DirecTV Update & The Future of the Pay-TV Industry

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:
       DirecTV Model

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Disclosure:

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.

9 thoughts on “DirecTV Update & The Future of the Pay-TV Industry

  1. I am a avid reader of your blog. I also own DTV personally, same as you, I bought at mid to high $40s, and sold 3/4 of it at low to mid $60s. Kind of a mistake due to lack of conviction too.

    My actual question is have you got any thoughts on Sirius XM? Share price has gotten whacked for months and is now priced as if it left to die. And if I just use the current market’s consensus, revenue is still expected to grow at 8-9%, and since SIRI is also a scale-driven business, margin would expand too and give a tailwind to the bottomline. Unlike DTV which is a more or less close to maturity (excluding the LATAM business), SIRI is still likely at the mid-point of growth, or probably, slightly over midpoint (at least based on the company’s presentation which guides for 40% ebitda margin and 40m subscribers at maturity stage, compared to low 30% and 26m subs now).

    Based on market’s consensus, FY2015 revenue is expected at $4.5b, assuming ebitda margin at 35% and fcf conversion at 80% of ebitda, FCF could be close to $1.26b. Current share count is 6.2b and SIRI, like all other Malone’s related companies, is a huge repurchaser of its own stock, and assuming they repurchase total of $3b from 2014 to 2015 at say $3.3 per share, share count would be reduced from 6.2b to 5.3b. As a result, FCF for FY2015 could be almost $0.24 per share, which makes the forward multiple only 13x. Looks like a better deal than DTV as an alternate investment.

    • I find SIRI attractive but I think you may be able to get it even cheaper via LMCA. I haven’t crunched the numbers for a while but LMCA likely still trades at a 5% – 10% discount to NAV. If it’s still at a NAV discount then you get a situation where you potentially get the benefit of a double buyback (both at SIRI the operating entity and also at LMCA the holdco), as long as LMCA doesn’t sell into any future SIRI repurchases. I don’t think Maffei wants to sell any more SIRI given how much it’s dropped and the current valuation (high teen multiple over FCF for a solid double digit grower, still below leverage target).

      One issue with SIRI is that it’s currently over-earning. As you pointed out the FCF/EBITDA conversion is abnormally high since they are using their NOLs to shield income taxes. But again the NOL is huge relative to this business’s earnings so they should be able to run tax-free for a very long time.

      I can see a lot of parallels between SIRI today and DTV in 2006, except the case might be even stronger with SIRI given its secular growth tailwind and stronger competitive position. I think SIRI also still operates with untapped pricing power, some of which has been unlocked in the past two years but they should still be able to keep raising prices at a few hundred bps above inflation for a while.

      Another thing that slightly bothers me is that SIRI will be borrowing a ton of money for a pretty long period of time to fund at least a portion of the buybacks. An interest rate spike would be bad news.

      Richard what do ya think?

    • So a better way to value SIRI is to put a multiple on its theoretical after tax FCF, which will probably be something like $800 – $900 mil in 2015, then add the PV of the NOLs to it which is around $2 billion the last time I checked.

      If you look at it that way, the market cap is 20B; take out 2B in PV(NOLs) it’s $18B, so the stock is selling for something like 20 x to 22 x 2015 FCF. That doesn’t look cheap but I think given the top-line growth potential (mid single digit sub growth + mid single digit price increases), margin expansion opportunities, SIRI at 20 x or a 5% FCF is undervalued, but not by THAT much.

      If LMCA trades at a NAV discount (suppose 10%), then you can effectively “create” (damn I hate pretentious Wall Street jargon) a cheaper levered version of SIRI by buying LMCA and shorting LMCA’s other public holdings. Some of the most important pieces like Charter will be used to form a new tracker so post-transaction SIRI will be relatively isolated anyway.

      Currently I think I have better opportunities to pursue but I could crunch the numbers if SIRI drops to $2.80 or something like that.

    • Hi Brian, thanks for your question. My quick take on SIRI is that I would view it in a similar lens to DTV – a scale-driven business that relies on providing exclusive content that no other competitor can match. Similar to DTV, SIRI should be able to generate the highest customer lifetime (LTV) – the net present value of every subscriber – relative to competitors given its scale. In terms of an entry point I would mostly agree with Steven and try to pick it up somewhere below $3.00, but to each his/her own.

  2. I am trying to wrap my head around satellite technology. Let’s operate under the assumption that Pay TV does actually shift to a more on demand/two way type system, which should theoretically hurt DTV. Can satellites be re-purposed easily? Is there another service that DTV’s satellites can provide other than Pay TV? Same question for SIRI (although maybe SIRI has an advantage as there is a trend towards cars demanding more data, which hopefully SIRI technology can provide).

    Also, I think NFLX is an interesting company to study. I think people have them in mind when they think of unbundling and OTT, but they are/were essentially a bundler. I think that was the push towards original content for them. If OTT becomes prevalent, a service like NFLX doesn’t seem to have a place as I imagine content providers would stream directly to consumers. Why have NFLX bundle your content and make a profit? It will be interesting to see if they can continually launch new shows and become a content provider and what their role in the marketplace will be.

  3. Pingback: Links I didn’t get to so here is a reminder for myself! Getting sick of all my tabs! | Counterintuitive Investing

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