Dollars And Sense: DBS Stocks Become More Appealing

by Armand Musey

After a significant sell-off following the World Trade Center (WTC) attack, we raised our ratings on the DBS companies. At the time, all three stocks were trading at 52-week lows, having underperformed other media stocks, with an average 52-week decline of 70 percent. However, our change of heart was underpinned by more than just depressed share prices. Lately we have witnessed several credible efforts at all three companies to address the deterioration of the DBS business model, which had caused us to become negative on the group in the first place. We are now looking for improved results as they transition their focus from subscriber growth to cash flow generation.

The first step the DBS companies made to improve their business model was to increase their emphasis on leasing plans. These plans lower subscriber acquisition costs (SAC) because the equipment is recovered and can be reconditioned for another subscriber. This means its cost can be spread over its useful life, rather than the typically shorter life of a subscriber. The lease model also guards against cable buy-back programs because subscribers cannot sell equipment if they do not own it. Subscribers who do not opt for the lease model are increasingly being required to pay more for the equipment or make an upfront commitment to subscribe for a certain length of time, reducing the upfront risk for the DBS companies.

Over the long-term, reforming the retail channel will be more important. DBS companies have already begun to incentivize retailers to provide fewer, but better quality subscribers. DirecTV is renegotiating its retail commission structure so that a greater part comes in the form of payments upon customer activation or in residual payments. Pegasus has begun to differentiate its retailers based on activation levels, and is penalizing those with a high level of non-activations. However, in the long-term, the DBS industry must wean its dependency on the retail channel, a delicate matter, particularly for DirecTV, given the risk of alienating this important sector.

The DBS companies are also beefing-up their direct sales capabilities. These subscribers have the lowest SAC (principally due to lower sales commission) and DBS management teams believe they are often higher quality subscribers because they have more control over sales practices. This means adding salespeople and investing in internal marketing capabilities such as customer referral programs, direct marketing, and targeted attacks on specific cable systems. Echostar and Pegasus currently have the strongest direct-sales capabilities, while DirecTV is working hard to catch up. We understand that Echostar sells over 10 percent of its new subs directly.

Finally, the industry is beginning to deal with piracy. There are an estimated 500,000 to one million pirated DBS receivers in the United States, which translates to $300 million to $600 million in lost revenues per year. This problem is most acute for DirecTV, which is in the process of a system-wide upgrade to boxes that can be reprogrammed remotely to help offset piracy. All three companies have also taken steps to better monitor activation rates. Over the long term, better management of the retail channel and an increased emphasis on lease sales and direct sales should help guard against piracy by reducing the number of boxes that are sold just to be stripped of their program cards.

In the current environment, investors are concerned about companies’ ability to generate sufficient cash flow to cover operating and financing needs as well as planned capital expenditures. Lower SAC and longer subscriber lives are the keys to improved cash flow. We look for improved cash flow economics from the DBS companies as they transition their business model.

As we enter an economic turndown, subscriber growth may drop off with overall consumer expenditures, as we witnessed prior to the WTC attack. However, instability brought about by this tragedy should offset some drop in demand, particularly in rural areas, as people’s underlying desire to be better connected and informed via television rises. Exogenous variables aside, we estimate transitioning pirated customers to a subscription model would alone be enough to help maintain solid growth. We believe DBS companies will be increasingly valued for the ability to generate cash flow as opposed to just growing their subscriber base. We do not necessarily view slower subscriber growth as a negative, as long as the subscribers that are added have good economic characteristics.

Finally, we expect any announcement of a successful bid to acquire Hughes will serve as a positive catalyst for DBS share prices. The multi-channel industry has reached a mature level of saturation. We believe DirecTV and Echostar have been reluctant to transition from subscriber growth strategies to cash flow stories as they do not want the consequent disruption of their shareholder base, and the temporary weak share prices that would ensue. Consequently, we believe they have been trying to “force growth” to maintain appearances. Once the “Hughes issue” is settled, we believe that the DBS companies will be able to fully focus on cash flow, which would be to the long-term benefit of their shareholders.

Armand Musey is the satellite communications analyst at Salomon Smith Barney (SSB). The foregoing article should not be considered as a recommendation with respect to any security. SSB and its affiliates may maintain a long or short position in, act as a market maker for, or purchase or sell a position in, securities of referenced entities and may also perform investment banking, advisory, or other services for any such entity.