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Cable's Hole Card: Internal Returns

11/24/2002 7:00 PM Eastern

Even if the merger of EchoStar Communications Inc. and DirecTV Inc. is dead, those direct-broadcast satellite giants are still continuing to steal market share from cable operators.

But the cable guys are starting to argue the bright side of their financial model, in comparison to satellite.

DBS has gained a substantial piece of the television market, amassing about 19 million subscribers since 1996. During the same period, cable has gained about 8.3 million customers, rising from 64.7 million in 1996 to 73 million in 2001.

Cable is still holding its own on some valuation bases, though.

Subscriber values for DBS are about $2,010 for EchoStar and $1,686 for DirecTV. For basic-cable customers, the valuation is $2,069 per subscriber, but that rises to $3,446 per customer when high-speed data and digital service are factored in, according to a September research report by Banc of America Securities LLC cable and satellite analyst Doug Shapiro, based on video-only service.

Riding the IRR

Shapiro also contrasted "internal rates of return," or IRR, which compare start-up investment costs relative to cash flow streams. Cable looks pretty good on that basis.

Cable's IRR is 43 percent for basic-cable customers and 50 percent when digital and high-speed is data factored in. EchoStar's IRR was 19 percent and DirecTV's was 18 percent, according to Shapiro's calculations, using financial figures for the first half of 2002.

Those numbers should hearten cable operators, given that basic has been a major target for DBS competition and delivers lower profit margins than digital and high-speed data services.

"If basic cable is healthy, then the bundle is three times as healthy," Insight Communications Co. CEO Michael Willner said.

In an interview, Shapiro said it's tricky to compare the business models of the two rival video industries.

"The criticism of that analysis is that you're being way to optimistic on the actual replacement cost of the cable plant," Shapiro said. "The other thing for cable is that you have a big allocation issue. When you look at the returns on video, digital and data, you're looking at the return on incremental capital and not allocating any of the cost of the upgrade."

But even with those caveats, Shapiro said the numbers appear to show that cable model is still strong and could ascend, given the growth of new services.

In the SAC

Dragging down DBS's IRR are high subscriber-acquisition costs, or SAC.

Satellite-delivered TV has relatively low fixed costs — about $15 in plant costs per home passed, compared with $500 for cable — but its SAC costs are much higher. According to Shapiro, SAC costs for the two DBS providers average $553.50 per subscriber, versus $172 for basic cable.

Driving DBS SAC: heavy advertising, retailer incentives, third-party sales commissions, manufacturer subsidies and payments to independent installers.

DBS has been acquiring plenty of subscribers. In the third quarter, EchoStar reported 320,000 additional subscribers, one of its highest-growth quarters to date.

DirecTV chief financial officer Mike Palkovic was not available for comment. And EchoStar spokesman Marc Lumpkin declined to comment. But on EchoStar's third-quarter earnings conference call, company chairman Charlie Ergen said SAC is beginning to come down.

In the recent quarter, EchoStar trimmed expensed SAC by $43 per new subscriber, mainly by encouraging more customers to lease set-tops. Ergen said EchoStar expects expensed SAC costs for all of 2002 to be about $430 per gross additional customer.

EchoStar's total SAC — which includes capitalized costs —actually rose, though, to $545 per customer, and Ergen conceded there are no signs it will slow down.

But Ergen took issue with cable's ability to recover the estimated $65 billion it has spent on upgrading plant, compared with the $4 billion to $5 billion EchoStar has spent to provide service.

"Given that half the people are going to be analog customers, and never care about modems and digital cable, and yet they paid $65 billion — $32 billion for [basic customers] — they will never get a dime back of it," Ergen said. "I have no doubt that we are going to get the four or five billion that we have invested in our customers back."

Willner disagreed.

"Up until a couple of years ago, they [DBS] were competing with more channels and had digital quality pictures, while we were still delivering analog," the Insight CEO said. "That was a tough fight. But once we start delivering [video-on-demand], high-speed data, telephony, local interactive services like we're doing, we're finding our churn rates going down dramatically and customers start coming back.

"To me there's a whole sea change going on now with regard to the competitive nature of our business against satellite, and it's working in our favor."

Churn impact

Churn also costs DBS more.

Overall, monthly DBS churn has been lower than cable's. DBS has lost 1.5 percent to 1.6 percent of its subscriber base, compared with 2.5 percent for cable. But when a cable operator loses a customer, that operator basically loses about $40, or the cost of a truck roll.

When a DBS provider loses a customer, that provider is out more than $500.

Ergen also acknowledged that DBS churn was rising — by about one-tenth of 1 percent a year — because of service theft and customers defecting to get a cable modem.

"Where somebody wants a cable modem, that's a huge advantage that the cable industry has," Ergen said on the conference call. "And our industry doesn't have a response. We spent about $150 million trying to figure out how to do it via satellite and we were unsuccessful at that."

Ergen said he thought EchoStar could solve the high-speed-data dilemma through relationships with telephone companies that offer digital subscriber line service.

Shapiro stressed that the two models can thrive, mainly because both generate IRRs in excess of their cost of capital.

While cable will become increasingly profitable by offering new services, DBS can boost its profits by bringing down SAC and reducing churn.

"If you're generating a return above your cost of capital, you're making money," Shapiro said. "Theoretically, a model that generates return above the cost of capital is a model you're going to continue running until it ceases to do so."

DBS vs. Cable
EchoStar DirecTV Basic Cable Digital Cable High-Speed Data Cable Total Cable Value
Source: Company reports, Banc of America Securities estimates
Fixed Costs
Replacement Plant Cost/Home Passed$15$15$500$25$15
Plant Cost Per Subscriber$107$100$769$51$43
Variable Costs
Subscriber Acquisition Cost (SAC)
Expensed SAC/Subscriber$413$525$20$25$150
Total SAC$525$525$170$289$250
Revenue/subscriber (Monthly)$49$58$48$17$40
Unlevered Free Cash Flow/subscriber (Annual)$74$69$107$27$157
Churn (Monthly)1.53%1.60%2.50%3.50%1.50%
Net Present Value/Current Basic Sub$2,010$1,686$2,069$216$1,161$3,446
Internal Rate of Return19%18%43%21%67%50%

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