Driving DirecTV Forward

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It was not exactly a Hollywood opening. The first digital subscriber system enabling DirecTV Inc.’s direct-to-home satellite broadcasting service was sold at Cowboy Maloney’s, an electronics retailer in Jackson, Miss., on June 17, 1994 — 10 years ago.

At that point, executives had no way to know that in 2004, their service would be in 12.4 million homes — a number projected to rise to 13 million by year-end.

<p>DirecTV at a Glance</p><p>As of March 31, 2004</p>

Subscribers

12.4 million

Subscribers added Q1 2004

460,000

Average revenue per unit

$63.60

DVR subscribers

700,000

Projected DVR subscribers*

1.7 million

Projected local b’cast signal coverage*

92%

They’d also have to have a pretty impressive crystal ball to anticipate that on the eve of the service’s 10th year, News Corp. would step in to buy a 34% interest in the service.

The basic operation, plus the anticipated financial and creative contributions by News Corp. companies, has prompted some analysts to tout DirecTV with a “buy” rating, although it’s still branded as high-risk by analysts at Salomon Smith Barney. Wall Street also has apparently been impressed by its first-quarter results, a period in which the newly dubbed DirecTV Group Inc. reported operating metrics that exceeded analysts’ expectations in all areas.

According to the company, DirecTV U.S. added 460,000 “owned-and-operated” subscribers (those not acquired through resellers such as the National Rural Telecommunications Cooperative) in the first quarter — greatly exceeding the projections of analysts, who expected growth in the neighborhood of 300,000 to 325,000 subscribers. The amount of revenue generated by each of those homes also grew. The average revenue per unit is now $63.60, a 7.6% increase over first-quarter 2003. That exceeded analysts’ estimates by $2.24 per home, per month.

That led Smith Barney analyst Niraj Gupta to advise clients that his firm continued to regard DirecTV as “the best investment in the cable/satellite industry.”

Eddy Hartenstein — formerly president and CEO of DirecTV and now vice chairman of DirecTV Group — said company founders always dreamed the company would be this robust one decade after launch.

“We never had very specific expectations of where we’d be in 10 years, but we’re pleased with where we are,” says Hartenstein sitting in his 12th-floor office of DirecTV’s headquarters in El Segundo, Calif., overlooking the bustle of the south runway of Los Angeles International Airport.

“If the last three quarters are any indicator, reports of our demise, or slowing down, have been proven to the contrary,” he adds.

During the quarterly conference call earlier this year, the new president and CEO of the group, News Corp. veteran Chase Carey, attributed 80% of the rapid new growth of the direct-broadcast satellite service to a consumer embrace of a satellite product that includes local broadcast signals.

The local dynamic was DirecTV’s biggest sales hurdle, Hartenstein says. Its launch five years ago solved the DBS provider’s biggest marketing problem: the lack of a complete suite of video services. Before the launch of so-called local-into-local service, he says, as many as 25% of the company’s customers retained at least basic-cable TV or a rooftop antenna to acquire local broadcast programming.

According to Hartenstein, by December 2004, local broadcast signals should be available to 92% of DirecTV’s U.S. footprint. “We’re revising what people came to believe was our limitation.”

DirecTV’s earliest hurdle was the cost of hardware: at launch it was about $700. And that amount, on top of a program subscription caused some sticker shock. But mass production has dropped the price of the rooftop dish and set-top hardware to the point that DirecTV can offer free three-room set-up in return for a one-year programming commitment.

THE DVR BOOST

Also adding to the growth is the launch of digital video recorders.

“We expect to add 1 million [DVR customers] this year, for a total of 1.7 million by the end of the year,” Hartenstein says. “All evidence — from the anecdotal to metrics — shows this is nothing but a 'thumbs up’ all the way around.”

Though DirecTV intends to do some near video-on-demand, Hartenstein believes the DVR is the superior offering. “DVR trumps VOD anytime,” he says.

Statistics show that the DVR-using consumers watch more TV, buy more programming and have a lower churn rate than the rest of DirecTV’s subscriber base, he notes. In the latest quarter, DirecTV had a churn rate of 1.4% per month. In DVR households, “that’s cut by half, or better,” Hartenstein says.

The company is in the midst of upgrading its middleware platform to allow for newer interactive applications, “if customers want that.”

One of the early changes made by News Corp. was to divest itself of its stock in DirecTV’s DVR vendor, TiVo Inc.

News Corp. says the action was taken as part of a strategy to eliminate non-core assets. It also sold its 80% ownership stake in the satellite provider PanAmSat Corp., another DirecTV Group company.

Hartenstein says the divestiture of TiVo would have no impact on the business relationship between DirecTV and the DVR vendor. “We have a multiyear contract with TiVo,” he says, adding that the relationship was always non-exclusive. The company also experimented with the Ultimate TV interactive set-top from Microsoft Corp.

“We have 1.7 million [TiVo-enabled] customers. We aren’t going to abandon them,” he says. But he also mentioned that a sister News Corp. company, News Data Systems Group (NDS), is working on a broad-based DVR product. DirecTV may include any newly developed technology from that company in its options.

Though the company is monitoring the development of new interactive applications, Hartenstein supports those that are “program synchronous” and can be controlled without a keyboard in front of the household’s main TV.

“If we can bring certain additional information to the TV that can be accessed easily and intuitively through the remote control, so much the better,” he says.

One successful DirecTV feature won’t change anytime soon: the DBS company’s exclusive football package, NFL Sunday Ticket, which provides subscribers with all 13 football contests each Sunday through the season for $199 (if bought in advance). DirecTV renegotiated its contract for the pact in 2003, locking up the rights continuing through 2008.

ISSUES OF CONCERN

Though DirecTV continues to charge ahead, some issues trouble analysts. Among them is the conclusion of litigation between the DBS provider and resellers NRTC and Pegasus Satellite Television. Some also question whether the satellite company has enough bandwidth to carry upcoming digital broadcast and HDTV signals.

There’s also concern about the future of DirecTV’s programming distribution deals with telephone companies. One partner, Verizon Communications, has announced plans of its own to build plant capable of delivering video to subscribers. DirecTV also has a partnership with BellSouth Corp. in which DBS service is bundled with voice and digital subscriber line products.

Some analysts also question whether News Corp. executives will make decisions about DirecTV that will benefit corporate shareholder value at the expense of the DBS service. For example, will DirecTV be encouraged to cut carriage deals that are extremely attractive to outlets like Fox Sports Network, but not so attractive to the platform itself? After all, News Corp. owns 100% of that channel, but only 34% of DirecTV.

“The management here, from top to bottom, is incentivized only by how DirecTV does, not by how Fox TV does or how News Corp. does, from Chase Carey on down. There’s no conflict there,” Hartenstein says.

Hartenstein says it is possible that DirecTV would participate in promotion of other News Corp. divisions, such as 20th Century Fox theatricals or Fox television network TV shows. That would follow the strategy of The Walt Disney Co., which uses its cable and broadcast networks to carry content promoting the company’s theatricals or theme park divisions.

“We’d look to take advantage of things DirecTV users would be interested in,” he says. Any cross-promotion would be at arms length, a “related parties” transaction, he adds, noting the majority of DirecTV’s board is independent, as is all of its audit committee.

Of all the questions hanging over DirecTV’s future, its relationship with the NRTC is the biggest due to the mid-June bankruptcy filing of Pegasus Satellite Television, the NRTC’s largest member. Pegasus wishes to stymie the attempt by DirecTV to buy the NRTC’s DBS subscribers for a reported $670 million, which works out to $1,763 per 380,000 subscribers, according to analysts. The payout to the NRTC would be made incrementally through 2011. Pegasus asserts it has bona fide agreement guaranteeing it exclusive rights to service its 8.4 million DBS customers in 41 states. Currently, NRTC members resell DirecTV and remit only 5% of the customer revenue to DirecTV.

COURT WIN

Last week, Pegasus failed to obtain a temporary restraining order to prevent DirecTV from directly accessing customers, so the DBS provider has begun marketing directly to Pegasus customers, a DirecTV spokesman said on June 23. Direct access is important, especially as the programming provider adds local-in-local signals, which may necessitate repositioning of consumer dishes or equipment swap-outs. Pending resolution of Pegasus’ Chapter 11 bankruptcy filing, “We would hope that Pegasus is an entity we could buy out as well,” Hartenstein says.

As for that potential phone company problem, Hartenstein says he’s not worried. That may seem like posturing, given that Verizon has begun fiber-to-the-home installations and has confirmed that it hopes to construct video-able plant to 2 million of the homes it passes by the end of 2005. But Hartenstein explains, “We discussed their plans going in,” and the co-branding agreements are all term specific, not open-ended.

The executive also expresses confidence that, among the DirecTV Group companies, the DBS service will have access to enough bandwidth to cope with two impending situations: the day when broadcasters migrate to digital frequencies and an expanded lineup of HDTV channels.

As company executives eye those impending developments, they fine tuning other aspects of DirecTV.

By the end of the second quarter, all new set-tops going into the field will have the same operating system, the same remote control and the same features, Hartenstein says. That will further improve customer service that has been consistently highly ranked by J.D. Powers and Associates and others. Some of the service that has been done historically by outside vendors is being brought in house. New DirecTV-owned call centers have been set up in Tulsa, Okla., and Huntsville, Ala.

Those two changes “will allow us to be quicker, more nimble … and save a little money,” he says.

Hartenstein believes the company is on top of a problem that spiked for DirecTV in the late 1990s and early 2000s: piracy. Hackers cracked the conditional-access cards utilized by the DBS provider. According to early 2000 estimates by the trade publication Satellite Week, there may have been as many as five illicit customers for every one that bought DBS service, an estimate DirecTV has always challenged.

The problem was severe enough that DirecTV dropped, and sued, its smart card vendor in 2003, announcing it would go in-house with security development. Ironically, that vendor was News Corp.-owned NDS Group plc. DirecTV sued NDS for fraud and breach of contract; NDS counter sued with a claim that the DBS company misappropriated trade secrets.

NDS is now DirecTV’s conditional access card partner once again, and Hartenstein is solicitous, “We have common goals and connections.”

Hartenstein wouldn’t guess at how many subscribers the company might have by the end of its second decade, but he is optimistic, “It’s a good business to be in.”

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