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February 08, 2006

DirecTV: Controlled Growth Strategy Might Work

DirecTV (DTV) shares are up about 3% in response to a solid quarterly earnings report. My key takeaway is that the street is beginning to respond favorably to the company's transition to a controlled growth strategy where EBITDA and free cash flow growth is paramount and subscriber growth is secondary. The street is also pleased to see the announcement of a $3 billion share buyback. None of the buyback will come from the GM pension plan which is not a seller at this time.

The strategy transition is evident in the 4Q05 numbers. EBITDA was a big positive surprise while gross and new subscriber additions fell well short of estimates. The subscriber shortfall was mostly a self-inflicted wound as DTV has been trying to upgrade the quality of its subscribers. Thus far, that has been accomplished by an increase in involuntary churn as tighter credit policies have been maintained. This quarter the strategy was extend to include termination of certain distributors and a change in incentives for distributors. Churn came down a bit last quarter to 1.70% but that is still high. On a base of 15 million subs, that means each month 255,000 subs are lost, 765,000 a quarter, or over 3 million a year. DTV has said it wants to add 1 million subs a year and grow to 20 million subs. A strategy that deemphasizes sub growth and leads to greater EBITDA and free cash growth seems appropriate given the churn obstacle and the high cost of that churn....

During the quarter, management claimed that subscribers with high credit scores actually grew by 14%. Given the mediocre net adds of 200,000 that implies that they must not have tha many really high credit scores in the customer base. However, it is a sign of where th company is headed. If they can pull it off and sustain solid EBITDA and free cash flow growth, the street might respond.

EBITDA benefited from a combination of factors, some of which might flow from the controlled growth strategy. ARPU rose more than expected to $75.53 per month, up 5% over a year ago. The absolute ARPU figure is high in the fourth quarter due to the NFL Sunday Ticket, but the theory that higher quality customers are more willing to take bigger programming packages, premium services, HD and DVR packages is plausible. Those add-ons can be high margin.

EBITDA also benefited from "improved scale and operating efficiencies." Management noted that upgrade and retention marketing was stabilizing and G&A leverage was appearing. The quarter also benefited form lower than expected subscriber acquisition costs directly related to lower gross subscriber additions, declining prices for set-top boxes, and lower installation and commission charges.

DTV is hosting an analyst meeting in a couple of weeks but did provide some broad 2006 guidance. Questions about the assumptions behind the guidance were generally deferred to the analyst meeting. Overall, DTV expects EBITDA growth of greater than 20% in 2006 driven by continued solid ARPU growth, and "reasonably flat" subscriber acquisition costs. Continued gains in operating leverage against G&A and upgrade and retention marketing are also anticipated. Besides continuing to upgrade the quality of the subscriber base, key strategic initiatives for 2006 include rolling out local high definition channels to 2/3rds of the country, jump starting the company's COD initiatives, and making further investments in original content.

Finally, DTV provided no additional color on its potential broadband wireless initiatives. In the long run, Rupert Murdoch, whose News Corporation owns 34% of DTV, is on record as saying a broadband data product is necessary for DTV to grow subscribers. This is a major wildcard for DTV shares as investors will be rightfully about the size and financial drain of any investment.

Overall, this was a good quarter from the perspective of near-term DTV stock performance.

Posted by Steve Birenberg at February 8, 2006 03:24 PM in DTV