DIRECTV (DTV)

So here is another ripple from the recent flurry of Buffett stuff on this blog (from the letter to shareholders to the 3T's etc. OK, so two posts does not a flurry make).

A lot of people look at Buffett's holdings for investment ideas, but for most of the recent ten or twenty years, he has invested in large cap or super cap names.  Buffett's pool where he can fish is just the top 100 or so market cap companies.   With a $100+ billion equity portfolio, he really can't be looking at smaller names.  So we often wonder, if Buffett was managing a lot less, what would he be investing in?  For example, if he was only managing $100 million, it's almost certain he would not own Coca-Cola or even Wells Fargo.

We can't really ever know that.  But he did pick two investment managers who do fish in a smaller pond.   So isn't that the next best thing?   Buffett and Munger have screened and vetted these two managers for us and they are managing $7 billion each (and they outperformed both the S&P 500 index and Buffett by a wide margin for two years in a row).

So we really have to drill down and focus on what they own, right?  That's a totally rational thing to do.  I've already looked at Davita Healthcare Partners (DVA) and really like it (see post here).

Let's take a look again at Berkshire Hathaway's large stock holdings from the recent annual report:

Out of this, I think the only non-Buffett stock is DIRECTV (DTV).  The table shows that they own 22.2 million shares, but this excludes shares held in the pension funds.   The 13-F shows that BRK owns 36.5 millions shares.  That comes to $2.9 billion at the current $79/share.  Buffett says that Weschler/Combs each manage around $7 billion, and they both own DTV (one or both said that it was the first stock they bought upon joining BRK).

Between the two of them, they manage $14 billion.   So this $2.9 billion position in DTV is around a 21% position.  (BRK owns 36.5 million shares of DVA which is worth, at $69/share, $2.5 billion which makes it a 36% weighting in Weschler's BRK portfolio).

So that's pretty astounding.  They both own DTV, and combined, it's 21% of their portfolios. Obviously, we have to take a closer look.

Actually, I have looked at this a few times in the past and always thought that satellite TV will be more vulnerable to new trends such as over-the-top TV and things like that.  Cable companies can get around that as they have a fat two-way pipe that goes into the home.  So even if you give up on the TV/video business, you can generate some good cash flow on the broadband business (like Washington Post does; Graham said that they have given up completely on the video business).   I always wondered about satellite TV because they don't have that two-way pipe.  They really do just distribute video.


Focused Investing
OK, so going off on a tangent for a second.   Both Buffett and Munger have often talked about focused investing.  Greenblatt said in his genius book that you only need six to eight stocks in a portfolio to get the benefit of diversification.  But very few people actually do that.  Most of this is due to size; many funds just become too big to do this.

But check this out.  When Todd Combs appeared on CNBC with Buffett the other day (see here), he mentioned Tom Bancroft as a money manager that he would recommend.  Bancroft runs Makaira Partners.  He worked for Lou Simpson for 13 years before striking out on his own.   Of course, like any attentive value investor, I immediately went to the SEC website to pull up Makaira's 13-F:

So check it out.  Nine names in the portfolio.  That's focus.  Of course I did take a quick look at Wesco Aircraft and CDW Corp and think they are very interesting (maybe a future post).

No Bonus for Originality
And by the way, one great thing about investing is that there often isn't a bonus for originality.  Well, if you dig deep and find an overlooked gem, obviously you can get great returns.  And yes, you can't do well doing what everyone else is doing.   But what I mean is that if you see or hear of a good idea and jump on it, it doesn't matter where the idea comes from.

If someone owns an interesting looking stock that has a 10% free cash flow yield, you don't have to say, gee, that looks great but I'm going to go look for my own 10% free cash flow yielding stock.  If 10% free cash flow is good for you, then just buy that stock!   Of course you still have to do the work to understand the business etc.

In many other areas, you can't do that.  Private equity guys can't do that.  If you are a composer and you hear a great melody on the radio, you can't go, gee, that sounds great.  I'm gonna use that melody for my own song!   But in the investing world, if you buy a stock that Buffett owns, you are going to get the exact same return on it that he will.  Someone owning a stock doesn't preclude you from enjoying the same benefits.  And unlike the Olympics where only one person is going to get the gold medal, in investing, one person doing well doesn't preclude others from doing well too.  But then again, we can't all be above average either.

Back to DTV
One thing you will notice when you read the DTV annual reports is that they are really well written and they are very shareholder oriented.   They had their investor day in December 2013 and it's really detailed and good.  If you are interested at all in DTV, I highly recommend going to the DTV website and listening to the whole thing.  The presentation slides are good too, which I will cut and paste from.

December 2013 Investor Day
Just to get your attention, I will put one of the last slides up front.  Here is one of the biggest reasons, probably, that both Weschler and Combs likes DTV:

Just like outsider CEO's do, they are aggressive in their share repurchases.  Since 2006, DTV has repurchased 65% of their shares outstanding (based on float).  That's astounding.  You would think that the satellite TV business is capital intensive, like cable.

DTV
But first, let's just take a quick look at what DTV is all about.  Here is a nice slide from the presentation that gives you a snapshot of DTV:

The basic story is that DIRECTV in the U.S. is pretty mature (but can still grow) and a lot of growth can come from their Latin America business.  The growth potential there is very large due to the increasing penetration of pay TV and the rise of the middle class there.  The region is facing a lot of headwinds in the past couple of years driven by the slowdown in China, but they still manage to be growing.

Despite the competitive challenges / maturation in the U.S. and problems in Latin America (macro), they have managed to grow revenues and earnings at a nice clip.

Of course EPS is not going to grow 31% over the next few years, but as we'll see, DTV does expect some decent earnings and free cash flow growth going forward.

Competitive Advantages
There is a lot more in the presentation but here's a slide that shows some of the competitive advantages that DTV has.   My biggest question with DTV is what their edge is compared to alternatives.

The outstanding customer service is curious as if you google DTV Yelp, you will only find one star ratings with many comments like, "DTV doesn't even deserve one star; there should be a zero star option" or some such.  But I understand that there is a bias in some of these things as people will generally speak up more often when they have a problem rather than when they have a good experience.  With 20 million subscribers, a few negative Yelp reviews may not mean much.  And besides, if you look at cable companies, you won't see much difference.

Challenges
So here is what we investors have to worry about:

DTV U.S. is obviously in a mature market with increasing competition.  The increasing rates for content sort of reminds me of the pharmaceutical and branded goods industry in the 1980s and 1990s.  It can keep going until at some point the system can't take it anymore and the model blows up.  The pharmaceutical industry may be a little different as they didn't keep raising prices on the same product over the years, but it is similar in that things got more and more expensive until the system couldn't handle it anymore.

The Point
So here is the most important slide (for many of us) that gets to the point.  What can we expect from DTV over time?  Their outlook to 2016 is for 15%/year growth in EPS and 25%/year growth in FCF/share, both of which would get to $8/share by 2016.

DTV Latin America / SKY Mexico
There is a lot of detailed information on the non-U.S. DTV business, but here are just a few slides that show what it's about.   They are growing despite some serious macro headwinds:

Emerging markets do tend to have cycles, and we seem to be in a big growth down cycle in emerging markets, largely due to the slowdown in China, Fed tapering and some geopolitical problems.  So I am not so concerned with that as cycles do eventually turn.

There seems to be plenty of room for growth despite the macro headwinds.

DTV U.S. Performance Despite Competition
Despite competition from FiOS and cable triple play (and others), DTV U.S. seems to be doing well versus other pay TV providers:

Managing Churn
Of course managing churn is critical in sustaining and growing the subscriber base.  This chart is interesting.  DTV U.S. is focusing on higher end DTV subscribers as they add more value to DTV (as shown in later slides).  But the higher end users also have lower churn.  The more they pay DTV, the stickier they are:

Revenue and OPBDA Growth versus Peers
And DTV U.S.'s revenue and OPBDA growth is better than peers (again, despite the intense competition in recent years):

How Do They Do It?
So how do they grow earnings and revenues in a mature market with such intense competition?

Quality over Quantity?
Going for higher end users seems to add more value to DTV (and they have lower churn too as seen in the above chart).

And despite TV provider complaints of rising content cost, DTV has managed to increase programming margin.  Of course there is nothing wrong with passing on higher costs to the consumer.  But at some point people will start to balk and content providers will have to think about further price hikes or abandon this model altogether (which would be highly risky too).

And obviously, cost management is key:

New Businesses
So DTV is looking at new business opportunities (U.S. business).  There are details in the presentation, but here's just one slide.

Commercial is offering DTV to restaurant/bars, hotels, gyms and things like that.  DTV says they have an edge in home security due to their current customer base and installation staff.  Ad sales is targeted ads for advertisers; much more efficient than broadcast advertising, for example.  SVOD is subscription-video on demand, EST is electronic sell-through (like iTunes store) and OTT is of course over-the-top business.

But this will only be $1 billion or so in revenues in 3-5 years, versus $25 billion in revenues for DTV U.S.

Some Financial Stuff
So here are some financial slides:

Valuation versus Peers
And here's an interesting slide comparing DTV's valuation versus peers:

DTV closed around $67/share on December 11 and 12 (investor day was on the 12th) and is now at around $78/share.  As of December, DTV was trading at a very attractive level given growth trends there versus the S&P 500 and peers.

2013 Results
Just to fill in some figures that came out after this presentation, DTV had full year 2013 adjusted EPS of $5.42/share, better than the 2013 target set back in 2010.  Free cash per share was $4.76.  So currently, at $78/share, DTV is trading at 14.4x 2013 EPS and 16.4x free cash per share (on a trailing basis).

2014 Outlook
On the 4Q 2013 conference call, DTV said they expect DTV U.S. to have mid-single digit revenue growth based on ARPU growth and modest subscriber growth and OPBDA growth in the mid-single digit range.  Programming costs per sub is expected to increase 7-9%/year in each of the next three years.  EPS will grow in the mid-teens from the reported $5.22 and free cash flow will grow 10% in 2014.

Assuming 2014 EPS of $6.00 (+15%) and cash flow per share of $5.24 (+10%, on the conference call I think they said free cash flow will grow +10%, not free cash flow per share.  But let's just call it +10% to be conservative.  It may be higher on a per share basis due to share repurchases).  With DTV trading at $78/share, that's a 13x p/e and 14.9x free cash per share.

Their 2016 goal is $8/share in both EPS and free cash flow per share, so DTV is trading at less than 10x that.  If they get to the more normal looking 15x valuation, that would put the stock at $120/share.  That leads to a 15%-ish return over the next three years.

But of course, the big question is what would the outlook for DTV be in 2016?  Pay TV in the U.S. will be more competitive.  Latin America and Mexico will probably do well over time as those markets get through their macro down cycle (cycles do turn, eventually...).  Better performance there and an increased valuation of those businesses can boost DTV over time.

Significantly Undervalued
On the 4Q2013 conference call, Michael White (CEO) said that DTV stock "remains significantly undervalued".  The conference call was on February 20, 2014 and DTV was trading at $75 at the time.  He said they will be buying back another $3.5 billion in stock.

Conclusion
This is very interesting.  We have a stock here that:

• both of Buffett's handpicked investment managers have in their portfolios with a collective 21% weighting which is pretty big
• A really great looking business in terms of ROIC, growth and other metrics, 
• Trading at a reasonable price, cheaper than the market and peers given the growth rate
• A shareholder friendly management that buys back tons of stock (having bought back 65% of float since 2006)
• The CEO says that the stock is significantly undervalued

So how can you not be excited?  I think DTV is an incredible company.  My concern is the same as most other people, I suppose, who don't own DTV.  

Malone's rationale for buying Charter (CHTR) was that they own a fat two-way pipe into people's homes.  Even if the current pay TV model ceases to exist (and he thinks it won't exist in five years), CHTR has a broadband connection; people will still need broadband to get TV/video into the house.  Malone feels that he can package his broadband internet service with some other TV/video service and have a good business.  As for competition from FiOS and other broadband service providers, he feels that cable can get to fiber-optic-like speeds and capacity with much lower cost (and capex). 

When thinking about DTV, satellite TV providers don't have that.  Satellite is one way so what will they do when the current pay TV model starts to fall apart? 

It may not be two way, but they still do have very low cost one-way connection and that may become more important as we get more HD and super-HD (and who knows what comes after that).  The combination of satellite and cloud is interesting because much of the really heavy traffic might be just one way (which the satellite can provide), and the other way traffic (user input to DTV) over the cloud may be light (and therefore can be handled by various forms of internet access) so wouldn't cost too much.  

So there is a lot of potential competition, but at the end of the day, it's going to boil down to cost.  Fiber optics may threaten cable, but what is it going to cost to build it out and will people pay for it?  I suppose the same can be said for DTV.  Other forms of competition can come in (internet TV, over-the-top), but what is it going to cost? 

Having thought this through a little bit, even if the current pay TV model blows up completely, DTV will still have a pretty fat pipe going into homes so the model may be different but they can still be a major player given their cost competitiveness; the hybrid satellite/cloud will provide interactivity. 

I think one of the fears is that content providers will eventually just go direct to the customer over the internet and eliminate the middle man (cable and satellite TV operators).  But this ignores the cost, both in terms of lost revenues (will Discovery Channel actually make more money going directly to viewers over the internet?  I wonder about that) and total cost to the end user (broadband connection and possible tiered pricing?).

On a personal note, we recently bought a Samsung SmartTV (internet enabled).  I only bought it, actually, because some of the prices I saw during the holiday season (Amazon versus Best Buy price war) looked ridiculous.  I was convinced they were losing money on the deal so I ordered a TV, and sure enough, after the heavily promotional time period, prices shot right back up again (so I got to buy the low tick! Once a trader, always a trader, I suppose).

And this SmartTV is amazing.  It connects directly to the internet (via my wifi, which goes through cable broadband) so I can get Netflix, Amazon Prime (movies), YouTube and whatever else right on the TV.  There are even some full length HD movies on YouTube for free.  The picture quality is good (HD) and it streams way better and smoother than when we hooked up an iBook to our old TV.

So this is scary.  With this stuff (Netflix, Amazon Prime, YouTube), I don't think I'll ever pay for a premium movie channel ever again.  Why would anyone?  But would I cut the chord completely?  No.  I think Netflix more or less replaces the old premium movie channels and of course the local video rental shops.  Plus, surprisingly, Netflix doesn't have all that many movies streaming.  Their DVD catalog is great, but the streaming catalog is very limited, still.  I think as long as the basic TV package is reasonably priced, I will keep some sort of pay TV going even though we don't really watch a whole lot of TV here.

With Americans watching TV for five hours a day on average, it's hard to imagine a whole lot of chord-cutting happening any time soon.  But who knows.  Maybe I'm too lazy, but I would find it hard to watch five hours of TV a day online.  I don't watch all that much TV, so I am not the best judge of these things.

Having said all of that, DTV looks really good but I don't think I could put 20% of my portfolio into it (but then Weschler/Combs did it much cheaper and they are already sitting on some decent gains!).   Buffett said that both of these managers not only performed well, but have the ability to see things coming that never happened before (in terms of risk), so they have no doubt thought through all of these issues.  One bummer from their recent CNBC appearance is that they were asked about DTV but they never had the chance to talk about it.  Oh well.  That will have to wait for the annual meeting, I suppose.