Dollars And Sense: Valuing The Possibility Of A DISH/GMH Merger

By Armand Musey

As of mid-January, shares of all three DBS companies had risen an average of 40 percent from their post-September 11th lows and were approaching our pre-merger-announcement, 2002 year-end price targets. We believe richer valuations reflected improved industry fundamentals, since throughout the past two quarters all three DBS companies have made progress at lowering subscriber acquisition costs (SAC) and put policies in place that should lower churn. However, the fourth quarter’s strong performance also reflected speculation over the potential synergies that would be created by a merger of Echostar and Hughes.

The potential benefits from a merger of Echostar and Hughes could result in significant upside for both Dish and GMH shareholders, even at current levels. We have created a consolidated post-merger model that forecasts total synergies worth nearly $11 billion to current shareholders. After accounting for the incremental debt that will be required to redeem GM’s interest in Hughes and the resulting pro forma change in ownership structure, we estimate that this translates to a 2002 post-merger price target for current shares of DISH of $36 and for current shares of GMH of $26.

At this point, though, we believe the chance of this upside being realized is far from certain. We think the DOJ will be responsive to evaluating the merger in terms of multichannel television rather than just satellite television, based on precedents set at the time of Hughes’ acquisition of Primestar. However, even under this broader interpretation of the market, approval will still be an uphill battle, as a Dish/DirecTV merger would lead to market concentration levels that the DOJ is likely to consider problematic on a national level and that are most definitely troublesome in rural markets.

This being the case, the impetus is on the management of Echostar and Hughes to provide a compelling argument that consumers will be better off as a result of the merger. Echostar and Hughes have framed such an argument in the context that the merger would end duplicative transmission of about three-quarters of each service’s total channels, freeing up spectrum for more local programming, which would allow DBS to be a stronger competitor to cable. They have also argued that a merger is the only way to develop the economies of scale necessary to guarantee the rural United States competitively priced broadband access.

Frankly, we are not persuaded by either argument. Our analysis indicates that both companies will have sufficient capacity to comply with must-carry regulations once new spotbeam satellites are operational. Moreover, if capacity is truly an issue, next-generation Ka-band satellites could be available before a merged Dish and DirecTV could swap-out their old set-top boxes in order to be able to share spectrum. We also do not believe the DOJ will find the need for economies of scale in developing a broadband offering compelling enough to override market concentration concerns with regard to multichannel television, given the alternative solution of a broadband joint venture.

In the event of a broken deal, DirecTV’s competitive position is likely to be damaged. By the time the merger is resolved, DirecTV will have been in merger negotiations for two years. Not only is this likely to have compromised its strategic planning ability, it would not be surprising to see management defections and retailer disruptions. We note that General Motors has structured the deal so that Hughes would be “fully funded” in the event of cancellation. However, this assumes lower-than-historical capital expenditure levels that would leave DirecTV vulnerable to market share loss to Dish.

Given the high level of uncertainty and the different returns from various possible outcomes, we developed a framework for valuing DISH and GMH that incorporated four potential merger outcomes: two successful merger scenarios, and two unsuccessful merger scenarios. We model each scenario separately to derive a 2002 price target for DISH and GMH for each outcome. We then assign each outcome a probability in order to derive our new 2002 year-end price targets for DISH of $31, up from our pre-merger announcement target of $27, and for GMH of $20, up from $18. This indicates to us that unless further information comes out of Washington indicating an improved probability of approval, much of the potential upside from a merger has already been priced into the shares of DISH and GMH.

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.