This Company is Raking in the Cash

For many years, investors had to sit and wait for profits as cable and satellite companies re-invested every spare penny into building their business. That wait is now over, most notably for investors in DirecTV (NYSE: DTV). The satellite TV provider is now throwing off large amounts of free cash flow, which is leading to some generous shareholder initiatives such as large stock buybacks and (eventually) fast-growing dividends. And shares, despite a recent upward move, still trade on the cheap.

For quite some time, investors have been trying to handicap which cable and satellite firms would win the race for market share. That game is almost over as market share rates are holding fairly steady these days. Each of these players lose a decent number of customers to rivals every quarter, but they also convert a similar number of subscribers back from those rivals. This has led to an era of sharply-reduced spending on efforts to lure new customers (known as SAC, or Subscriber Acquisition Costs). For DirecTV, that means lower marketing spending and fewer discounted pricing offers. The net result: the firm now collects $80 a month on average from each customer, up from $75 a year ago — and it is spending less to acquire those customers, which yields impressive profits for each subscriber.

Much more importantly, DirecTV has largely completed its internal investments in North America, so investors need not look just at operating cash flow (which does not include capital spending), and can instead focus on free cash flow, the real measure of shareholder returns. DirecTV generated $648 million in free cash flow in the first quarter, up from $340 million a year ago. For the full-year, the company is on track to generate more than $2.6 billion in free cash flow.

So what to do with all that cash? A stock buyback is an obvious move. Management has already taken the share count down from above 1.1 billion in 2008 to a recent 938 million. Based on current plans, the share count should fall below 900 million by the end of this year. So by using the projected year-end share figure, cash flow should equal about $2.90 a share, up from $2.09 in 2009. Goldman Sachs’ research thinks the share count will be reduced to less than 800 million in 2011, and below 700 million in 2012. Even if sales, reported income and free cash flow grew at a snail’s pace, they would still grow quite nicely on a per share basis during the next few years, if ongoing buybacks are enacted.

But there’s no reason those operating metrics should be static. Average Revenue Per User (ARPU) is expected to exceed $84 on a full-year basis this year, thanks to recent price hikes. Those price increases did not cause customers to flee at an above-average clip. The expected further gains in sales and cash flow should enable DirecTV to eventually augment its buyback program with a freshly-minted dividend. That won’t likely happen before 2011. But if the company gave back one-third of free cash flow in the form of dividends, then a $1.25 or even $1.50 dividend may be in the offing, good for a 3% to 4% yield. Management wants to wait to offer a dividend until gross debt is less than 2.5 times EBITDA, which should happen in sometime in 2011.

South of the border

Although DirecTV’s North American market is largely mature, the company is still seeing dynamic growth rates in Latin America, thanks to more aggressive anti-piracy moves and still-low penetration rates. Whereas DirecTV may only add around 300,000 to 400,000 net new subscribers here in North America this year, the company is on track to add more than one million net new subscribers in Latin America. With one business (North America) largely mature and the other (Latin America) in high-growth mode, some have speculated that management may look to separate the two businesses if they will create a higher valuation as standalone entities.

Action to Take —-> Despite the impressive momentum, shares still trade for less than 4.5 times projected EBITDA, on an Enterprise Value basis. Assuming they trade up to around 6.0 times EBITDA/EV, investors are looking at a +33% gain in this stock. As the company builds on its impressive string of free cash flow results while the share count steadily shrinks and the company moves closer to issuing a robust dividend, investors are likely to start bidding up that EBITDA multiple to a level that is still a sharp discount to the long-term double-digit EBITDA growth rate.