Buying DirecTV Group

I bought shares of The DirecTV Group (DTV/NYSE) yesterday (Wednesday, 7/20). It's the biggest satellite operator and the second-biggest multi-channel video provider in the US. I think the company qualifies as undervalued. Even though at first glance it may not appear that way.

I say that because DirecTV has been trading at roughly 2.92 times book value and 1.73 times sales. That price/sales ratio isn't bad, but I almost never buy a stock that's trading at nearly 3 times book. The reason I am this time is because DirecTV's "stated" book value is not representative of the company's true value.

DirecTV closed yesterday at $15.50 and has a market cap of approximately $26.8 billion. Its 52-week high of $18.25 was reached last October. The company has been signing up new customers at an impressive pace, yet the share price has lagged. Why?

The 2 reasons DirecTV gets a fuzzy reception on Wall Street:

First, the way DirecTV signs up new customers gives the impression that the company will not produce meaningful free cash flow. Each time DirecTV signs up a new customer, it subsidizes much of their equipment. This means the income statement for that one customer will show a net loss for that first year. But in the second year (and every year thereafter) the company will no longer be subsidizing this customer -- and will show significant free cash flow from him or her.

The "problem" is that DirecTV is signing up new customers so fast, and growing the entire business, that all of these new customers mask the free cash flow. Management is correctly taking the long view and continuing to acquire new customers because it understands they represent potentially huge future economic returns. Of course, this model demands that once a customer signs up, they remain a customer after the first year. This appears to be happening.

Eventually DirecTV's rapid growth will slow. It must. At that point the company's free cash flow will "suddenly" appear and be noticed by Wall Street analysts.

The second reason DirecTV's shares have lagged is that General Motors owns one of the largest stakes in the company. (DirecTV used to be Hughes Electronics, formerly owned by GM.) General Motors has been selling its DirecTV stock -- it dumped over 57 million shares on the market in the first quarter alone. With GM still holding in excess of another 215 million shares (as of 3/31/05) ready to be sold, investors have resisted buying DirecTV stock in the face of this headwind.

What will clear up the DirecTV picture for investors?

The stock price has been hampered by what I think are short-term factors. Over the next 3 to 5 years, I'm confident the stock offers significant price appreciation due to the following:

• DirecTV's free cash flow is ultimately recognized by Wall Street and fully valued by the marketplace.
• GM eventually completes the unwinding of its massive stake and ends the fears of it depressing DirecTV's stock price.
• DirecTV has a rock-solid balance sheet with virtually zero net debt.
• DirecTV has excellent management -- the company is controlled by News Corporation, which has a proven track record in running satellite companies.

As always, I could be wrong about DirecTV and you should do your own research before buying stock in this company.

Comments

[Directv Affiliate]

I think you're absolutely right on with this one. Right now Directv is putting a lot of money and effort into gaining market share. Once Directv has gained a fair share of pay TV customers and no longer needs to focus so much on growth, the enormous base of acquired customers will represent tremendous profits each and every subsequent year.

[John]

I take it by your posting name that you're non-partial? ;-)

I agree with you and look forward to being a DirecTV shareholder for sometime to come.