DOLLARS AND SENSE: Maturity Slows Down DirecTV

by Marc Crossman and Aileen Chen

Hughes Electronics has, in the past couple of years, shown strong fundamentals due mostly to the strength of its direct broadcasting services (DBS) business, DirecTV. However, this picture seems to be transforming slightly due to a change in the outlook of DirecTV.

DirecTV posted weaker net subscriber additions for the third quarter than the Street was expecting; net subscriber additions have often been used as an indication of the health of the business. DirecTV is beginning to reach a point of maturity where customer churn will start to drift upwards and where each additional subscriber will cost more to acquire than before. Churn will float upwards in the future as a result of the company’s need to look to lower quality subscribers in order to maintain subscriber growth. The cost of acquiring a subscriber is rising, (despite the elimination of manufacturing subsidies), due to increased competition from the cable companies. These concerns are further highlighted by the fact that 2001 will most likely be the first year the company experiences declining subscriber net additions.

DirecTV added 450,000 net new subscribers during the third quarter of this year, representing 6 percent growth year-over-year but a slight decrease from 452,000 net additions during the second quarter of this year. The Street was expecting the company to add 100,000 more net new subscribers. The discrepancy between the actual net additions and the Street expectations is primarily due to two factors.

First, more customers left the system during the past three months than expected. The $2 price increase implemented across the board during the third quarter for all basic service customers resulted in the higher churn. Second, there was weaker gross subscriber additions relative to expectations. The increase in churn accounts for only half of the shortfall from expectations, in our opinion. The balance of the shortfall is attributable to weaker than expected gross demand.

Separately, higher churn among Primestar By DirecTV customers left fewer customers to convert to DirecTV’s high-powered services. (DirecTV acquired Primestar in early 1999, after which it began converting customers of Primestar’s medium-powered services to the DirecTV platform.) This enabled DirecTV to complete the conversion process three months ahead of its original conversion schedule, but contributed less to DirecTV’s subscriber additions.

While net subscriber additions for the third quarter were lower than the second quarter for the first time, DirecTV should be able to show healthier net subscriber additions growth during the last three months of this year. DirecTV will be offering another free professional install promotion that will be offered on the heels of the end of the NFL Sunday Ticket promotion, lasting until mid-January.

The free install promotion has, in the past, been effective in bringing in new customers. Also, the fourth quarter has traditionally been a strong quarter for net additions because of the holiday selling season. Further, the absence of another price hike or remaining Primestar customers to convert should bring down the churn rate. Therefore, it is likely that DirecTV will add significantly more net new subscribers (approximately 639,000) in the fourth quarter, bringing total net additions in 2000 to 1.9 million. Based on this assumption, DirecTV will end the year with approximately 9.6 million customers.

However, the fundamental outlook of DirecTV seems to be changing as net additions growth in 2001 is unlikely to be as robust as it has been in the past. With the DBS industry maturing (with over 14 million subscribers), we believe that gaining subscribers will cost more than it has in the past and that churn will drift upwards. DirecTV has successfully penetrated the market to gain 9 million subscribers, with the average household income of a DBS subscriber being substantially higher than that of cable.

However, as DirecTV’s penetration continues to increase and as it saturates the high-end of the market, it will increasingly add lower quality customers who are more likely to churn from the system. Further, DirecTV will reach its one-year mark with its local-into-local product in November; (it will take another 12 months for the launch of all the markets). In addition, cable has been steadily improving and expanding its service offering, providing digital cable, while DirecTV has been late in rolling out its enhanced services such as Tivo, Wink and AOLTV.

As a result, churn will rise for the full year 2001, and net additions for the year will total approximately 1.7 million. This means that net additions will be down 12 percent for the year 2001 from 2000. At the heart of this estimate is a slowdown in gross demand. By way of background, the company grew gross subscribers by 24 percent in 1998 and by 54 percent in 1999, and gross subscribers are projected to grow by 35 percent in 2000. For 2001, the growth in gross demand is estimated to slow to 10 percent. v

Marc Crossman and Aileen Chen are satellite analysts at J.P. Morgan in New York City.