EchoStar’s Free Cash Flow Soars

Littleton, Colo.-based EchoStar Communications [Nasdaq: DISH], fueled by a gain of 270,000 net new subscribers, flexed its financial muscle during the second quarter by sharply boosting free cash flow, revenue and net income.

Industry analysts reacted positively to the news, despite a number of problems acknowledged by company officials in regulatory filings last week that could slow EchoStar’s momentum for improved performance.

EchoStar’s free cash flow, an important measure of liquidity, jumped to $151 million for the second quarter, up dramatically from $33 million for the corresponding period in 2002. The 2003 free cash flow includes one-time occurrences, such as the positive impact of a litigation settlement and the negative impact of a $50 million deposit paid to SES Americom for the use of a satellite that is to be launched during 2004.

Free cash flow, defined as net cash flow from operating activities, minus purchases of property and equipment, is significant because it measures the amount of cash generated during a given period that is available for debt obligations and investments other than purchasing property and equipment. Indeed, many investors look upon companies with strong free cash flow with admiring eyes.

Net cash flows from operating activities, another financial measurement of interest to investors, climbed to $248 million during the second quarter, up 42 percent from $175 million for the same quarter a year ago.

EchoStar’s surging free cash flow surpassed the estimates of four out of five Wall Street satellite analysts surveyed by SATELLITE NEWS.

The company’s second quarter 2003 free cash flow of $151 million well exceeded the estimates of:

• $69 million by Lehman Brothers’ Vijay Jayant;
• $100 million from Merrill Lynch’s Marc Nabi;
• $109 million by Bear Stearns’ Robert Peck; and
• $136 million from Deutsche Bank’s Karim Zia.

Only Benjamin Swinburne, the satellite analyst at Morgan Stanley, estimated free cash flow that exceeded the actual figure. He predicted EchoStar’s free cash flow would reach $160 million.

Financial Firepower

EchoStar’s second quarter revenues hit $1.41 billion, a healthy 21 percent jump from $1.17 billion for the same quarter last year. The subscriber gain lifted EchoStar’s total customer base to approximately 8.8 million at the end of June 2003, and sent net income rocketing to $129 million for the second quarter, compared to net income of $37 million during the same quarter in 2002.

In addition, EchoStar’s earnings per share jumped to 27 cents during the second quarter, up from 8 cents a share for the same quarter last year.

Net income for the second quarter was aided by reduced subscriber acquisition costs of roughly $34.4 million, primarily due to a litigation settlement that entailed a $34.4 million reimbursement for pre-paid subsidies on the sale of set-top box equipment. Net income for the same period in 2002 included income from favorable legal resolutions totaling approximately $10 million and an adjustment of approximately $17 million related to royalty expenses, company officials said.

Jimmy Schaeffler, a satellite broadcasting analyst who heads The Carmel Group consulting firm, of Carmel-by-the-Sea, Calif., said EchoStar achieved another “banner quarter.”

The improved results raised the bar yet again for competition among satellite TV and cable TV operators, Schaeffler said. The competitive model in the multichannel marketplace is working well, he said. “That’s really the bottom line, and it’s a good one,” Schaeffler said.

EchoStar also is looking for future growth through its EchoStar X satellite, a high-powered spacecraft that will be ready in 2005. EchoStar X will provide EchoStar with spot- beam capacity to deliver local stations throughout the United States and to offer value-added services.

Risks Remain

However, EchoStar’s strong performance and favorable reviews from industry analysts do not eliminate significant risks faced by the company. Those risks, according to a 10-Q document filed with the Securities and Exchange Commission on Aug. 13, include:

• Intense and increasing competition from the cable TV industry. Cable TV competitor Cablevision Systems [NYSE: CVC] is entering the satellite TV business with advanced technologies that may well heighten competition (SN, July 28);
• EchoStar’s subscriber growth may decrease, while subscriber turnover and subscriber acquisition costs may rise;
• Pirating of satellite TV signals is an industry-wide problem in the United States and likely will continue in the future. The unresolved issue costs both satellite TV and cable TV operators potential subscribers and revenues;
• Programming costs have been on the rise and may increase beyond current expectations, despite the company’s best efforts to curb the attempts by programmers to jack up prices;
• No commercial insurance is held to cover potential losses from the failure of satellite launches and/or in-orbit satellites. The company also has claims pending with insurers for hundreds of millions of dollars that it may not be able to settle;
• Service interruptions arising from technical anomalies on board in-orbit satellites or on ground components due to war, terrorist activities or natural disasters may cause customer cancellations or otherwise harm the company’s business;
• Retransmission consents, Federal Communications Commission authorizations and export licenses can be difficult to obtain;
• The company’s propensity to become embroiled in legal disputes has left it in the midst of various lawsuits which, if adversely decided, could have a significant adverse impact on EchoStar’s business;
• Patent licenses from holders of intellectual property needed to redesign the company’s products to avoid patent infringement could prove unattainable;
• Sales of digital equipment and related services to international direct-to-home service providers may decrease;
• Weakness in the global or U.S. economy may harm business generally and adverse local political or economic developments may occur in markets where EchoStar operates;
• A high degree of leverage puts numerous constraints on the company’s ability to raise additional debt; and
• In-orbit satellite problems have plagued the company, while further malfunctions of its spacecraft recently have occurred and additional anomalies may ensue.

In-orbit Anomalies

The latest in-orbit anomalies on EchoStar’s fleet include the EchoStar III, EchoStar V and EchoStar VIII satellites.

For EchoStar III, a transponder pair failed in June that caused a temporary interruption of service. Operation of the satellite was quickly restored but, combined with the six transponder pairs that malfunctioned in prior years, the latest anomaly leaves the spacecraft with a total of 14 inoperable transponders.

Originally designed to operate a maximum of 32 transponders at any given time, the EchoStar III satellite is equipped with 44 transponders to provide redundancy. Now, only 30 of the transponders are operable. However, EchoStar is licensed by the FCC to operate just 11 transponders at the 61.5-degree orbital location, along with an additional six leased transponders at the same slot where EchoStar III is positioned. As a result, EchoStar could withstand further transponder failures on the satellite without affecting its customers.

The EchoStar V satellite has lingering problems stemming from anomalies during 2000, 2001 and 2002, in which three solar array strings on the spacecraft were lost. The satellite incurred further problems in January 2003 that resulted in the loss of an additional solar array string.

Consequently, the EchoStar V has a total of approximately 96 solar array strings and approximately 92 are required to ensure full power availability for the estimated 12-year design life of the satellite. An additional problem occurred during January 2003 when an EchoStar V electronic component affected the spacecraft’s ability to receive telemetry from certain on-board equipment. Other methods of communication have been established to alleviate the effects of the flaw.

The solar array and electronic component anomalies have not affected commercial operation of the EchoStar V satellite but an investigation into the problem is continuing. Until the root cause of the anomalies is determined, there can be no assurance future anomalies will not cause further losses that could impact commercial operation of the satellite, company officials acknowledged in the SEC filing.

The EchoStar VIII satellite experienced anomalies during June and July 2003 that temporarily halted rotation of one of two on-board solar arrays that rotate continuously to maintain optimal exposure to the sun.

The faulty array currently is fully functional but rotating in a mode recommended by the satellite manufacturer that is different than the originally prescribed method. An investigation of the solar array anomalies is continuing. No impact on commercial operation of the satellite has occurred thus far, company officials said. However, unless the root cause of these anomalies is finally determined, there can be no assurance future anomalies will not cause losses that could affect commercial operation of the satellite, EchoStar officials explained.

EchoStar still has not been paid any portion of a $219.3 million insurance claim filed in 1998 for a “total loss” of the EchoStar IV. The company subsequently rejected an offer by the insurance carriers to pay approximately $88 million, or 40 percent of the total policy amount, to settle the EchoStar IV insurance claim. The insurers assert, among other things, that EchoStar IV was not a total loss and that EchoStar did not abide by the terms of the insurance policy.

In response, EchoStar filed arbitration claims against the insurers for breach of contract, failure to pay a valid insurance claim and bad faith denial of a valid claim, among other things.

Due to individual forum selection clauses in the insurance policies, EchoStar is pursuing its arbitration claims against Ace Bermuda Insurance in London, England, and its arbitration claims against dozens of other insurance carriers in New York. The New York arbitration commenced on April 28 and was followed by two weeks of hearings. The arbitration will resume on Sept. 16. The parties to the London arbitration have agreed to stay that proceeding pending a ruling in the New York arbitration.

Since the indentures of EchoStar’s senior notes contain restrictive covenants that require the company to maintain satellite insurance on at least half of the spacecraft it owns or leases, EchoStar has set aside $135.2 million in cash reserves to provide self-insurance. That move was necessary when the insurance policies for EchoStar I through EchoStar VIII expired and the company was unable to obtain insurance on terms that it considered acceptable.

–Paul Dykewicz

(Vijay Jayant, Lehman Brothers, 212/526 6019; Marc Nabi, Merrill Lynch, 212/449-2468; Robert Peck, Bear Stearns, 212/272-6665; Karim Zia, Deutsche Bank, 212/250-7591; Benjamin Swinburne, Morgan Stanley, 212/761-7527; Jimmy Schaeffler, The Carmel Group, 831/643-2222)