DirecTV’s (DTV) management downplayed their Q4 results a few months ago, wisely cautioning analysts and investors of the challenging economic environment that confronts us all. However, there is no denying that their numbers were strong – simultaneous with the economic meltdown happening all around them. Their results put them in the catbird seat – and in striking distance to deliver a severe blow to competitors (more on that in a moment)

In times of strife, Americans did what they have always done: gathered around the television. The company added 461,000 net new domestic subscribers in both the fourth quarter of 2008 and Q1 2009, the best quarterly results in four years. Their churn rate is only 1.33%, the lowest in ten years. First quarter operating profit was down, but that’s due to the company’s increased advertising, leading to higher customer acquisition costs.

You can examine the financials, but they are strong across the board. I want to emphasize the health of the balance sheet and operational cash flow. DirecTV is sitting on $2.1 billion of cash. Q1 Free Cash Flow was $500 million. Their debt service is more than covered. They are running a strong operation offering a superior product that is only getting better. As main competitor DISH network loses subscribers, DirecTV is picking them up.

The Very Bright Future

There are three macro trends playing in the company’s favor.

First, in a bad economy, people are going to stay home to save money. A November study by sociologists at the University of Maryland concluded that “TV viewing might increase significantly as the economy worsens…work is the major activity correlate of higher TV viewing hours…as people have more time on their hands, viewing hours increase”.

That’s gold for DirecTV. As they enhance their offerings, including an allusion to an upcoming “Whole Home Experience” in 2H09, they have the opportunity to further steal viewers away from competitors.

Second, a trend towards enhancing the home theatre experience has been in place for a while. Flat-screen TV sales and home theatre systems have exploded, and DirecTV’s VOD and HD offerings play right into this existing infrastructure. If people have home theatre, they take advantage of it. If they don’t already have DirecTV, they’ll be strongly considering it.

Third – and this is what I’ve been alluding to – part of their strategy has been about differentiation from competitors. There is one huge play they can make that will leave competitors in the dust. They have been brilliantly scooping up reruns of top shows for next to nothing (Deadwood, Oz, Wonderland) to air on their in-house channel, The 101. That’s a great retention play and might even bring in a few new subscribers who missed out on programs that were too good for network television, or started out on Pay TV but couldn’t be syndicated because of too much sex, violence and/or profanity. Their primary expenditure in this space has been to snag original episodes of Friday Night Lights for an exclusive window prior to it airing on its original home at NBC. Media reports suggest they are spending around $13 million per season to do this.

The Big Bold Hammer

DirecTV’s next big initiative should be an aggressive foray into original programming.

“What? Are you kidding? Do you know how expensive that is?”

Pay attention. Times are changing. DirecTV’s healthy financial position gives them a great strategic advantage.

There has been a marked breakdown in the quality of television programming. Network ratings are tanking. NBC has eliminated a full hour of scripted programming by offering the nightly 10PM slot to Jay Leno. HBO is not the juggernaut it once was in this arena (They never should’ve cancelled “Deadwood”). Audiences crave originality. And now, with the TV being their new best friend, they will want alternatives.

Do you think any cable company or DISH (DISH) can afford to do this? Do you think they would even be able to take the first steps? Not a chance.

Now, DirecTV can’t just jump in willy-nilly. There is a very specific strategy that will work for them, and them, alone. The background is this: DirecTV owns about 18% of the US viewing market. Friday Night Lights averaged about 6 million viewers before it started on DirecTV, suggesting that about 1.1 million viewers were already subscribers. Ratings for the show in its first year on DirecTV had about 600,000 – 800,000 people watching it. This says that FNL is a solid retention play, but did not grab new subscribers which, in fairness, may not be DirecTV’s goal with The 101.

But it should be, and here’s why:

For the $13 million I assume they are spending to get FNL, they could produce 10 episodes of their own original series. Right now, they get no tangible revenue for FNL because they don’t own it. But they’d own their own series, which could attract new subscribers, allow them to sell into all the ancillary markets, and begin to build a library. This strategy, properly executed:

1) Is low-risk and not capital intensive.

2) Takes advantage of other programmer’s weaknesses.

3) Provides further differentiation from their competitors and will put them in the position of being the heir to HBO.

4) With the value of a new subscriber arguably worth more than $600 in net revenue per year, and a churn rate of only 1.33%, this strategy stands to bring them in far more revenue than an HBO subscriber ever would.

5) Could leverage and integrate many of the extraordinary assets of Liberty Media (LMDIA) and vice-versa.

The Monte Carlo simulations I’ve run on this strategy offer high levels of confidence in returns that range between 30% and 110%.

However, the type of programming they’d produce would have to have several highly specific parameters. What are those?

Nuh-uh. I’m not that easy. I want to know if anyone out there has a hypothesis. Until then, feel free to pepper me with your guesses, and I’ll discuss it next time around.

Examining the Stock

Here is a company that is clearly the outstanding brand in its field, with a well-defined strategy for retention, and with customer satisfaction that is so high that only 1.33% of customers bail on the service in any given quarter. Their competitors are slowly fading, they have at least one low-cost differentiation strategy that hasn’t even been attempted, and market conditions that directly favor their product.

The stock is currently selling at $22.75 per share, meaning it is flat with where it was two years ago! Yet FY 2010 estimates are for $2.08, a 45% increase over 2009 estimates of $1.45. That gives DirecTV a p/e of 11, a price-to-sales ratio of 1.1, an Enterprise Value-to-EBITDA ratio of just over 5 (cheap by most standards). All of this ignores the $1.68 billion in free cash flow it threw off in 2008.

I love range-bound undervalued stocks. They allow me to engage in a strategy with which I’ve enjoyed good returns. I open up a position, sell calls against half of the underlying position, and hold the rest. With the July 22.5 Calls yielding about 6%, that’s a nice return. If the stock isn’t called away, you’ve reduced your basis and can sell another round.

When I add all of this up, I see a tremendously undervalued asset with significant upside, which is probably why Liberty Entertainment scooped it up, as is their wont.

So while we wait for the price to improve, Mr. Malone and Mr. Maffei, please take note. Whether you consider retaining DirecTV or selling it off, it will have more value as an original programmer on top of its current success.

Full Disclosure: No position in DTV, DISH, or LMDIA.

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