Dollars And Sense: Hughes/Echostar Merger Consolidation: Will It Succeed?
by Armand Musey
As we enter 2002 the biggest question facing satellite investors is whether regulators will approve the merger of Hughes and Echostar. Members of both management teams, led by Echostar CEO Charles Ergen, have been telling investors they are confident that the deal will pass, citing the “overwhelming benefits” for rural U.S. markets that would result from the merger. Detractors of the deal point to the overwhelming market share the combined entity would have, the potential for monopoly price gouging and the disincentive to roll-out new services rapidly due to a lack of competition. We believe that Ergen may find it easier to convince investors of the merger benefits than he will regulators, and estimate the deal has less than a 50 percent chance of succeeding.
Proponents of the merger argue that the market in question can no longer be defined as satellite television only, but must be looked at in terms of all multichannel video programming. They contend that a combination of Hughes and Echostar would actually benefit consumers because it would better position itself to compete against cable. They point to the elimination of duplicative transmissions, which would free up spectrum to increase the number of channels that could be offered, and to the significant economies of scale that would be created, permitting a reduction in prices and/or an accelerated roll-out of new services. Finally, they propose a national pricing policy, which they argue would benefit rural subscribers because of DBS’ need to compete with cable in urban markets.
We believe it is fair to characterize the market in terms of all multichannel video programming and suspect that the Justice Department is likely to concur. However, we suspect that even under this interpretation it may still be hard for the merger to gain regulatory approval as the resulting Herfindahl-Hirschman Index (HHI)–which is how regulators measure market concentration–will be too high in their view to safeguard consumers. The fact of the matter is, in most of the rural United States there are three primary providers of multichannel video programming, Echostar, Hughes and a local cable company. The merger of Hughes and Echostar would reduce the number of competitors from three to two, and from two to none in many markets.
Moreover, in most smaller markets, local cable companies do not represent a competitive alternative to DBS. These companies do not have the breadth of DBS programming, nor do they have the financial wherewithal to invest in a digital upgrade of their plants or the next generation of enhanced services. A combination of Hughes and Echostar could weaken these companies’ competitive position still further, which would result in even fewer options for consumers in a large portion of the country.
We also find the argument that this merger is necessary for DBS to compete with cable less than completely compelling. The introduction of new compression technology and PVRs, as well as the upcoming launch of new spotbeam satellites and opening of Ka- spectrum, should reduce spectrum constraints significantly, leaving excess capacity for new channels or HDTV programming even after each company complies with “must carry” regulations. Finally, we project that most of DBS’ growth will come from increased penetration into rural markets with limited consumer options, and that increasingly, most urban subscribers who choose DBS will do so because of programming differentiation. This negates much of the rationale for an aggressive uniform national pricing policy. This is particularly true for broadband satellite services, which we believe will largely be a rural offering as satellite’s return path performance profile is unlikely to be competitive with an urban digital cable plant.
If regulators fail to approve the merger, Hughes’ competitive position is likely to be damaged, benefiting Echostar. At the same time, we do not believe that Echostar’s breakup penalty is all that arduous. Echostar would be forced to pay Hughes $600 million and it has agreed to buy Hughes’ interest in Panamsat. While $600 million in not an unsubstantial sum, we believe Echostar’s agreement to purchase Panamsat for roughly $22.50 per share amounts to a forward contract on controlling interest in that company at roughly its 52-week low and a significant discount to fair value. Panamsat is a blue-chip property that generates significant amounts of high-quality free cash flow. Moreover, after Panamsat refinances its $1.7 billion note to Hughes it should have close to $600 million in cash on its balance sheet.
Net-net on this deal, Echostar wins if it is approved and Echostar wins if it is not approved. Hughes shareholders could benefit more if the deal is approved, but could face downside risk if it is not, which is somewhat more likely to be the case. We believe this is confirmed by the large spread that developed between the shares of the two companies almost immediately following the announcement of the deal and continued to widen thereafter. With Echostar trading at a premium to fair value and its relative transaction value, and Hughes trading at a discount, it seems that most investors are agreeing with our assessment of the situation.
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.