by Armand Musey

As the U.S. multichannel television market matures, growth will becomes more elusive and subscriber returns are likely to fall for both DBS providers. DBS subscriber growth, however, should continue to outstrip cable, due to structurally lower churn, DBS’s ability to increase penetration in unserved regions and areas that have not been upgraded to digital cable, and a favorable operating cost structure that should allow DBS to continue to under-price cable. This view is grounded in our belief that DBS and cable have become near-perfect substitutes for one another and that the most significant differentiating factor going forward will likely be price.

When DirecTV first launched in 1994, it was not viewed as a direct competitor to cable, but instead was positioned as a premium service for diehard TV fans and people who lived in rural areas with no other option. In subsequent years, as Echostar entered the market and DBS penetration increased, DBS equipment prices came down significantly, making the service more accessible to a greater percentage of the population, which in turn, helped to support strong DBS subscriber growth. The cable industry responded by investing heavily in digital upgrades in the hope that it could leapfrog DBS by offering subscribers a suite of services including video, broadband access and telephony.

While cable’s digital upgrade is now largely complete in most major urban markets in the United States, subscriber conversions are inhibited by slower deployment of digital set-top boxes. Meanwhile, DBS has responded to the challenge posed by digital cable by increasing the number of local and special interest channels and offering bundled DBS/DSL or satellite broadband services. As a result, the competitive differentiation between DBS and cable has steadily diminished. DBS continues to offer higher quality video than cable does, and in most cases more channels for the same amount of money. Cable, on the other hand, continues to have the advantage in terms of online access, although the gap continues to close on both ends.

In retrospect, because DBS’s service offering has been enhanced, it looks like cable’s expensive digital upgrade is more of a defensive maneuver than a source of higher returns. At the same time, because the DBS operators are now subsidizing consumer equipment and installation, there is little difference in the upfront cost to the consumer of DBS or cable. Both are investing heavily to upgrade their offerings, but with no change in their relative competitive position. As a result, we believe cable has been increasingly forced to compete with DBS on the basis of monthly subscription rates.

While pricing pressure is likely to cause the return on new subscribers to fall for both DBS and cable, we believe in the long run the DBS business model can withstand a significant price war with cable. DBS has higher subscriber acquisition costs (SAC) than cable, but lower maintenance capital expenditures and an inherently more scalable distribution platform, making it less capable of withstanding the levels of churn that cable considers normal, but well equipped to undercut cable prices. From current levels, reductions in ARPU do not affect cable subscriber cash flow as negatively as increases in churn.

The question from a competitive standpoint is, can cable develop a strategy that causes DBS churn to spike, or will DBS be more successful at stealing cable subscribers with lower rates? We believe it would be hard for cable to drive DBS churn to cable industry levels. DBS’s churn is structurally lower than cables’ because of its large number of rural/suburban subscribers and because cable is a default choice in nearly 20 million multi-family dwellings where turnover is high. Moreover, while cable “dish buybacks” have proven to be an effective tactic for converting DBS subscribers in smaller, targeted markets, we believe it is a prohibitively expensive strategy to get DBS subscribers to switch in mass. At the same time, Echostar’s aggressive pricing strategies appear to be taking their share from both DirecTV and its cable competitors.

At this stage of the game, it is hard to say how this will all shake out. Therefore, we believe investors should focus on the companies that are best equipped to withstand a difficult pricing environment. In this regard, we believe DBS is fundamentally better off than cable, due to the relatively high operating leverage inherent in its business model, and that a post-merger, delevered Hughes, with no debt and more than a billion in cash on its balance sheet is better equipped than Echostar, which will have at least $7 billion in net debt, despite Echostar’s otherwise leaner operating cost structure. Put it all together and this is why we remain more favorably inclined towards GMH over DISH.

Armand Musey is a satellite communications analyst at Salomon Smith Barney (“SSB”). Part of the information provided herein includes excerpts, abstracts, and other summary material derived from research reports or notes published by Armand 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 research-report disclosure required by the NYSE and NASD rules relating to analyst independence and conflicts of interests, please visit http://www.ssbaccess.com or contact a SSB Financial Consultant. Valuation methodologies and associated 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% or more of any class of common equity of EchoStar Communications Corp. and EchoStar Communications Corp and has received compensation for investment banking services provided within the last 12 months from Hughes Electronics.