by Armand Musey

Late last year, we downgraded the DBS stocks over concerns of near-term deterioration in their business model. Throughout 2000, we have noticed that DBS subscriber acquisition costs (SAC) have risen faster than monthly average revenue per user (ARPU) while subscriber life has shortened, resulting in deteriorating returns on a per-subscriber basis. Ultimately DBS operators have significant leverage to drive up revenues through the introduction of new services, but we expect this pattern of deteriorating returns to continue at least through the first half of 2001.

A careful analysis of DirecTV’s fourth quarter results reveals that our worries were well founded. We estimate that DirecTV spent $110 more on marketing per new subscriber in the fourth quarter than it did in the third quarter. While DirecTV was able to get its manufacturing and distribution partners to shoulder a significant portion of this increase (we estimate $86 of the $110), this cannot continue indefinitely. Adding back DirecTV’s total marketing costs from all sources, including those covered by DirecTV’s manufacturing and distribution partners, significantly lowers per-subscriber returns and lengthens payback periods. Ultimately, we believe DirecTV will be forced to increase its share of this burden or face slower growth.

DirecTV reported 4Q00 SAC of $535, up from $525 in 3Q00. At first glance, it would appear that DirecTV has managed to stem the tide of rising SAC. However, a closer look reveals that DirecTV reduced non-marketing related SAC by $35 by terminating its set-top box subsidy. Keeping other factors constant, this would imply that DirecTV actually spent $45 more per subscriber acquired on marketing in the fourth quarter than it did in the third quarter. Given DirecTV’s roughly 950,000 gross adds during the quarter, this translates to a total of $43 million in incremental marketing expenses in the fourth quarter versus the third quarter.

Moreover, DirecTV did not capture the entire terminated $35 set-top box subsidy, as Hughes Network Systems (HNS) produces roughly 40 percent of DirecTV’s set-top boxes. Termination of this subsidy essentially transferred SAC from DirecTV to HNS. This is a zero-sum game for Hughes, as any increase in DirecTV earnings is offset by the same size decline in HNS’ earnings. On a per-subscriber basis, we estimate that DirecTV transferred $14 in SAC, or a total of $13 million, to HNS in the fourth quarter. Adding this $14 back to DirecTV’s reported results, actual fourth quarter SAC was $549.

DirecTV’s other set-top box manufacturers (RCA Thompson and Sony) bore the remainder of the costs of terminating the $35 set-top box subsidy, or roughly $27 million. Although RCA has confirmed that it will continue to be a major supplier of DirecTV set-top boxes, we expect that by terminating its $35 subsidy, HNS’ share will rise significantly.

We also believe DirecTV’s fourth quarter SAC was heavily subsidized by retailers who undercut “list” price and sacrificed their commissions because DirecTV drives traffic and helps sell TVs. In our fourth quarter channel check, we saw a $49.99 retail price for DirecTV in most large consumer electronic stores in all regions of the country. This would imply a $100 per unit dealer markdown, or a 50 percent reduction in dealers’ $200 commission. To be conservative, we estimate these “unofficial” dealer subsidies came to an average of roughly $65 per new sub. Adding this $65 to the terminated $35 set-top box subsidy and the $10 reported increase in SAC, marketing expenses from all sources totals $110 per-subscriber above third quarter levels.

Given gross adds of 950,000 in the fourth quarter, a $110 increase in per-subscriber SAC translates to over $100 million in incremental marketing spending to drive subscriber growth that was below expectations. Even if RCA and Sony continue to produce the majority of DirecTV set-top boxes, we believe it is unlikely that dealers will contribute more of their commissions. Throughout the next couple of quarters, we believe Hughes will be forced to increase its share of this growing marketing burden or face slower growth.

We plugged the figures for DirecTV’s fourth quarter SAC into our subscriber model that calculates per-subscriber IRR (internal rate or return). Reported fourth quarter results ($535) show a slight deterioration from 31.9 percent to 31.1 percent in the third quarter, due to SAC rising faster than ARPU, inline with our overall thesis. However, as we layer on the $14 in terminated subsidies to HNS ($549), per-subscriber IRR falls to 29.5 percent. Add the full $35 in terminated subsidies ($570) and it falls to 27.3 percent. Add the $65 in “unofficial” dealer subsidies ($635) and IRR falls to 21.2 percent, nearly 1,000 b.p. (basis points) lower than reported results! This bolsters our thesis that the DBS business model continues to deteriorate.

We are not implying that all is bad for DBS. In particular, we believe broadband satellite services have the potential to generate large increases in monthly ARPU. Moreover, DBS also has the potential to increase its penetration of rural markets, as many local cable operators will have difficulty upgrading their plants to digital. We expect that DBS stocks will languish until we see these benefits in the latter half of 2001.

Armand Musey, CFA is a satellite communications analyst at Banc of America Securities LLC (BAS) . This article does not necessarily reflect the views of the Via Satellite editors and should not be considered as a recommendation with respect to any security. BAS 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.