by Armand Musey
To the very end, Echostar CEO Charlie Ergen swore that if his Dish Network and DirecTV were not allowed to merge, the DBS companies were doomed to second tier status among the U.S. multichannel television providers and consumers everywhere would be forced to accept increasing subscriber rates. We disagree. While we readily acknowledge a combination of Dish and DirecTV would have created a very dynamic competitor and investors would have benefited, we are less convinced that consumers would not have born a heavy cost for its creation. Instead, we argue that the U.S. multichannel television industry has become decidedly more competitive throughout the past year because of the competitiveness of the DBS companies on a standalone basis, benefiting both rural and urban consumers. Moreover, the emergence of two factors will ensure that this trend continues in the foreseeable future.
The first factor is that the U.S. multichannel television business is hitting mature levels of market penetration, which is driving increased competition between providers. Currently about 85 percent of all U.S. households subscribe to DBS or cable. This figure compares to just 40 percent when DBS was introduced in 1994. With more than 19 million subscribers, or an 18 percent market share, DBS has been a significant driver of this growth. However, as the percentage of unserved homes shrinks, growth is becoming a zero-sum game. In order for the DBS companies to add a subscriber they must steal one from cable, and visa-versa. This means the incentives to the customer are increasing, whether they are in the form of lower rates, increased programming or better service.
The second factor lies in the competitive differentiation between DBS and cable, which is diminishing, increasing consumer choice. This issue is diminishing, which is increasing consumer choice. DBS used to be the only way for the true videophile to get 200-plus channels of digital television. The cost of the equipment and installation was expensive and DBS did not offer local channels, so most of the country made due with a standard fair of 50-or-less channels of analog cable. Now, much of the country has access to digital cable and the cable companies are slowly, but surely, rolling out enhanced features such as interactive programming guides and video-on-demand (VoD). Both the Dish Network and DirecTV responded by launching spotbeam satellites, which should allow them to offer local channels to roughly 60 percent of the United States, and the Dish Network has been rolling out personal video recorder enabled set-top boxes that should allow it to offer a service comparable to cable VoD.
As the multichannel television market has become saturated, and as DBS and cable have become less differentiated, they are increasingly being forced to compete on price. This can be seen in both monthly subscription rates and the "all-in" cost of service. Our models show that DBS industry ARPU (average revenue per unit) is trending flat-to-down for 2002, despite the broad roll-out and take-up of local channels at an incremental $5 to $6 per month. We also note that more than one cable company has responded to competitive pressures and negative growth due to DBS with "dish busting" (low-priced offerings aimed at countering DBS competition). At the same time, DBS equipment and installation now typically cost the consumer less than $100, which is roughly equal to cable. We expect these trends to continue and believe that all of this, despite Ergen's protestations to the contrary, has benefited the consumer and will continue to benefit the consumer in the foreseeable future.
While these trends point to the strength of the competitive position of DBS in a new and more competitive multichannel television world, we believe it is important to warn investors that some of these trends are not necessarily positive from a shareholder's perspective. Increased competition means lower returns--somebody has got to pay for the consumer's benefits. Throughout much of 2002, shares of DISH and GMH remained range bound, despite consensus valuations calling for much higher share prices. We believe this is because these valuations where based on unrealistic forecasts for improvements in DBS subscriber economics that failed to recognize increased competition. In general, we believe DBS subscriber growth will decelerate significantly, but we think that DBS growth should continue to outstrip cable as it increases its share in markets with weak cable competitors, and that it is realistic for investors to expect DBS to ultimately capture 25 percent of the total U.S. multichannel television market. However, we believe that most estimates for strong rate increases, reductions in subscriber acquisition costs and little-to-no increase in long-term churn are aggressive, as are most valuations. Sorry Charlie, hooray for consumers.
Armand Musey is a satellite communications analyst at Salomon Smith Barney. Part of the information provided herein includes material derived from research by Musey as a member of the Firm's Global Equity Research Department. For a copy of the full research reports or notes or to view the report disclosure required by the NYSE and NASD rules, please visit http://www.ssbaccess.com or contact a SSB Financial Consultant. Valuation methodologies and risks pertaining to price targets, as well as other important disclosures, are contained in research reports and notes published on or after July 8, 2002. Salomon Smith Barney or its affiliates beneficially owns 1 percent or more of any class of common equity of Echostar and Hughes and has received compensation for investment banking services provided within the last 12 months from Hughes. For a copy of the full research reports or notes or to view the report disclosure, please visit http://www.ssbaccess.com or contact a SSB Financial Consultant.