by Armand Musey

As DBS subscriber growth slows, DirecTV’s dependence on retail distribution is becoming increasingly expensive. We estimate that cost inflation in the retail channel has caused DirecTV’s subscriber acquisition costs (SAC) to rise to the point where DirecTV’s return on a new subscriber is approaching its cost of capital. As a result, it is likely that DirecTV is looking for alternative means of distribution.

When DBS started six years ago, less than 60 percent of U.S. households subscribed to multi-channel television. Now that number is close to 85 percent. Growth has become a zero-sum game between DBS and cable. Additionally, new DBS subscribers are increasingly urban and suburban and do have access to cable, including digital cable, which is driving up the churn rates for new subscribers. As SAC and churn rates rise, returns fall. In other words, DBS companies are essentially paying more for subscribers who do not last as long.

We calculate the average return on a new subscriber has fallen from 40 percent two years ago to just over 20 percent today, which does not allow for an acceptable level of return. As a result, all three DBS companies are looking for ways to rein-in escalating SACs. But just how much growth must be sacrificed in order to bring new subscriber returns back to more acceptable levels? Because of its focus on metro areas where it faces greater competition from digital cable and its dependence on retail distribution, DirecTV’s growth is likely be the hardest hit by a reduction in SAC.

DirecTV currently has exclusive distribution agreements with the big-three consumer electronic stores (CES). We believe the retail channel is the most effective way to introduce a new consumer service to market and these arrangements have been critical to DirecTV’s strong growth over the past couple of years. However, with the market maturing, we believe dealer commission and other incentives designed to “grease” the retail channels have become too high. We estimate in DirecTV’s reported $530 SAC, that roughly $400 of this is going through the retail channel ($160 in dealer commissions and $250 in “consumer subsidies”).

However, changing the economics of this model will be difficult due to the importance of DirecTV sales to the CES. SSB Retail Hardlines Analyst, David Stasser, estimates that the big-three CES derive about one to four percent of their revenue from DirecTV sales, but eight to 10 percent of profits due to the high margin of the sale. Stasser estimates that DirecTV sales carry a 53 percent gross margin at retail. His analysis assumes a $50 retail price and $190 in commission and consumer subsidies from DirecTV, for total revenues to the CES of $240 per sale, and a wholesale equipment cost of $115, for gross profits of $125 per sale.

One of the keys to improving DirecTV’s new subscriber returns lies in changing the economics dealers receive for selling second set-top box units. Currently, the CES are not highly incentivized to sell second set-top boxes, because these sales bring down profitability, as DirecTV determines commission rates by the mix of one and two box sales. DirecTV, on the other hand, wants more two box customers because they generate higher returns, as they tend to have longer subscriber lives and higher monthly bills. However, the cost to DirecTV of subsidizing a second box sale under current economics is very high, as there is a second $35 subsidy to the manufacturers, a second consumer subsidy, and a second retail commission, as dealers are compensated per-box.

Moreover, because all of these costs are born upfront, it takes longer for DirecTV to recoup this investment. We estimate the average one box customer has a life of 35 months and a return of roughly 24 percent, while a two box customer has a life of 62 months and a return of 30 percent. However, because of higher up-front SAC, it takes 52 months before a two box customer generates the same 24 percent return as a one box customer. Therefore, obtaining acceptable returns on a two box customer is dependent on the longer life of these customers. As two box customers become a greater percentage of the mix, we doubt DirecTV can continue to subsidize second boxes under current upfront economics.

Given the longer payback period of two-box set-ups, DirecTV would like to reduce the up-front payouts to retailers. A major component of many retailers’ DirecTV commission already comes in the form of residual revenue from customers’ monthly service bill. We expect DirecTV to look to reduce upfront commission rates and increase this residual payment, which better ties the retailer’s commission to the revenue of the subscriber. We believe this has been the crux of negotiations between DirecTV and its retail partners that has been widely reported in the press.

In the long run, retail distribution is simply too expensive for DBS and it must look for alternatives if it is to grow. Of the roughly $530 DirecTV spends to acquire a subscriber, roughly $410 goes to retail sales commissions, consumer subsidies and installation. We note that all three DBS companies are beginning to develop direct selling channels. DirecTV currently acquires approximately five percent of its subscribers from direct selling. Whatever the eventual outcome of this shift, one thing is for sure, slowing DBS subscriber growth could have a profound impact for DirecTV and its retail partners.

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.