The Henry Fund Henry B. Tippie School of Management Srinivas Cheeni Rao

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1 The Henry Fund Henry B. Tippie School of Management Srinivas Cheeni Rao DIRECTV (DTV) November 25, 2013 Consumer Discretionary Cable/Satellite TV Stock Rating HOLD Investment Thesis Target Price $71-73 Henry Fund DCF $76.14 Henry Fund EP $67.50 Relative PE FY14 $66.01 Price Data Current Price $ wk Range $ Consensus 1yr Target $69.38 Key Statistics Market Cap (B) $34.6 Shares Outstanding (M) Institutional Ownership 80.5% Beta (model) yr. Avg Dividend Yield N/A Est. 5yr Growth (model) -2.5% Price/Earnings (TTM) Price/Earnings (FY1) Price/Sales (TTM) 1.11 (+)DTV Latin America has experienced a 33.4% CAGR in subscriber growth over the past three years. We project continued growth at a 6.6% CAGR through 2018 in this increasingly lucrative region. (+)We project a 1.7% CAGR for ARPU increases in the U.S. through 2018, and a 0.8% CAGR for ARPU increases in Latin America over that same time period due to DTV s continued excellence in customer service, as well as an increase in its PPV/VOD offerings and revenues from targeted advertising. (+) DTV maintains advantages in financial flexibility and economies of scale that have enabled it to maintain a satellite array providing it with increased bandwidth in high margin spectrums such as HD and 3-D. Though an increasing footprint for high-speed fiber optic networks threatens to disrupt the dominance in traditional satellite and cable providers, DTV s ability to add subscribers with limited marginal cost, versus the projected high infrastructural costs to install the new high-speed networks, will continue to drive ARPU gains for years to come. (-) We project DTV U.S. to lose subscribers at a 2.5% CAGR through 2018 due to increased competition from streaming online video options, as well as intensifying competition from satellite, cable, and Telco video providers. (-) Though DTV s bandwidth advantage over competitors, as well as its positive relationship with the NFL, is likely to ensure that it continues to carry NFL Sunday Ticket with exclusivity, the price in the upcoming 2014 negotiations is likely to exceed the $4B price tag of the prior contract, making the acquisition a net negative NPV play for which the primary benefit is slowing the rate of subscriber loss. (-) DTV s increasing reliance on Latin America to fuel revenue and subscriber growth increases earnings volatility for the company due to currency fluctuations as well as unpredictability regarding regulation country-tocountry. Earnings Estimates Year E 2014E 2015E EPS $2.47 $3.50 $4.65 $5.59 $4.73 $ % 33.1% 20.2% -15.4% -13.4% 30% 20% 10% 0% -10% 1 Important disclosures appear on the last page of this report. Price/Book (mrq) N/A Profitability Profit Margin (TTM) 9.58% Operating Margin (TTM) 16.92% Return on Assets (TTM) 16.12% Return on Equity (TTM) N/A 12 Month Performance Recent Developments 2 DTV S&P N D J F M A M J J A S O P/E DTV CATV Systems Entertainment- Diversified Profit Margin Launches Genie service; renews programming deal with CBS 2. Raises rates 4.5%; also involved in carriage dispute with Sinclair Broadcast Group 3. DTV beats 1Q EPS expectations by 13.2% ($1.20); reports organic 32% growth in Latin American segment 4. DTV misses 2Q EPS expectations by 11.3% ($1.18); NFL renegotiation of Sunday Ticket raises possibility of loss of pay-per-view

2 EXECUTIVE SUMMARY DIRECTV (DTV) is a current holding for the Henry Fund that has provided consistent gains for several years, and which has returned over 30% in FY13. However, DTV exists within a mature industry in the U.S. and is facing increasing commoditization in the face of entrenched cable and satellite competitors, while also trying to combat ongoing subscriber loss to the disruptive forces of internet streaming video. We project, however, that DTV s increasing dominance in Latin America, where its satellite technology enables it to reach customers across terrain that has not yet had effective cable or internet infrastructure built, will enable it to grow revenue and gain market share in an area with a burgeoning middle-class. As DTV s revenue sources shift to a more equal distribution between the U.S. and Latin America, DTV s ability to continue to drive high average revenue per user (ARPU) due to its award-winning customer service, high quality program offerings, and high-margin pay-per-view (PPV), video-on-demand (VOD), and high-definition (HD) services will continue to drive profitability. Given DTV s ongoing commitment to share repurchases, we still see potential in DTV in the short-term and recommend a HOLD. COMPANY DESCRIPTION DIRECTV (DTV) provides digital television entertainment services, transmitted directly to subscribers satellite dishes, through use of geosynchronous satellites. Founded in 1990, and headquartered in El Segundo, California, DTV operates through three segments: DIRECTV U.S., DIRECTV Latin America, and DIRECTV Sports Networks. As of September 30 th, 2013, DTV had 20.2M customers in the U.S., and 17.2M customers in Latin America. DTV is the market leader amongst satellite television providers, holding 59.7% market share, while its nearest competitor, Dish Network Corporation, holds 36.7% market share in the $39B U.S satellite TV industry. However, it is important to note that DTV and all satellite television providers are easily substituted in many areas by cable television providers. Thus, of the U.S. pay TV market, the cable industry retains approximately 54% market share, while satellite providers retain approximately 35%, and Telcos maintain about an 11% share. Page % Business Segments DIRECTV U.S. 2013E Revenue 0.8% 77.7% DIRECTV U.S. DIRECTV Latin America DIRECTV Sports DIRECTV U.S. provides its domestic subscribers with access to hundreds of channels of digital-quality video and audio entertainment, as well as video-on-demand (VOD) through customers digital video recorders (DVR). DTV U.S. carries an extensive, premium collection of programming, including over 185 national high-definition (HD) television channels and five dedicated 3D channels. Through their VOD service, named DIRECTV Cinema, they provide a selection of over 10,000 movie and television programs to their broadband-connected subscribers. Another key to customer acquisition and retention has been DTV s rights to broadcast premium professional and collegiate sports programming, such as the NFL Sunday Ticket package. By offering comprehensive services that are equal, if not better than what its competitors offer, while also maintaining best in market customer service, DTV has maintained a low level of customer loss, or churn, of approximately 1.5%. At the same time, DTV U.S. is able to charge a higher rate for each of its premium services, due to the reliability and quality of service it delivers. In this way, DTV U.S. is able to return an industry leading average revenue per unit (ARPU), which continues to drive revenue growth even if subscriber growth is flat. DTV U.S. faces stiff competition from both cable and satellite providers that has effectively commoditized the industry, and is facing an erosion of its competitive advantages due to the growth of internet provided video, which is acting as a disruptive force in the industry and is projected to cause a decline in paid subscribers for cable and satellite providers. We project DTV U.S. to lose subscribers at approximately a 1% per year rate over the next five years, but for ARPU to increase by an average of 2% a year over the same period.

3 DIRECTV Latin America DTV Latin America provides one of the most extensive collections of programming available in the Latin America pay television market. Its HD sports video content, as well as use of the innovative interactive technology which was developed for the U.S. market, enables DTV Latin America to differentiate itself from other regional competitors as a premium product. Of particular advantage is the ability to enter into undeveloped regions, and to sell differentiated products and services on a continent-wide basis, with limited marginal costs due to the ability to use existing satellites, rather than needing to lay new, expensive fiberoptic cable. As of December 31, 2012, DTV Latin America provided service to 24% of pay television households in PanAmericana, 31% of pay television households in Brazil, and 37% of pay television households in Mexico. Due to its competitive advantages we project continued growth across Latin America, fueled by both satellite based cost advantages enabling DTV to increase market share, as well as due to a rising middle-class creating more customers for DTV s offerings. Political instability has led to some difficulty in effecting expansion due to legislative obstacles, and ongoing currency volatility continues to create concerns. DTV offers a pre-paid option to its customers in this region, rather than the long-term contracts it can employ in the U.S., and tries to further navigate currency volatility by keeping cash in country to avoid exchange related losses. We project ongoing volatility in subscriber growth and ARPU growth in Latin America, but see subscriber growth growing at an approximate 4% clip over the next five years, with ARPU showing a growth rate of.8% over the same time period. DIRECTV Sports Networks In addition to NFL Sunday Ticket and other PFTV service, DTV also owns Root Sports Network, which manages three regional sports networks located in Seattle, Washington, Denver, Colorado, and Pittsburg, Pennsylvania. This segment of DTV s revenues is projected to be continue to provide less than 1% of total revenues. Product and Service Segmentation DTV offers several services which it then bundles into packages, offering different tiers intended to appeal to all ranges of customers. Revenue is generally earned through the monthly fees for these services, whether they be for subscriptions to programming, add on video-on-demand or pay-per-view services, or equipment leasing for DVRs and receivers. Although advertising is an additional source of revenue, it has not played a major role thus far. However, advertising revenue is expected to steadily grow due to the increasing ability to use technology to specifically target customers. Basic Programming and HD Channels Basic programming and high-definition channels are popular draws for customers, but have been having a declining impact on churn or customer transfers. The desire for basic services is on the rise, but alternative services like Netflix and Hulu threaten to erode demand. DTV combats this issue by providing content-specific features, such as ScoreGuide, which keeps track of scores and start times of major matches for fans. Perhaps more important than interface improvements, however, will be the ability to provide access to a diverse and current stream of programming so that the satellite provider space is known for providing a depth of content that alternatives cannot afford. More programming would expand revenue, but the increasing cost of carrying programming is a serious deterrent. This is a reason why consolidation can be an effective strategy: integrating with a content provider could protect against rising programming costs, while merging with Dish Network would provide much more substantive bargaining power with content providers. While DTV has significant channel capacity and is able to provide local, national, and international programming, as well as exclusive sport programming, another key differentiator is the quality of the picture and sound that Page 3

4 is delivered. All programming is digitally delivered, and due to the methods DTV employs to ensure video and audio fidelity, its picture quality is consistently rated higher than that of cable in J.D. Power and Associates annual survey. Due to the addition of advanced satellite technology, DTV has also expanded its HD channel offerings, and can provide both programming and movies at 1080p resolution, and is also able to offer 3D programming on five dedicated channels. Video-On-Demand DTV also offers customers the ability to watch programming on-demand for packages they have purchased, increasing the incentive for purchasing a higher programming bundle. For those who have not purchased a specific programming bundle, content specific programming and add ons can be purchased on demand in an a la carte fashion for a fee. In this way customers can fully customize their viewing of sports programs, TV shows, and movies, paying a premium price on selected add ons if they choose not to contract for higher option programming bundles. This type of VOD option has been increasing in prominence in the past five years, and has seen a recent trend towards enabling viewing on broadband-enabled mobile devices. DTV has aggressively implemented a product roadmap to capitalize on such high margin or multi-platform viewing. In 2012, DTV introduced the Genie, a premium HD wholehome DVR service with a terabyte hard drive and the ability to record five different HD programs simultaneously. This device also incorporated intuitive search and discovery functionality to further recommend additional VOD programming matched to the customer s viewing history. Yearly refinements are expected, and DTV should see increased revenue due to its ability to more accurately target customers for VOD purchases. DTV has also been focusing on connecting customer receivers to broadband service in order to provide access to a larger library of HD VOD content, as well as to better enable streaming to customer mobile devices. With a broadband connection, TV Apps could be enabled, not only keeping customers updated on programming options, but also enabling them to link their viewing choices to social media accounts, or to download content from YouTube or Pandora. As well, DTV could implement its fastest and most elegant HD user interface, incorporating voice search, as well as intuitive search elements. Such efforts are clearly intended to decrease any possible churn towards the currently available internet based programming options. DVR Services and Other DTV also gains revenue from fees charged to subscribers for multiple leased or purchased set-top receivers, warranty service fees and advertising services. As digital content is streamed over mobile devices and made available over the internet, the potential to advertise over on-demand and live streaming video is huge. As such, advertising is expected to account for an increasing portion of revenue, in line with DTV s stated focus to generate a greater share of revenue from commercial and local advertising. Indeed, in 2013 DirecTV announced a strategic investment in and partnership with FreeWheel, a platform for dynamic ad insertion in on-demand and live video feeds online. Demographic Segmentation The number of US households subscribing to satellite TV is declining, as is the proportion of revenue from basic TV services. Historically, older viewers were more attracted to satellite as they were more likely to live in rural areas that were not wired for cable, and because they were less likely to adapt quickly to newer technology. DTV continues to appeal to this demographic, and thus, despite the rise of internet based viewing options, is not expected to lose subscribers at a precipitous rate. Regardless, DTV has implemented strategies to appeal to the younger demographics, such as the use of higher tech DVRs and streaming platforms. As well, DTV is able to solidify its appeal with multicultural audiences by offering foreignchannels. Page 4

5 Industry Costs DTV faces large costs with its satellites. During the construction and launch phase, DTV s profitability shrinks and depreciation and purchase expenses increase. One the satellite is operational, however, DTV enjoys high profit margins. In recent years, DTV experienced strong profits as it spent a smaller portion of its income on satellite launches and updates. With DTV expecting to launch two satellites in 2014, profits will likely be depressed for a short time. However, Dish Network is also expected to see depressed margins due to high litigation expenses, programming costs, and advertising costs associated with their release of their Hopper set-top box. Subscriptions and on-demand revenue have grown over the past five years, but profits are also being eroded by the increased marketing costs required in the fight for subscribers, as well as increasing programming costs. Because of the high level of competition, these increased costs cannot be easily passed on to subscribers. As a result, profit growth is expected to be relatively flat in the next five years. RECENT DEVELOPMENTS NFL Sunday Ticket DTV possesses exclusive broadcast rights to NFL Sunday Ticket, having paid $4B for the possession of the rights from 2009 to This expensive programming option enables subscribers to watch any out-of-market NFL game, and thus provides DTV with an exclusive edge over all its competitors. Though DTV loses money through NFL Sunday Ticket, it has been considered by management as a key driver in reducing customer churn and in retaining high end sports fans. The contract is up for renewal in the coming year, and as such is expected to create a bidding war. With online players, such as Google, being courted, the successful bid may substantively exceed the previous $4B rate that DTV secured. If such a high price is required to win the contract, it is not likely that DTV would be able to contend, and would likely drop NFL Sunday Ticket rather than encumber itself with the costs. However, though the market currently considers loss of NFL Sunday Ticket as a realistic possibility, we predict that the inability of competitors to provide the level of bandwidth that DTV has provided, as well as the difficulty they will face in ramping up effective integration and customer service to the standard DTV has established, will enable to win the negotiation. Though the successful bid will be higher than $4B, we do not anticipate that negotiations will lead to DTV inking an unsustainable contract. Share Repurchases DTV has consistently repurchased shares over the past 7 years, having repurchased nearly $29B since It currently has approximately $1.6B remaining under its current $6B repurchase authorization. DTV has been funding this share repurchase primarily through taking on debt, making use of low lending rates. As of September 30 th, 2013, DTV has total debt of approximately $19.2B and $1.6B of cash and cash equivalents. At the same time, DTV has been able to consistently maintain the net debt/ebitda leverage ratio of 2.5X that management desires. As we anticipate DTV beginning payment of its debts with notes coming due in 2014, and as we project that it can do so comfortably, we view the share repurchase strategy favorably and believe it is in net adding value. Growth in Colombia Colombia contains the largest number of households in the PanAmericana segment of DTV s business, and due to continued improvements in the business environment, as well as favorable economic trends within the country, DTV expects to substantively increase its pay television penetration in country. In 2012, DTV announced its goal to make Colombia its third largest market. Subsequently, it introduced offers tiered towards both high-end and value markets, whiles also expanding its dealer network. Similar to its use of NFL Sunday ticket, DTV also acquired right to the popular Page 5

6 Colombian soccer league, and is expected to use these rights to drive subscriber growth. Decline in Subscriptions As the industry has matured and become commoditized in the U.S., we see the rise of the industry disruptive option of watching content via internet streaming causing a decline in subscriptions in the coming years. This trend is not only affecting DTV, but impacts its competitors in both satellite and cable mediums. However, though loss of viewers is to be expected, we project that DTV s high bandwidth, as well as its strong foothold amongst consumers over the age of 45, and its industry leading reputation for customer service, will lead to a much lower rate of loss for the company than will occur for its competitors. These losses will be restricted to the U.S., where we project an annual loss of approximately 1% per year of subscribers. These losses, however, will be offset by the explosive growth of subscribers in Latin America, where we conservatively project 4% annual growth in the coming five years. If DTV experiences growth in Latin America in alignment with its historic 3 year CAGR of 33.4%, then revenues should be substantially higher. In addition, subscriber volatility will be offset by continued ARPU growth, which we project as increasing by 2% and 0.8% in the U.S. and Latin America, respectively. This ARPU growth is a valid expectation given DTV s continued emphasis on quality customers and its efforts to capture incremental revenue opportunities through launch of VOD/Cinema products, targeted advertising, and increased targeting of commercial segments, such as hotels and restaurants. Wireless Broadband Wireless broadband has become an essential product for many customers, and so DTV has continued efforts to expand its offerings in this area. With plans to have 40% of its subscribers using broadband via its Connected Home initiative, DTV looks to minimize churn and attract new subscribers. Strategically, DTV is focused on acquiring spectrum and expanding profitable wireless broadband service in areas where broadband is currently limited, or where competition is weak. This strategy has significant impact in Latin America, and should continue to create positive growth in both Latin America and the U.S. Satellites DTV currently has a fleet of twelve geosynchronous satellites, including eleven owned satellites and one leased satellite. They have entered into contracts for the construction and launch of two new satellites: D14, which is expected to launch in the first quarter of 2014, and D15, which is expected to launch in the fourth quarter of D14 and D15 are expected to provide additional HD, replacement, and backup capacity. Though development of these satellites carries substantive costs for DTV, once in orbit, DTV is able to experience tremendous profitability growth as it can then effectively expand its subscriber base with limited marginal cost per subscriber addition. This is a substantive benefit, especially in South America, when in competition with cable competitors who face tremendous costs in developing the infrastructure to capture new subscribers. INDUSTRY TRENDS Streaming Video As internet speeds increase and data compression technologies become more widespread, streaming video has become a viable alternative to watching TV for many consumers over the past five years. With a large increase in the number of consumers with wired broadband connections and broadband-enabled mobile devices, a significant amount of video content has become available through the internet. Some examples of legitimate streaming services that compete directly with subscription Page 6

7 TV include Netflix, Amazon, YouTube, Hulu Plus and Vudu. Apple TV, Roku and Chromecast are offering ways to bring entertainment from the computer onto the TV screen. These services allow consumers to stream TV shows and movies directly to their TVs, computers or wireless devices. Smart TVs also allow users to customize their channel lineup and watch movies and TV shows from their own streaming devices. Nonetheless, many of these services do not yet offer enough content to fully substitute a TV subscription. For example, live sporting events are often not available for streaming through these channels. Additionally, the quality and reliability of streaming services are lower than that of satellite TV. A report from consumer research firm Nielsen has noted that, although the number of people streaming online video has steadily increased over the past five years, 98.0% percent of video was still watched on a traditional TV set. The report also noted that in the past year, the number of homes with a high-definition TV grew by more than 8.0 million, to total 80.2 million. Nevertheless, in August 2013, DirecTV launched its own Pivot TV Everywhere app to allow subscribers to watch the service live on computers, smartphones and tablets. Dish followed suit by offering Dish Anywhere, a website that allows customers to instantly watch TV shows and movies, along with the Dish Anywhere App that allows the content to be viewed on a smartphone or tablet. Although the threat from streaming video was negligible for the industry in the past five years, streaming video will pose an inevitable threat to the industry in the future, as wired and wireless internet connections continue to improve and the majority of consumers switch to broadband-enabled mobile devices. Additionally, Netflix released its first independently acquired TV show in February 2013, making the entire first season available at once. Emmy Awards solidified the threat the company now poses. Amazon is investing in original programming as well, and Google Fiber is building a production facility. These new developments are not yet a severe threat, but are expected to negatively influence future revenue growth as consumers increasingly migrate to other forms of content distribution. M&A Activity Due to Escalating Program Fees Retransmission fees have grown rapidly in recent years and become a crucial component of the revenue stream for TV broadcasters. Such fees have increased from just $215M in 2006 to $2.3B in 2012, and we project the total amount to triple over the next five years. Retransmission fees are the main reason why local television has witnessed a major financial turnaround in recent years, with both market activity and valuation expanding materially in There have been 16 major acquisitions (for $100 million or more) since late 2011, and both the frequency and size of deals have increased of late. In 2013 so far, TV stations worth $9.1 billion have been bought, compared with only $1.9 billion in full-year 2012, according to data from SNL Kagan, a media research firm. Notable deals include Comcast/NBCU, Time Warner Cable/Insight, Liberty/Charter, and Charter/Optimum West, as well as several opportunistic acquisitions by Dish Network. Increased competition due to next-gen wireless broadband offerings encroachment into the industry could prompt further M&A activity. Dish notably pursued Sprint in 2013, and DTV failed in its offer to purchase Hulu. Although Dish and DTV had attempted to merge nearly a decade ago, and failed, the recently approved merger between American Airlines and US Airways has reopened conversation considering the possibility of a successful merger. Given the rise of streaming video, it is possible that the legal climate may now favor a Dish-DTV merger due to the decreased monopoly concerns. Although this has potential benefits for both companies, DTV management has not publically stated any desire to pursue such a merger, and we do not believe that such a merger is likely to occur in the near horizon due to debt issues with Dish. Fiber-to-the-Home Fiber-to-the-home (FTTH) networks, which provide broadband speeds of one Gbps and beyond, is available in over one-fifth of North American households currently. FTTH is witnessing exponential growth as telephone companies are looking to intensify their competitiveness by offering faster Internet, along with television programming. In addition, broadband providers, in general, are readying themselves for an ever-increasing consumer demand for faster networks and more bandwidth. According to the FTTH Council, an industry trade association, Verizon Inc. s deployment of all-fiber FiOS service in the US directed the sector s strides towards FTTH. About 1,000 smaller operators in the US are now offering this service to their customers. Google launched its one Gbps FTTH service in Kansas City, while Sonic.net and Paxio launched in California. Based on these recent developments, it can be inferred that FTTH is here to stay Page 7

8 and will remain strong as Telcos are trying to take the experience a notch higher. According to a survey by market research firm RVA LLC and commissioned by the FTTH Council, the small and mediumsized companies that upgraded their networks to all-fiber reported an average annual operational cost savings of 20%, mainly due to a decrease in repair and maintenance expenses. The report also highlighted that the number of households with FTTH connectivity reached 9.7 million in April 2013, up 20% from April RVA projects that total North America investment in FTTH over the next five years will be around $18 billion, while the annual direct investment is expected to reach $4.7 million by Both Verizon and AT&T Corp. are aggressively targeting cable and satellite TV customers in a battle to become the one-stop shop for all voice, video, and data feeds into homes and businesses, thanks in large part to the carriers multiyear transition to bandwidth-rich fiber technologies. Over the past several years, a rollout of fiber-based video and broadband offerings from the Telcos has ratcheted the level of head-to-head competition in the US pay TV market. Verizon began offering video on its FiOS network in three markets in As of December 31, 2012, 13.4 million homes and businesses had access to Verizon s FiOS; many of these also had access to FiOS video. The company had a 37.3% penetration rate (5.4 million customers) with its FiOS broadband service and a 33.3% penetration rate for the video service (4.7 million). In 2012, the company migrated 223,000 homes from copper network to fiber optics, and plans to migrate an additional 300,000 homes in Meanwhile, AT&T has also completed much of its fiber-tothe-node (FTTN) deployment. As of December 2012, the company s broadband video service (U-verse), including U- verse TV, had been rolled out in part of AT&T s operating territory with about eight million customers. By the end of 2015, the company plans to deploy the service to 33 million households, while increasing the downstream Internet speed up to 75 Mbps. Meanwhile, by the end of 2013, AT&T also plans to offer high speed U-verse service (known as IP DSLAM), with downstream speed of up to 45 Mbps, to 24 million customers. We believe that this trend poses serious concerns to DTV in the long-term, but that cost of implementing new FTTH infrastructure will keep encroachment at a nonthreatening pace for the next five years. MARKETS AND COMPETITION Industry Overview DTV competes in a mature industry where it is essential to take advantage of economies of scale in order to survive. With low costs per additional subscriber once satellites are in orbit, profitability increases either through subscriber additions, an increase in the number of customers paying to upgrade their service, or a direct escalation of prices for all services. Due to an expected decline in the number of subscribers, overall revenue growth is thus expected to be lower than GDP growth over the coming years. These issues are shared by DTV s competitors in both the cable and satellite markets. In order to combat the decline in subscribers, DTV and its competitors will be looking towards ways to increase ARPU. This will be achieved by improving transmission quality, increasing the quality of content options, and by improving customer service. To improve quality and client services, the DTV and its competitors will open new uplink facilities and call centers over the next five years. All competitors will strive to improve the range of HD programming while also increasing online services and mobile apps. To achieve these results, cable operators will face increased infrastructure costs, while satellite providers will need to launch additional satellites. As previously noted, DTV is already well under way in this regard, with two new satellites expected to be in orbit by the end of Industry employment is forecast to continue growing at a healthy pace as satellite TV providers hire more staff to capitalize on a budding trend within the industry: the sale of advertising space. As companies continue to provide digital content to consumers over the internet and broadband-enabled mobile devices on an on-demand basis, the potential to advertise over this transmission medium is enormous. Providers are now able to offer targeted one-to-one advertising, down to the household level, based on subscribers demographic profiles and browsing history. As the amount of digital content that satellite TV providers make available over the internet increases, advertising is expected to bring a temporary revenue stream to the industry. As consumers increasingly use online streamers to watch TV shows and movies, satellite TV providers are expected to face increasing competition. A growing number of consumers are expected to drop or reduce their traditional multichannel video programming subscription package, decreasing profit margins and slowing revenue growth. Page 8

9 Competition Other than Dish Network, cable TV providers are the biggest competition to DTV due to the similarity of the products and services. While cable provides a more reliable connection, satellite providers compete on the basis of price and perks. They bundle more services and offer a wider variety of add-ons and channels in order to attract and retain consumers. Also, a certain percentage of US homes are not wired for cable, which gives satellite providers a clear advantage to service them. Competing industries also include telephone companies, online video streamers, mobile video and local broadcasters. Broadcast TV competes against this industry; however, competition from this medium is limited due to its declining audience. Home-video products and the internet are intensifying competition as consumers increasingly view programs over the internet, through internet TV, on MP3 players, smartphones and games consoles that are linked to the internet. As mobile broadband connections become more robust and ubiquitous, broadband-enabled mobile devices that stream content are emerging as the most significant external competitor to DTV after cable TV providers. Netflix recently broadcast a content-original show and Amazon and itunes are following closely. Google introduced its new Chromecast, which allows users to bring content from the web to their TV screen. Indeed, these devices have greatly increased the prevalence of cord cutters (i.e. consumers that do not subscribe to any pay-tv services and simply stream content through the internet) over the past five years. Competition from online streamers is expected to intensify quickly over the next five years. Key Factors Monitoring competition DTV needs to be vigilant concerning pricing packages offered by its competitors, as well as in how its competitors adjust content packages. As content is increasingly being delivered through a number of other media formats, it is essential that DTV remain aware of, and react quickly to, changing viewing trends. Price to Price to Price to Enterprise Enterprise Total Company Enterprise Earnings Earnings Earnings Value/ Value/ Page 9 It is essential to monitor prices across basic and higherprice, value-added services, especially for subscriber acceptance and adoption. Customers may be willing to pay more for a service they perceive as having a higher value. Customer Service and customer loyalty Maintaining its preeminence in customer service is an essential for DTV, both nationally and internationally, because this is a key deterrent to customer churn. With the overall number of subscribers in the industry expected to diminish, dominance in customer service could be a huge differentiator for DTV as it may enable it to successfully siphon off customers from its competitors. Maintaining a reputation for fast and efficient customer service is crucial and directly related to subscriber numbers. Customers may be willing to pay more for a service if they are assured that the customer service is up to par. Total Debt/ Debt/ Enterprise Gross EBITDA Pretax Net Name Value Actual FY1 NTM Sales EBITDA EBITDA Value Margin Margin Margin Margin Comcast Corporation Class A 169, x 19.64x 17.18x 2.66x 7.28x 2.00x 27.51% 62.4% 36.5% 16.9% 10.1% DISH Network Corporation Class A 28, x 36.32x 28.15x 1.98x 8.71x 4.33x 49.77% 22.6% 22.7% 6.7% 5.1% Time Warner Cable Inc. 61, x 20.22x 17.59x 2.78x 7.70x 3.15x 40.92% 38.2% 36.1% 13.7% 8.7% Average 86, x 25.39x 20.97x 2.47x 7.90x 3.16x 39.40% 41.1% 31.7% 12.4% 8.0% DIRECTV 51, x 13.15x 11.47x 1.67x 6.61x 2.42x 36.61% 38.8% 25.3% 14.0% 9.3% Innovation in Technology DTV must adapt to the newest technology to provide new and high quality services in a timely fashion, preferably ahead of their competitors, to attract new customers and retain existing ones. With the rise of mobile and internet based viewing options, DTV s efforts to keep itself technologically relevant will be essential to its long-term profitability. ECONOMIC OUTLOOK Henry Fund Economic Outlook Given the current environment of muted economic growth due to the recent government shutdown, potential for ongoing fiscal issues, as well as continued tapering, we do not anticipate any substantial changes in the current economic outlook. We expect Real GDP growth will pull back slightly due to fiscal turmoil to a level closer to 2% versus the 2 nd Quarter 2.5%. Due to a lack of strong economic growth and little movement in energy prices, both CPI and employment growth will remain subdued at an estimated CPI of 1.5% with unemployment slightly higher at 7.3%. Interest rates may back up from the current unsustainable rates of 0.11% for the 1 year T Bill and the 2.53% for the 10 year T-Bond, but we don t expect

10 them to rise above 0.2% and 3% respectively. With limited economic growth and an increase in supplies, we estimate oil prices to remain in the $ range for the near future. With current market levels at all-time highs, a pullback of 5% from current levels is certainly not out of the question. Despite our lackluster outlook, our concerns for portfolio construction are related to longer term macro issues, most notably the upcoming Federal Reserve tapering process. We are not in a position to predict a starting point in time, but are confident that it will occur during the holding period of any new selections for the portfolio. Given our concerns regarding market impact from the changes in economic policy from the Fed, we believe that underweighting holdings that would be most severely impacted by tapering is a priority. Portfolio holdings that would be underperformers would likely include higher yielding stocks and/or sectors, as well as companies with higher financing needs. These will be areas for potential future disinvestment. Industry Economic Outlook Although new household formation and increasing per capita disposable income are expected to drive revenue growth over the next five years, the number of households that sign up for pay-tv services is expected to decrease slowly. A recent study from Nielsen states that five percent of US households are getting their information from nontraditional TV devices. Of these households, 67% get their video content on other devices, such as computers, smartphones and tablets; 48% watch TV content through subscription services. Cost is the main reason that households are not considering subscribing to traditional TV services. The percentage of revenue stemming from DirecTV s US market decreased from 84.1% in 2010 to 78.1% in 2012, and the company lost subscribers in Dish reported 3.0 million pay-tv subscriber additions in 2010 and only 2.7 million in Fewer subscribers signed up for pay-tv services, including cable and satellite subscriptions, in 2012 than in the previous year. This slowing new-subscription rate will slightly hinder growth, with industry revenue forecast to increase at a milder annualized rate of 2.4% to $43.8 billion in the five years to Revenue is forecast to stagnate in 2014, growing only 0.1% as the decreasing number of TV subscriptions is slightly offset by a growing number of subscribers upgrading to more expensive programming packages. Increasing competition from online streaming companies over the next five years is anticipated to stimulate spending on marketing and new product development, which will likely cut into the extra revenue generated from new subscriptions. Furthermore, amid this competitive environment, industry providers will likely be unable to pass rising programming costs onto their subscribers. Satellite uplink costs (i.e. transmitting between earth stations via satellite) and investment in new equipment and facilities to support the subscriber base will also contribute to a lower industry profit margin. CATALYSTS FOR GROWTH Number of cable TV subscriptions The cable industry, which competes directly with satellite TV providers, has been bundling TV services together with internet, telephone and other services to generate higher demand and average revenue per subscriber. As cable attracts consumers, market potential for satellite providers shrinks. The number of cable TV subscriptions is expected to decrease slowly during Per capita disposable income Satellite TV services are a discretionary purchase for most consumers. As such, the industry is very sensitive to changes in economic activity. Lower disposable income during the recession hurt the industry s ability to hold onto existing subscribers and attract new ones. If per capita disposable income increases in the coming years, TV could benefit from the potential opportunity. Number of mobile internet connections Over the past five years, broadband-enabled mobile devices, such as smartphones and tablets, have proliferated throughout the United States. As mobile broadband connections have become more ubiquitous and reliable, consumers are increasingly using these devices to view video content, intensifying the external competition satellite providers will face. Mobile internet connections are expected to increase in the coming years, representing a substantive threat to the industry. However, if DTV can effectively incorporate services which take advantage of mobile internet connections, it could diminish the negative impact of this disruptive force, and potentially see revenue benefits. Number of households DTV s primary market is residential households. As such, household formation provides a natural increase in potential demand for satellite services. As the number of households is expected to increase year-to-year, DTV Page 10

11 could experience benefits if they can cost effectively acquire a larger share of these new households than their competition. Consumer Confidence Index Changes in consumer sentiment directly affect discretionary expenditure, particularly on high-priced, value-added services. These expenditures decline when economic activity falters, as consumers opt to pay down loans, build their savings and conserve available income for basic needs. If consumer sentiment index increases, DTV will realize the direct benefits from customers opting for its higher margin packages. Key assumptions: Beta:.867 VALUATION Yahoo finance lists the Beta at 1.02, while other sources have the Beta at.92. However, based on averaging multiple Beta s calculated via Bloomberg over a 4 and 2 year period, it appears that a Beta of.867 is much more reasonable. Using the higher beta values would have resulted in a lower stock price and a sell recommendation. Weighted average of valuation methods The DCF and EP models did not equal each other, which we surmise is due to issues surrounding DTV s negative equity. However, with DTV not releasing dividends, making the DDM model price suspect, and projected negative growth rates for DTV in the future resulting in erratic pricing via the relative multiples method, it was necessary to heavily weight the DCF and EP prices in modeling the projected price for DTV. Debt Levels and Share Repurchases As DTV has a number of notes coming due in the years under the horizon of this model, we projected repayment of $7B of debt during the next five years. However, our assumption was that debt repayments would increase in the final two years due to cash liquidity issues. In addition, we projected DTV would fulfill its $4B share repurchase plan, but we projected this occurring in equal installments in the next five years. It may be more likely, however, that this share repurchases occur more quickly, or are abandoned in later years due to projected liquidity issues due to declining numbers of subscribers. Growth Rates Consensus estimates project over 12.3% earnings growth for DTV in the next five years. Our projections are far more bearish, however, as we project negative growth due to increased commoditization in the U.S. due to increasingly fierce competition. Though we suggest a hold on DTV at this time, we do not feel DTV should be held for the next five years, and, instead, anticipate selling DTV in the next year unless external factors dramatically change. Negative Equity DTV s share repurchase strategy currently leaves it in a negative equity position. Although we see this shifting in the coming years, it did make comparisons against peers in some valuation categories less helpful. As well, we have concerns about the overall impact of negative equity on the projections of our model. IMPORTANT DISCLAIMER This report was created by a student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. The intent of these reports is to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. Page 11

12 DIRECTV Share Price Estimate $ 71 to $ 73 Key Assumptions of Valuation Model Weight Weight DCF $ Rel P/E EPS 15 $ Ticker Symbol DTV EP $ Rel PEG EPS 14 $ (41.02) 0 Current Share Price DDM $ - 0 Rel Peg EPS 15 $ (91.70) 0 Fiscal Year End Dec. 31 Rel P/E EPS 14 $ Beta Weekly Daily Pre-Tax Cost of Debt 5.25% 2 year Beta year Risk-Free Rate 3.91% 30 year t-bond average Equity Risk-Premium 5.60% CV Growth of NOPLAT 1.00% Cost of Debt 3.52% Marginal Tax Rate 33% Cost of Equity 8.77% MV of Equity 42,006 MV of Debt 18,186 EV 60,192 E/V 69.8% D/V 30.2% WACC 7.18% 2012 Value 3 yr CAGR 5 yr CAGR 10 yr CAGR 2013E Step ARPU (U.S.) % 3.7% 4.7% % 2012 Step ARPU (LATIN AMERICA) % 1.0% 5.4% % 2012 Value 3 yr CAGR 5 yr CAGR 10 yr CAGR 2013E Step U.S. Subscriber Growth Rate 1.0% 2.2% 3.3% 5.7% 1.0% -1.00% Latin America Subscriber growth rate 31.2% 33.4% 27.7% 25.0% -3.2% 4% 3 yr CAGR 5 yr CAGR 10 yr CAGR COGS as % of Rev 52.4% 2.1% 0.9% -0.7% 52.90% 2.00% SG&A as % of Rev 22.3% -1.9% -1.8% -3.6% 22% -0.30% PP&E Gross % 11.6% 17.6% 12.00% LT Debt Pmt Share Repurchase 666,666, ,666, ,666, ,666, ,666, ,666,667 ($4 billion allocated) Page 12

13 DIRECTV Revenue Decomposition Fiscal Years Ending Dec E 2014E 2015E 2016E 2017E 2018E Revenues DIRECTV U.S. 20,268 21,872 23,235 24,602 23,607 23,598 23,348 22,863 22,154 Sky Brasil 2,013 3,020 3,501 3,804 PanAmericana 1,584 2,076 2,743 3,006 DIRECTV Latin America 3,597 5,096 6,244 6,810 7,034 7,431 8,150 9,266 10,910 Sports Networks, Eliminations and Other Total 24,102 27,226 29,740 31,661 30,902 31,289 31,758 32,389 33,324 Revenue Growth 11.8% 13.0% 9.2% 6.5% -2.4% 1.3% 1.5% 2.0% 2.9% % of Revenues DIRECTV U.S. 84.1% 80.3% 78.1% 77.7% 76.4% 75.4% 73.5% 70.6% 66.5% Sky Brasil 8.4% 11.1% 11.8% 12.0% PanAmericana 6.6% 7.6% 9.2% 9.5% DIRECTV Latin America 14.9% 18.7% 21.0% 21.5% 22.8% 23.7% 25.7% 28.6% 32.7% Sports Networks, Eliminations and Other 1.0% 0.9% 0.9% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% ARPU DirecTV U.S. Total number of subscribers (in thousands) 19,223 19,885 20, ARPU DirecTV Latin America ARPU DIRECTV Weighted Average Cost of Capital (WACC) Estimation Beta Pre-tax Cost of Debt 5.25% Risk Free Rate 3.91% Tax rate 33% Risk Premium 5.60% Cost of Equity 8.77% Cost of Debt 3.52% MV of Equity 42,006 E/V 69.79% MV of Debt 18,186 D/V 30.21% Enterprise Value WACC 7.18% Page 13

14 DIRECTV Income Statement Fiscal Years Ending Dec E 2014E 2015E 2016E 2017E 2018E Sales/Revenue ,661 30,902 31,289 31,758 32,389 33,324 COGS ,749 16,965 17,803 18,705 19,725 20,961 Depreciation & Amortization Expense ,287 2,457 2,774 3,206 3,738 4,199 Gross Income ,626 11,479 10,711 9,846 8,926 8,164 SG&A Expense ,965 6,706 6,696 6,701 6,737 6,831 EBIT (Operating Income) ,660 4,774 4,016 3,145 2,190 1,333 Nonoperating Income (Expense) - Net Interest Expense Unusual Expense (Income) - Net Pretax Income ,247 4,378 3,745 2,890 1,953 1,048 Income Taxes ,732 1,445 1, Net Income ,516 2,933 2,509 1,936 1, EPS (recurring) Basic Shares Outstanding DIRECTV Common Size Income Statement Fiscal Years Ending Dec E 2014E 2015E 2016E 2017E 2018E Sales/Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% COGS 50.2% 51.3% 52.4% 52.9% 54.9% 56.9% 58.9% 60.9% 62.9% Depreciation & Amortization Expense 10.3% 8.6% 8.2% 7.2% 8.0% 8.9% 10.1% 11.5% 12.6% Gross Income 39.5% 40.1% 39.4% 39.9% 37.1% 34.2% 31.0% 27.6% 24.5% SG&A Expense 23.2% 23.1% 22.3% 22.0% 21.7% 21.4% 21.1% 20.8% 20.5% EBIT (Operating Income) 16.3% 17.0% 17.1% 17.9% 15.4% 12.8% 9.9% 6.8% 4.0% Nonoperating Income (Expense) - Net 0.6% 0.5% 0.9% 0.7% 0.6% 0.8% 0.7% 0.7% 0.4% Interest Expense 2.3% 2.8% 2.8% 1.8% 1.6% 1.4% 1.3% 1.2% 1.1% Unusual Expense (Income) - Net 0.0% 0.1% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% Pretax Income 14.6% 14.6% 14.9% 16.6% 14.2% 12.0% 9.1% 6.0% 3.1% Income Taxes 5.0% 5.0% 4.9% 5.5% 4.7% 3.9% 3.0% 2.0% 1.0% Net Income 9.1% 9.6% 9.9% 11.1% 9.5% 8.0% 6.1% 4.0% 2.1% Page 14