EchoStar’s Growth Trend Slows

Englewood, Colo.-based EchoStar Communications’ [Nasdaq: DISH] third quarter subscriber numbers fell short of consensus Wall Street estimates, leaving many analysts uncertain about its future growth.

EchoStar had 285,000 net new subscribers during the third quarter of 2003, slipping below consensus estimates of 300,000 to 325,000. Despite the shortfall, EchoStar managed to build its total subscriber base to approximately 9 million subscribers at the end of the third quarter and boosted its revenue 19 percent to $1.45 billion from $1.22 billion during the same period of 2002.

Thomas Eagan, a satellite and cable analyst at Oppenheimer, described EchoStar’s results as “generally disappointing” and noted that EchoStar fell far short of rival DirecTV, which posted 326,000 net new subscribers for the quarter. Indeed, this marks the first time since the first quarter of 2002 that EchoStar failed to top DirecTV in net new subscribers.

EchoStar subscribers may have switched to DirecTV to receive the latter’s exclusive NFL Sunday Ticket programming. If so, that situation would pose a concern for the fourth quarter if further EchoStar customers converted to DirecTV in October.

EchoStar’s overall subscriber growth helped to lift its net income to $35 million for the quarter, compared to a net loss of $168 million for the same period in 2002. Basic earnings climbed to 7 cents a share for the third quarter, compared to a loss per share of 35 cents for the third quarter of 2002. Net income for the latest third quarter included the negative effects of a $25 million charge from the partial redemption of EchoStar DBS Corp.’s 9 1/8 percent senior notes due 2009, while the net loss for the third quarter of 2002 included $138 million in charges from non-recurring items.

Overall, EchoStar’s third quarter results were “somewhat” disappointing, according to Vijay Jayant, a satellite and cable analyst with Lehman Brothers.

Aside from reduced subscriber gains, other key metrics that failed to meet expectations included churn and average revenue per subscriber (ARPU), Jayant wrote to his clients last week. Monthly churn of 1.71 percent was slightly better than the 1.78 percent EchoStar reported in the third quarter last year but not as good as the 1.6 percent estimate of Lehman Brothers. The company’s ARPU of $50.79 fell short of Lehman’s $51.58 estimate due to promotions during the quarter that offered free and discounted programming.

Doug Shapiro, an analyst with Banc of America Securities, said he believed the company’s earnings shortfall during the third quarter was overblown. “We think the ARPU weakness was a function of the nature of promotions, not an indication of deteriorating pricing power,” Shapiro wrote to his clients.

Benjamin Swinburne, a Morgan Stanley satellite analyst, said he expects additional local into local and digital video recorder (DVR) penetration among EchoStar’s subscriber base to “drive” gross additions and to improve churn numbers during 2004.

EchoStar officials blamed lower net subscriber additions and higher churn during the quarter to delays in the delivery of several new products, such as DVRs. A number of these new products are to be deployed in the fourth quarter and completely rolled out in the first quarter of 2004, Jayant explained.

Bob Peck, a satellite analyst at Bear Stearns, predicted that EchoStar’s monthly churn rate for the third quarter would be 1.74 percent, very close to the actual churn rate of 1.71 percent.

EchoStar’s gross subscriber additions of 744,000 during the most recent quarter fell only marginally below the 755,000 estimate of Lehman Brothers, Jayant wrote. Subscriber acquisition costs (SAC) per gross subscriber addition hit $466, close to the investment firm’s estimate, while cash SAC per gross addition of $501 was slightly higher than Lehman Brothers’ $493 estimate.

The company’s recent decision to buy up to $1 billion of its common stock is “positive” for several reasons, Jayant said. One, it signals that management believes its stock is undervalued at current price levels. Two, it further aligns the interests of management with those of its shareholders, especially because at current prices, the company could purchase 25 million shares, increasing Chairman Charlie Ergen’s stake to 51 percent from about 49 percent.

Free cash flow (FCF) during the third quarter rose to $134 million, up from a predicted $70 million, due to reduced working capital requirements and lower than expected capital expenditures, Jayant pointed out.

In-orbit Anomalies

EchoStar’s 10-Q document filed Nov. 10 with the Securities and Exchange Commission stated that the company’s EchoStar IV satellite remains impaired because of the previously disclosed failure of its solar arrays to fully deploy and the outage of 38 transponders. The spacecraft now only has six of its 44 transponders available for use. In addition to transponder and solar array problems, EchoStar IV experienced problems with its thermal systems and propulsion system. The company admitted there could be further material degradation of the satellite, now located at the 157 degree West orbital location.

EchoStar’s $219.3 million insurance claim filed in 1998 for the total loss of the satellite has yet to be paid by a group of underwriters. The company earlier rejected their offer of $88 million, or 40 percent of the total policy amount. The insurers maintain that EchoStar IV is not a total loss, as defined in the policy, and that EchoStar did not abide by the terms of the insurance policy.

Arbitration claims filed by EchoStar against the insurers for breach of contract, failure to pay a valid insurance claim and bad faith denial of a valid claim are pending. Clauses in the policies spurred EchoStar to pursue its arbitration claims against Ace Bermuda Insurance in London, England, and the other insurers in New York. The New York arbitration commenced April 28 and hearings are set to resume later this month. The parties to the London arbitration agreed to stay that proceeding pending a ruling in New York.

Arbitration Uncertainty

When EchoStar filed its claim in 1998, it recognized an initial impairment loss of $106 million to write-down the carrying value of the satellite and related costs, while simultaneously recording an insurance claim receivable for the same amount. That receivable will be reduced if a final settlement is reached for less than that amount.

To maintain debt covenants with its lenders, EchoStar is self-insuring half of its eight operating in-orbit satellites for $121.7 million. The launch and/or in-orbit insurance policies for EchoStar I through EchoStar VIII have lapsed and company officials could not find insurance on acceptable terms.

The company’s SEC filing also disclosed an anomaly on EchoStar VIII. That problem occurred in September, when a battery cell lost power. With 72 battery cells on the satellite, all loads can be maintained for the full design life of the spacecraft with up to two battery cells fully inoperable. An investigation of the battery cell problem is underway. The flaw has yet to hurt commercial operation of the satellite.

–Paul Dykewicz

(Steve Caulk, EchoStar, 303/723-2010; Thomas Eagan, Oppenheimer, 212/668-5769; Vijay Jayant, Lehman Brothers, 212/526-6019; Bob Peck, Bear Stearns, 212/272-6665; Benjamin Swinburne, Morgan Stanley, 212/961-7527; Douglas Shapiro, Banc of America Securities, 212/847-5676)