Erik Kobayashi-Solomon: I'm Erik Kobayashi-Solomon, one of the editors of Morningstar's OptionInvestor, and today it's my great pleasure to welcome Mike Hodel, who is an associate director here, covering telecom companies. Mike, thanks for coming.
Mike Hodel: Thanks for having me here.
Kobayashi-Solomon: A couple days ago, I wrote an article about DirecTV, a company that you cover. You had convinced me, and I think that you have a really good point, that it seems like they're running out of room economically, that their stock price seems to be a little bit high.
So I wrote an option strategy trying to take advantage of that. Can you explain a little bit your thinking about DirecTV, and why you think the stock is looking a little toppy right now?
Hodel: Sure. I guess at the outset, I'd point out that DirecTV has executed extremely well over the past couple of years. They've done a great job of marketing their service, building the brand, continuing to provide good service and grow their customer base, and grow cash flow as well.
But what we really see from this point forward, though, is that competition in the pay television industry continues to increase. You have phone companies, Verizon and AT&T in particular, that are steadily building out their network capability so they can offer television service to a larger percentage of their customers.
We also see maturity in the pay television business, so the number of new customers out there is declining as well.Read Full Transcript
Kobayashi-Solomon: Right. Now, you mentioned Verizon and AT&T. I know that they can offer television service, but can DirecTV offer things like cable, and... How do you say it? Cable, and Internet access or phone service?
Hodel: Not generally, no. The satellite guys, at this point, are television only. They do offer packages of service in conjunction with the phone companies.
So the phone companies, AT&T, Verizon, Qwest, are marketing satellite television service in conjunction with Internet access and phone service that they provide, but in terms of offering Internet access or phone service over satellite, they're not doing that generally today.
Kobayashi-Solomon: OK. So in other words, the competitors have a foot in on their business, but they don't have a foot in on the other guys.
Hodel: That's right. So we think that the cable guys are doing a good job of solidifying their customer base by increasing the percentage of their customers that take multiple services. You also have the phone guys who are skimming a large percentage of what industry growth there is out.
So historically, as the pay television business has grown, the satellite guys have captured most of that growth, but you're starting to see the phone companies usurp that position. And the satellite guys, they're still growing, they're just not growing nearly as quickly as they were three years ago, say.
Kobayashi-Solomon: See, this is another thing I wanted to ask you about. Looking at your model, I see you have growth really tapering off, and I wonder, what's your thinking about that growth model? Do you think that they're just going to hit a wall?
Hodel: We do think that the satellite guys are reaching the peak in terms the number of customers that they will ultimately serve. That includes DirecTV and Dish Network, their main satellite rival.
There's one scenario where you could see increased subscriber growth at DirecTV and Dish, and that would be if they become more aggressive on price. But if you do get into a price war where DirecTV or Dish starts to buy market share by lowering prices, you'd expect to see a hit to their margins as well.
The one constant in the pay television industry, is that the cost of content is steadily increasing. So what you pay to Viacom, Disney, News Corp, is steadily rising. So if you're discounting the prices that you're offering consumers, you're taking a hit directly in your margin, because that cost isn't coming down.
Kobayashi-Solomon: So their top line could continue to look pretty strong, but their bottom line...
Hodel: That's a potential. So again, the one thing that could impact our... Or make us look wrong on the subscriber count, is if they discount more aggressively, but we'd expect them to have an offsetting hit to their margins as well.
Kobayashi-Solomon: So net, net, it works out.
Kobayashi-Solomon: Now, is there anything else that I should be thinking about with a bearish position in DirecTV?
Hodel: The biggest risk, I think, here, is that DirecTV is acquired by one of the phone companies. AT&T and Verizon, again, would be the most likely to acquire in a situation like that, but we don't expect that to happen.
We think that AT&T, and Verizon especially, will be content to use their own networks for their video strategy. The portion of the video strategies that they own, and they'll be content to resell satellite service, rather than making an acquisition.
And if we did see an acquisition, we'd expect Dish Network to go first, simply because their valuation is much more compelling right now than DirecTV's, if all you want is the capability to offer satellite service and a customer base. You can buy those assets much more cheaply with Dish Network today.
Kobayashi-Solomon: I see. Well Mike, thanks a lot for the insights on this company. I sure appreciate it.
Hodel: Thank you. My pleasure.
Kobayashi-Solomon: And thank you for joining us. Please stop by the Morningstar OptionInvestor site. We have many more ideas about how to use options to transact and invest using Morningstar's fundamental research.