Joseph Wright, the president and CEO of Wilton, Conn.-based satellite operator PanAmSat Corp. [SPOT], has laid out a growth strategy for his company that entails entering the broadband market later this decade after demand for such services rises sufficiently.

Wright’s cautious view on broadband is in marked contrast to recent speculation from media reports and Wall Street analysts that a merger could be on the horizon between PanAmSat and its sister broadband satellite company, Hughes Network Systems [HNS]. Both companies are units of Hughes Electronics Corp. [GMH], which recently ended merger plans with EchoStar Communications Corp. [DISH]

In an interview with SATELLITE NEWS last week, Wright said he sees PanAmSat growing in the near term through low-risk value-added services. Cost-cutting, coupled with curtailed capital and operating expenses, form an essential part of Wright’s thrust to improve PanAmSat’s profitability and to overcome reduced revenues from a sluggish economy.

PanAmSat had been one of the industry’s most aggressive satellite operators in ordering and launching new spacecraft prior to Wright joining the company in August 2001. His emphasis on profitability and cash flow does not fit a risky merger with HNS and its $1.8 billion SpaceWay satellite broadband venture.

Instead, PanAmSat is targeting revenue growth by offering a host of value-added services that go beyond its bread-and-butter satellite transponder leasing business.

“There are three areas of opportunity in our future that we are pursuing, in addition to continuing to focus on our core customer base,” Wright said.

The first opportunity is consolidation, Wright said. Consolidation is occurring in this industry and PanAmSat is looking at these opportunities, despite pulling out of bidding for European rival Eutelsat almost two weeks ago.

The second opportunity is to expand services, such as those used by the government, digital customers and users of hybrid networks, Wright said. The third opportunity is the development of technology that will offer new ways of transmitting content across PanAmSat’s network, while increasing its role in video-on-demand, high-definition TV, the integration of fiber/satellite/wireless technologies and broadband-over-satellite. However, broadband is not a high priority, Wright added.

“When we decided to complete the $2 billion, seven satellite expansion, we decided to manage the fleet and leverage it for profitability,” Wright said. The company will not launch any “green field satellites” where markets do not already exist, he added.

PanAmSat’s financial conservatism since Wright’s arrival contrasts with the $1.4 billion already spent by its parent company Hughes to build and launch the SpaceWay satellite broadband system that would be operated by HNS.

The planned SpaceWay Ka-band satellite system would allow HNS to offer its customers a “a very promising service,” Wright said.

“What we’re doing is managing a large satellite feet, not managing SpaceWay,” Wright said.

A near-term effort to pursue broadband opportunities “doesn’t make a lot of sense” because the marketplace is not there right now, Wright said.

“We are not going to jump out on a limb. Our business is leveraging our worldwide satellite fleet. I believe that, short-term, vertical services will add incremental value because the cost of doing it is not very high.”

The goal of adding value-added services to PanAmSat’s exiting capabilities is one of the company’s “main strategies,” Wright said. “I think some acquisitions will play a role in that,” he added.

PanAmSat’s management assesses potential projects by using return on investment (ROI) criteria. That approach has eliminated many “fuzzy R&D projects” where a market would need to be established for a new technology, Wright said.

“If it makes sense and we have a customer base to make it succeed, we will make it happen,” he added.

PanAmSat does not currently serve the enterprise broadband market that HNS would be targeting with its SpaceWay project. SpaceWay would be the world’s first commercial satellite Ka-band system when it is ready to begin serving North America during 2004.

William Kidd, satellite analyst with Lehman Brothers, wrote in a recent note to his clients that a merger between HNS and PanAmSat would allow the latter’s strong cash flow to support the SpaceWay venture.

“Clearly, [Hughes owner] GM is not interested in retaining what is, in our opinion, a far less saleable company consisting of just PanAmSat and HNS, unless it means the difference between selling DirecTV [another Hughes unit] or not selling DirecTV,” Kidd wrote.

For PanAmSat, its luster would dim if its cash flow were used to support the unproven SpaceWay business, Kidd explained. A combination would “convolute” PanAmSat’s investment story and transform a safe business into a risky one, unless SpaceWay flourished, Kidd said.

Only Ku-band satellite broadband systems have been put in orbit so far and none has developed into a profitable business because of competition from lower-priced fiber optic and DSL alternatives. A small number of C- and Ku-band satellites have included Ka-band transponders for operators to test the market.

The best niche for satellite broadband is to serve rural markets where fiber optic cable and DSL services cannot be deployed profitably.

Tom Watts, a satellite analyst with SG Cowen, took the speculation about a potential merger between PanAmSat and HNS seriously enough to write a research note about it.

Revenues of $1.17 billion at HNS during 2002 would more than double the size of PanAmSat and the $812 million in revenues it amassed last year, Watts explained. However, a merger would degrade PanAmSat’s financial performance that included fourth quarter EBITDA (earnings before interest, taxes, depreciation and amortization) margins of 73.4 percent and EBITDA of $144 million. In contrast, HNS barely topped EBITDA breakeven in the fourth quarter.

HNS offers long-term growth potential if SpaceWay succeeds but would depress earnings in a merger with PanAmSat due to increased depreciation, Watts wrote in his research note.

The combination would make it easier for Hughes to sell itself by packaging PanAmSat, HNS and the SpaceWay project. Potential Hughes buyer News Corp. [NWS] has shown little interest in acquiring those units, Watts explained.

Arunas Slekys, vice president of corporate marketing and general manager of the Russia/NIS business at HNS, said Wall Street does not appear to recognize the value of the company’s SpaceWay satellite broadband system, which is expected to begin commercial service next year.

The SpaceWay system would feature a new generation of Ka-band satellites to provide business customers with networking capabilities that would go well beyond those currently offered by Ku-band services. Ku-band services are limited because they cannot match Ka-band satellites in throughput, capacity or “intelligent” routing, Slekys said.

“With SpaceWay, we have switching intelligence and approximately 10 times the overall capacity of Ku-band satellites,” Slekys said. “Think of 5,000 T-1’s of traffic capacity or 10 Gbps, and uplink speeds of 100 Mbps. And because SpaceWay is a mesh network with spot beams, we can deliver bandwidth on demand. So customers need only pay for what they use. That capability will give us an unprecedented potential to provide services where satellite has not been competitive in the past.”

SpaceWay also gives HNS a first-time opportunity to own the satellites that serve its customers, Slekys said.

By using its own satellites, HNS would be able to control the transition of its existing customers to the SpaceWay platform. The company also would be able to grow its revenues, margins and breadth of value-added services and applications, he said.

To date, more than 50 companies have partnered with HNS in a broadband marketing alliance aimed at providing value-added applications when SpaceWay is available, Slekys said. The partners in the HNS broadband alliance include Sun Microsystems [SUNW], Sony [SNE], Hewlett-Packard [HPQ] and Polycom [PLCM]. “SpaceWay is opening up a new world of satellite capability,” Slekys said.

One key benefit for HNS is that the SpaceWay satellites would offer large, managed-bandwidth services, Slekys said. The potential market for broadband services to serve business users in North America alone is estimated at $30 billion to $40 billion, he added.

SpaceWay initially would target enterprise users. As its revenues grew and its cost structure improved, opportunities would arise to pursue the consumer market, he added.

HNS already has an existing customer base of 160,000 DirecWay satellite broadband subscribers who are potential users of the SpaceWay platform in the future. “It is a substantial number,” Slekys said. “It shows there is a market where satellite reaches and DSL and cable do not. The potential market gets bigger as we can lower the cost.”

Out of the remaining $400 million that Hughes has committed to pump into the SpaceWay venture, roughly $270 million will be spent this year and the rest will be needed in 2004 and 2005 for the launch of the second and third SpaceWay satellites. The first is scheduled for launch this year. All three satellites will serve North America; one will be used as an in-orbit spare.

“SpaceWay will increase our top-line and bottom-line earnings,” Slekys said. “HNS does not earn any satellite space segment revenue today.”

With 400 or 500 major enterprises as customers, HNS is “not starting from scratch, such as some newcomers to the Ka-band business,” Slekys said. “We are market leaders and our plans are based on migrating existing Ku-band customers onto the SpaceWay platform. In some cases, we also expect to win new business with customers currently using terrestrial networks. Many of our customers currently use fiber and frame relay to satisfy requirements that are beyond Ku-band throughput or capacity capabilities. We will be able to move those customers onto SpaceWay and also introduce value-added, mesh-networked services. The risk profile for us is very low.”

SpaceWay Prospects

“Wall Street does not yet believe that our success with SpaceWay will generate a positive ROIC [return on invested capital],” Slekys said. “We are convinced that SpaceWay offers a compelling business case and that is why the investment was approved.”

A technical advancement that HNS achieved in the development of SpaceWay during recent weeks is a digital chip for a 440 Mbps modem that would transmit and receive information to and from a satellite to eliminate the need for an expensive ground hub switching point.

What previously required a centralized hub and “racks of equipment” now will be performed by a single chip measuring less than a square inch, said Adrian Morris, senior vice president of engineering and SpaceWay development for HNS.

By using high levels of integration to produce a single device, the cost of the terminal has been substantially reduced without sacrificing performance, HNS officials said. The reduced size translates into a 20 percent cost reduction over today’s comparable unit, they added.

-Paul Dykewicz

(Joseph Wright, PanAmSat, 203/210-8606; William Kidd, Lehman Brothers, 212/526-4849; Tom Watts, SG Cowen, 212/278-4260; Arunas Slekys, Hughes Network Systems, 301/428-5502)

Major HNS Activities:

• Manufacturing DirecTV set-top boxes and satellite networking equipment;
• Operating corporate satellite networks with VSATs;
• Providing DirecWay consumer satellite broadband service; and
• Preparing for the 2004 introduction of the $1.8 billion SpaceWay satellite system

Source: HNS

SpaceWay Technical Milestones:

• The first 440 Mbps digital chip developed for use in terminals;
• Packet switching;
• Spot beams; and
• Bandwidth-on-demand

Source: HNS