series such as House of Cards to help differentiate their platform, but will they be able to expand into Live News, Sports, or even killer nature shows? I think not. Exclusive content comes at a high price, especially if they are online rights. To me Netflix looks like a cheaper version of HBO, and even Reed Hastings admits that HBO is Netflix’s largest long-term competitor. In fact the only reason not everyone can watch HBO online without a Pay-TV subscription is because Time Warner doesn’t want to piss off the the DBS/Cable/Telcos. Platforms such like HBO, Starz and Netflix tend to focus on theatricals and original series, so they won’t appeal to every type of customer, and especially those that want a very broad range of content.
Eventually everybody will have an online video streaming service, including DTV. In fact DirecTV is already starting to complement its existing satellite TV service with an online-video product. As more customers demand “TV-everywhere” and place-shifting television, TV distributors will focus on building their online product. That’s why I think DirecTV tried to buy Hulu earlier last year. And with DTV’s large existing customer base and strong relationships with content providers, they should have no problem scaling a solid online video service. Who knows how it would actually look like, but I wouldn’t be surprised if it was sports focused.
So to sum it all up:
1) Despite all these fears of the death of the Pay-TV industry, the market has basically misunderstood the DirecTV story for a while now, and using some second-level thinking, it’s safe to conclude that DTV’s business will not get fucked overnight.
2) Online streaming providers such as Netflix are basically selling their services at an artificially low price, but they can’t have their cake and eat it too. Eventually the economics of online streaming will not be as attractive.
3) The US Pay-TV industry is very slow to change, but even if the bundle breaks DTV can successfully transition to an Internet-TV world. Some of the best investment opportunities are created by uncertainty and taking a contrarian view. As long as one is able to price in the risks and come up with a range of possible future outcomes, one can make money.
4) DirecTV is led by CEO Michael White, who was hand picked by John Malone. This guy knows what he’s doing, and is a very savvy and disciplined capital allocator. Eventually they may spin-off the Latin American business when the time is right which would help unlock shareholder value.
5) If all else fails DTV’s backdoor play is to merge with DISH, and maybe even AT&T will buy them both eventually :). Although I’m not betting on it, it does provide some downside protection.
6) By the way, John Malone actually holds a lot DirecTV shares, and someone may want to confirm this, but last time I checked he owned ~3% of DirecTV’s total shares outstanding. Malone was former chairman of DirecTV, and he was basically forced to step down by the FCC as he had competing cable assets in Puerto Rico. Let’s also not forget that the Berkshire guys own the largest stake in the company, and oh yeah, they are pretty damn good investment managers.
7) I am an idiot for selling a bunch of shares when DTV was in the low 60’s. I didn’t maintain conviction when I should have. Sometimes that happens when you maintain a very overweight position (it was more than 30% of my portfolio at one point). Mistakes come with learning to become a better investor, and I have a long way to go. At least I put the money back into Liberty Interactive :).
For those of you who read sell-side research, I would recommend following Jason Bazinet @ Citigroup, Matthew Harrigan @ Wunderlich Securities and Craig Moffet. They seem to know what they’re talking about in the Cable and Satellite industry.
For now I am holding on to my shares, and have modelled out my IRR assumptions for DTV below. Click on the DirecTV icon below and you will see my income statement and key driver assumptions. A 12% IRR at a modest 14x multiple is nothing crazy, but will beat 99% of institutional investors out there, including hedge funds, mutual funds, pensions, and endowments.
My DirecTV Income Statement and Operating Model – You may have to zoom in:
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The author is this post owns shares in the company mentioned (DTV) and may purchase or sell shares without notice. This post represents only the author’s personal opinions and is not a recommendation to buy or sell a security. No information presented in the post is designed to be timely and accurate and should be used only for informational purposes. Readers of the post should perform their own due diligence before making investment decisions.