Dollars and Sense: The Evolving Broadband Business Model

by Armand Musey

Recently, Hughes Network Systems (HNS) held a press and investor luncheon in New York to unveil DirecWay, its next generation of two-way broadband satellite services. In our opinion, the two most important points from this meeting were that DirecWay will be sold to the consumer market principally through a wholesale distribution model, and that HNS is targeting the consumer, SOHO (small office/home office), and enterprise markets with a common offering.

The potential market for broadband satellite services is significant. A year ago, there might have been too many proposed offerings, but weak capital markets have thinned their ranks to a more realistic number. However, given investors’ and corporate parents’ current lack of patience for far-away earnings stories, the surviving service providers are under pressure to demonstrate a clear route to profitability.

Because a satellite distribution platform cannot be built-out incrementally like cable or DSL, the only way for these services to lower their cash requirement is to reduce subscriber acquisition costs (SAC). Among the services currently on the market, and in the later stages of development, we are seeing two principal strategies to reduce SAC: find a distribution partner, and consolidate the market offering. HNS’s approach with DirecWay encompasses both.

The least expensive way for a broadband satellite service to find a distribution partner is to offer the service wholesale, usually to an ISP or DBS provider for a straight monthly fee, and let them deal with subscriber acquisition and maintenance cost. This model has its pros and cons. While it speeds-up market penetration and mitigates upfront SAC it will also limit HNS’s future returns because DirecWay does not own the customer and thus will have a hard time increasing its monthly ARPU (average revenue per user).

When Starband announced it would be relying largely on a wholesale distribution model it was understood, in light of the venture’s inability to find financing in current markets. However, given HNS’s relatively deep-pocketed parent, we believe DirecWay’s decision to follow suit is somewhat shortsighted and suspect management’s principal motivation is to reduce cash needs to make a potential acquisition of Hughes more palatable to an acquirer.

Assuming that DirecWay’s consumer SAC is $500, as HNS is forecasting, total savings in 2002 would be $250 million, given our forecast for 500,000 gross subscriber additions. However, as DirecWay is a low fixed-cost, high variable-cost Ku-band system, there is little long-term margin upside from growing a wholesale subscriber base to cover fixed costs, as with the high-fixed cost, low-variable cost Ka-band business model.

On the other hand, we applaud HNS’s decision to target the consumer, SOHO and enterprise markets with a common offering because this strategy lowers SAC, although clearly to a lesser extent than the decision to utilize wholesale distribution, without limiting future returns. Savings are generated by standardizing the equipment package to generate economies of scale faster. We also suspect there is significant marketing synergies due to an overlap in customer base.

All of this points to some strong arguments for a joint VSAT (Very Small Aperture Terminal) and broadband service offering. For one, the equipment for VSAT networks and these broadband satellite services is very similar. The VSAT business is becoming increasingly cost sensitive, which gives the VSAT providers strong economic incentives to produce equipment for broadband services in order to generate economies of scale. Gilat has already combined equipment development and manufacturing for Starband and Skyblaster for just this reason.

Moreover, as high-end VSATs become more sophisticated, functionality will be more and more similar to that of these broadband satellite services. We expect VSAT networks to be increasingly used for higher bandwidth applications including a wide range of interactive, online data, two-way voice and multimedia functions. At the same time the technology being developed to improve the networking ability of VSATs may have huge potential in broadband satellite applications. As this evolution occurs there will be substantial convergence between the two services.

This could lead to a significant opportunity for some of the smaller VSAT providers to become equipment suppliers for the proposed Ka-band services. Over the past decade HNS has maintained its hold on roughly 50 percent of the global VSAT market, while Gilat has emerged from nowhere to capture most of the rest of the market, until it began to look as if no other players would remain. However, HNS is aligned with DirecWay and will be launching Spaceway in 2003, and Gilat is aligned with Starband. We suspect that proposed Ka- band services are not particularly eager to do business with the competition.

Last year, military satcom provider, Viasat, acquired the satellite network business of Scientific-Atlanta (S-A). Although S-A was far from a strong player in the VSAT business, the transaction gave Viasat the scope to win preliminary equipment development contracts from Astrolink, Wildblue and Connexion by Boeing. We believe if any one of the these proposed services is a success it could be a blockbuster for Viasat in terms of top-line growth, and there are still other opportunities out there for Viasat and its smaller brethren.

Armand Musey is the satellite communications analyst at Salomon Smith Barney (“SSB”). He can be reached at 212-816-6008. 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.