The DirecTV Group, the El Segundo, Calif.-based parent company of DirecTV, the largest U.S. satellite television operator, showed its zest for taking bold action to shape the company for future growth by buying the nearly 1.1 million rural subscribers to the service owned by its partner Pegasus Satellite Communications in a deal valued at $938 million. The same robustness also was exhibited last week when the satellite TV arm of DirecTV impressed Wall Street analysts by achieving an all-time high subscriber gross subscriber gain of 944,000 during the second quarter and notching improvements in key performance measures.

The Pegasus deal called for DirecTV to pay $875 million in cash and to forgive a $63 million judgment in its favor against Pegasus. A big benefit for DirecTV from the pact is that it also gained the rights to market its own service in rural territories that previously were the exclusive turf of its partner. The odd arrangement of using partners to sell the service in rural territories nationwide had become problematic for DirecTV because its various partners that were members of the National Rural Telecommunication Cooperative (NRTC) began losing subscribers to each quarter rather than adding them.

To fix that problem, DirecTV agreed to pay $374 million earlier this summer to 94 eligible NRTC members for their rights to approximately 357 million DirecTV subscribers. Pegasus did not join the settlement with DirecTV at that time but the carrier recently reconsidered and sealed the pact announced last week. The Pegasus deal, once closed, would give DirecTV free rein to pursue customers anywhere in the country rather than rely on partners in rural areas that were giving ground in head-to-head competition with satellite TV rival EchoStar Communications [DISH].

As part of the settlement, DirecTV received a commitment that Pegasus officials would work to help ensure, upon closing of the transaction, that an orderly migration of the 1.08 million subscribers will occur. In addition, on Aug. 3, Pegasus Satellite Communications filed a motion with the U.S. Bankruptcy Court in Portland, Maine, seeking approval of the transactions provided for in an asset purchase agreement, settlement and cooperation pact with DirecTV.

The 944,000 new subscribers DirecTV amassed during second-quarter 2004 were 49-percent more than the gains achieved during the same quarter a year ago. When improving churn is considered, DirecTV added 455,000 net new subscribers during second quarter 2004, up 151 percent compared with the same quarter last year.

The irony of boosting subscriber growth is that DirecTV’s operating profit before depreciation and amortization declined in the second quarter to $175 million, down from $325 million for the same quarter last year. DirecTV now has more than 13 million subscribers nationwide, and it has been gaining momentum since its sale to Rupert Murdoch-controlled News Corp [NWS] last December.

DirecTV is making improvements across key areas of operations that including expanding the number of markets in which it provides local channels, adding international programming and opening new customer service centers to keep pace with the rising subscriber numbers, said Chase Carey, president and CEO of The DirecTV Group, who spoke last Thursday during a conference call with analysts.

DirecTV’s revenue for 2Q04 rose to $2.22 billion, up 23 percent compared with the same quarter last year, due to strong subscriber additions during the past year and a 7- percent rise in average monthly revenue per user (ARPU).

Benjamin Swinburne, a satellite analyst with Morgan Stanley, detailed in a research note last Thursday another pleasant surprise: DirecTV’s programming and other expenses totaled just $856 million (38.6 percent of revenue), compared with his estimate of $875 million, (39.5 percent of revenue). This reduced expense may be an indication of early benefits from DirecTV’s scale, and it mirrors a similar trend seen at Comcast [CMCSA] in the second quarter, he explained.

Because DirecTV’s contract with ESPN expires this year, that same advantage of increased scale could spur further reductions in programming cost growth that should be realized in 2005, Swinburne added.

Future Plans

Carey said the DirecTV parent company is forging ahead with other steps to focus solely on its satellite TV business. To that end, The DirecTV Group not only resolved its roughly five-year-old dispute with Pegasus but it previously had announced agreements to sell its satellite operating unit PanAmSat [SPOT], its data- networking subsidiary Hughes Network Systems’ [HNS] set-top box manufacturing business, Hughes Software Systems and stakes in other businesses that include XM Satellite Radio [XMSR].

The group also is expected to complete its process of finding a buyer for the rest of its HNS business. Satellite News has learned that efforts are underway that soon would trim an earlier list of between 18 and 20 serious bidders for Germantown, Md.-based HNS to the finalists.

When asked during the conference call about the $1.8 billion Spaceway project, Carey talked about DirecTV continuing to work with its engineers to make the Ka-band satellite project better suited to provide such supplemental satellite TV services as HDTV and local channels. The satellites initially were built to offer high-speed broadband access to businesses but implementation of those plans would hinge on the final disposition of the HNS assets through the ongoing bidding process.

His comments lent support to industry observers who are beginning to speculate that DirecTV might retain the Spaceway satellites and operate them as part of the DirecTV business, while proceeding with plans to sell the rest of HNS. With most of the $1.8 billion cost for the Spaceway already paid, the relatively modest additional amount DirecTV would need to pay to put the satellites into orbit might well be worthwhile. The value of the Spaceway assets likely would be written down under such a scenario.

PanAmSat Predicament?

Uncertainly about the closing of the PanAmSat sale and the price that ultimately would be paid for the Wilton, Conn.-based satellite operator by financial buyer Kohlberg Kravis Roberts & Co. (KKR) arose last week due the sudden and unexpected failure of the xenon ion propulsion system (XIPS) on the in-orbit Galaxy 10R satellite, a Boeing [BA] 601 HP model spacecraft. The bird is operating, however, and it can continue to do so for the next three years due to the availability of bi-propellant fuel onboard, PanAmSat officials said.

The primary XIPS propulsion system had failed on the Galaxy 10R satellite previously, and the backup XIPS malfunctioned last week. No material impact is expected from the XIPS problem on PanAmSat’s services, revenues or operations, its officials said. PanAmSat operates three other Boeing 601 HP satellites that continue to operate normally with XIPS as their primary propulsion system. Two of those satellites have six years of bi-propellant fuel and the third has more than 11 years of such fuel onboard.

Under the sale agreement with KKR, the permanent XIPS failure would allow the buyer to abandon its purchase of PanAmSat. The purchasers — KKR and its investment partners The Carlyle Group and Providence Equity Partners — are evaluating the impact of the XIPS failure on their planned purchase of PanAmSat, and they are in discussions with DirecTV officials about the situation. Keep in mind that, with a number of buyers previously interested in the company, it is highly unlikely KKR would take any action to forgo its planned purchase of PanAmSat.

The Galaxy 10R is insured, and PanAmSat will make a claim under its policy. Any proceeds obtained would be used to partially offset the cost of a replacement satellite. Construction already is underway on the Galaxy 17 satellite as an on-ground spare for the Galaxy 16. Upon a successful launch of the Galaxy 16, the Galaxy 17 would be available as a replacement for the Galaxy 10R, company officials said.

(Bob Marsocci, DirecTV, 310/726-4656; Benjamin Swinburne, Morgan Stanley, 212/761-7527)