DirecTV: Changing the Channel to Latin America
Over the past three months, we’ve built a position in DirecTV (DTV), the largest satellite cable television provider with 20 million subscribers in the U.S. and 15 million in Latin America. While most of the cable and media companies have rocketed upward over the past couple of years, DirecTV has put in a relatively quotidian performance, leaving it valued at a very significant discount to its cable peers, which trade at about 16x 2013 EPS estimates versus DirecTV at a mere 12×. There are a couple of reasons for the underperformance. The first is investors’ concern that cable competitors such as Comcast and Cablevision will use their control of both the television and internet markets to ratchet up rates charged on internet subscriptions and lower rates on cable television, protecting their profitability but squeezing DirecTV in the process. The second is the concern that content providers like News Corp, ESPN, and others are gaining bargaining power through the continued proliferation of modes of distribution such as their own online websites, Netflix, iTunes, and Hulu, all of which compete with DirecTV and other cable providers.
We believe these concerns are overblown. While we believe that the problems in the U.S. are real and should pressure growth over time, we also believe they are very unlikely to lead to sudden declines in cash flow. Cable television providers have offered both internet and cable TV for many years and yet DirecTV has grown subscribers in the U.S. every year of its existence, most recently growing them at 1% during 2012. Additionally, DirecTV has consistently raised its average revenue per subscriber, enabling it to successfully offset programming cost increases. It’s been able to accomplish this feat as a result of the peculiar nature of its customer base. Its subscribers tend to be either wealthier than average or more rural than average. Both of these customer categories are fairly sticky. Wealthy customers care less about price and more about customer service and programming offerings (both of which are competitive strengths of DirecTV) and rural customers have few alternatives since it’s hard for cable companies to justify the cost of expensive build-outs to areas with low population density. Furthermore, the history of technological advancement suggests that consumers value proliferation of choice, leading to older technologies existing for many years alongside newer ones. Just look at banking. The consumer can now deposit or withdraw money through a bank teller, on her mobile phone, at an ATM, or in a retailer’s check-out line. Similarly, we believe it’s most likely that customers, particularly wealthier ones, will use Netflix, Hulu, and iTunes in addition to, not to the exclusion of, cable or satellite TV.
Though investors’ excessive negativity about DirecTV’s U.S. prospects is certainly good, in and of itself, for buyers of the stock, the best outcome of this myopic focus on problems at DirecTV U.S. is that it has caused investors to underappreciate DirecTV Latin America’s value to the company as a whole. This phenomenon—the tendency to pay attention to the dominant stimuli in one’s immediate environment and neglect other equally relevant but less visible data – is called “attentional bias,” and it consistently plagues attempts at rational decision making. Let’s not make this mistake and instead properly evaluate the less-discussed-but-no-less-important other division of the company, DirecTV Latin America.
DirecTV Latin America is the dominant pay TV provider in Latin America, where the cable plant is much less developed and will take many years to develop a comparable geographic coverage to DirecTV. This fact, combined with rapid growth of the middle class in Latin America and the massive under-penetration of cable-TV in Latin America versus the U.S., explains why cumulative DirecTV Latin America subscribers are growing 30% per year and should be able to grow rapidly for the foreseeable future. Even if this torrid growth rate slows over the next ten years, DirecTV will likely make well over 50% of its profits in Latin America instead of the current 20% by the end of this time period.
We believe this transformation will result in a major perception change among investors, just like it has in the past with similar situations such as eBay and YUM Brands. In eBay’s case, the growth of the PayPal division has transformed eBay in investors’ minds from a boring and mature auction business that has been out-competed by Amazon to an exciting and fast growing payments stock. In the case of YUM Brands, the rapidly growing Asian KFC division has slowly eclipsed in prominence the underperforming US divisions of KFC, Taco Bell, and Pizza Hut. And just like for eBay and YUM Brands, we believe the transformation in investor perception from a mature U.S. business to a dominant and fast-growing Latin American one will expand DirecTV’s P/E multiple from the aforementioned discount to parity or even to a premium versus other media companies. In the meantime, the excellent capital allocators at DirecTV continue to buy back stock at a truly mind-blowing pace (having shrunk the share base by 46% over the last five years), ensuring that we will own an even bigger share of the business when this valuation expansion occurs.
Only time will tell, but, if this investment plays out as we anticipate, we’ll be very glad we tuned in.
Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.