by Armand Musey

Last month, we wrote how satellite television services are becoming the principal economic driver of the global satellite industry and what a merger of Echostar and Hughes might mean for the U.S. satellite industry. This month, we expand upon that theme by looking at the impact DBS providers are having on the U.S. multi-channel television business by using their increasing market clout to challenge the regulatory status quo and change the marketplace. In particular, Echostar’s litigation strategy aimed at tilting the age- old conflict between content and distribution. We believe these efforts could have an even more profound effect than the merger itself, particularly for local broadcasters and smaller networks.

The first thing one must look at is Echostar’s continued challenge of “must carry” regulations. With its proposed merger with Hughes currently under review by both the FCC and DoJ, one would think Echostar would want to tread lightly with regard to its contention of other regulatory issues. However, after being overruled in a circuit court, Echostar decided to continue its challenge of DBS “must carry” regulations by appealing its case to the Supreme Court. Echostar’s management contends this is a First Amendment issue and asserts that “the government should not choose what type of programming consumers can or cannot watch.” We believe Echostar’s motivation for overturning “must carry” is economic, since the uplink and spectrum costs make broadcasting local channels with small audiences a money-losing proposition. We believe that if Echostar were to prevail in this case, it would eliminate carriage of many smaller local broadcasters and special interest channels, essentially cutting them off from the multi-channel provider of choice in their own local markets.

Echostar has also filed a suit seeking to overturn a September ruling that limits its broadcast of affiliate networks to the local market of their origin. Echostar’s management is also arguing that this regulation is a violation of free speech because it violated the rights of viewers to choose the television programming they want to watch. If Echostar prevails in this litigation, we believe it would also have a significant impact on the television broadcasting industry, because it would force smaller local affiliates to compete with much larger and better-funded regional affiliates. If Echostar were to prevail in both this case and its challenge of “must carry” regulations, it could have a profoundly negative impact on smaller local broadcasters, because larger regional affiliates and national special interest channels would likely replace them. This scenario would surely be exacerbated if DBS penetration rates increase in many smaller communities, as we feel they will.

Finally, Echostar has demonstrated a repeated willingness to play hardball with even the largest content providers. After several months of “heated” negotiation that ended with both parties in court suing one another, Echostar and Disney resolved a dispute over carriage of the ABC Family Network. The dispute had stemmed from the fact that after Disney acquired the network last November from News Corp., Echostar forced it to file a request for an injunction to prevent Echostar from dropping it because of low ratings, citing a provision in its affiliate agreement that allows it to drop a network in the event of a change in its control. We believe Echostar’s willingness to take on one of the largest content providers over their practice of tying carriage and pricing agreement of less popular networks (such as ABC Family) to more popular networks (ABC Network and ESPN) could ultimately limit the leverage of content providers, particularly if the merger of Echostar and Hughes is approved.

We are not legal experts in the areas of multi-channel television regulation; however, those we have spoken with indicate they believe Echostar is unlikely to prevail in its legal challenges of “must carry” and distant network regulations. Nevertheless, we believe it is significant that the greatest legal challenges to the regulatory and marketplace status quos are coming from a company that not long ago was known as the scrappy number two DBS player. We believe that it is in large part due to Echostar CEO Charlie Ergen’s consistently “out of the box” thinking and innovative approach to managing the Dish Network, which has helped him deliver far better returns for Echostar shareholders than the more traditional management team of Hughes. However, it is also a reflection of DBS’ increasing importance to the muti-channel television business vis-a-vis other options, and this is a trend we expect to continue in the foreseeable future.

Armand Musey is the satellite communications analyst at Salomon Smith Barney (SSB). 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.