Simmering DBS Merger Looks to Be Boiling Over

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The long-pending merger between EchoStar Communications Corp. and Hughes Electronics Corp.'s DirecTV Inc. unit was dealt another blow last week, as published reports said the U.S. Department of Justice was ready to block the deal — paving the way for News Corp. chairman Rupert Murdoch to swoop in.

According to a Sept. 23 report in The New York Times, DOJ staffers were ready to recommend scuttling the direct-broadcast satellite deal to Charles James, head of the agency's antitrust division, claiming that the combination would be anticompetitive.

James has the ultimate decision-making authority and could opt not to follow the staff recommendation. However, it is unlikely that he would do so.

Blocking the deal could end up starting the auction process for Hughes all over again, with some observers citing News Corp. and General Electric Co. unit NBC as the likely bidders.

Last week, Liberty Media Corp. chief operating officer Gary Howard — whose career included a stint heading up Tele-Communications Inc.'s satellite operations — told investors at a media conference that Liberty could either join Murdoch in a bid, or make one on its own.

"If Murdoch were to go back into the equation, my guess is that we would be talking to them," Howard said at the Banc of America Securities LLC 32nd Annual Investors Conference in San Francisco last Tuesday. "Whether Murdoch is involved or not, we might be interested on our own for footprint distribution. A lot of that is all speculative until we see what really comes out of Washington."

Liberty had backed Murdoch in his earlier failed bid for Hughes.

EchoStar, the No. 2 DBS provider, agreed to buy No. 1 Hughes from parent General Motors Corp. in a stock-and-cash deal worth about $26 billion in October. But because of a steep decline in EchoStar stock — down about 40 percent this year — the deal is now valued at about $15 billion.

Buyout move denied

Even at $15 billion, Hughes may find it hard to attract a better price. With a market capitalization of $11 billion — DirecTV's market cap is about $3.3 billion — finding a buyer willing to pay such a high premium for Hughes could be difficult.

Hughes also denied reports last week that DirecTV management would attempt a buyout of the company on its own, in an effort to keep it away from News Corp.

A report in the Los Angeles Times
said DirecTV president Roxanne Austin had told company employees that a management buyout was an option, given the DBS provider's improved performance.

In a memo to employees, Hughes CEO Jack Shaw denied such a possibility.

"Roxanne has denied any such discussions, and I can personally assure you that no such alternatives are being considered," Shaw wrote in the memo.

In that same memo, which was filed with the Securities and Exchange Commission last Thursday, Shaw wrote that Hughes executives met with the DOJ on Sept. 24 — the day after the story in The New York Times
broke — and were "assured that the staff recommendations regarding approval of the merger have not been made."

Shaw added that Hughes is still engaged in discussions with the DOJ and the Federal Communications Commission, and the review process is ongoing.

Sub growth slows

Although DirecTV's cash flow has increased — it revised third-quarter cash-flow estimates upward last week, to $195 million from $150 million — its subscriber growth has slowed. The company said that third-quarter subscriber additions would be between 200,000 and 210,000 customers, instead of the previously estimated 250,000 to 300,000 homes. This would be the second consecutive quarter that DirecTV will miss earlier subscriber-group targets.

In the second quarter, the company added 202,000 new customers, short of its forecast of 225,000 to 250,000. For that reason, several analysts believe that no matter the outcome, Ergen has already won.

"His [Ergen's] business is not predicated on a deal going through," said Banc of America Securities LLC cable and satellite analyst Doug Shapiro. "EchoStar has performed well. Hughes has hit a speed bump."

Despite the denials, most observers have said the merger has been on shaky ground for months, with some giving it a 10 percent chance of passing regulatory muster.

At the heart of the problem is the fact that the deal would combine the No. 1 and No. 2 competitors in the DBS industry, a fact that even the merger-lenient Bush Administration may find impossible to avoid.

"This is a classic case of two competitors merging," said Legg Mason Equity Research telecom and media analyst Blair Levin. "Obviously, if you believe the [published reports], staff has done an assessment that leads them to believe that the answer [for merger approval] is no."

It was Levin's report earlier this month claiming that DOJ staff were deposing satellite retailers, programmers and other merger foes in preparation for a court battle to stop the merger that helped touch off the speculation the deal would be rejected.

Analysts declined to speculate on whether the DOJ would scuttle the deal. But most agreed that regardless of Justice's decision, Hughes would be sold.

"One thing I do know is that GM and Hughes are headed for a divorce one way or another," Shapiro said. "GM needs the cash, whether they sell it to EchoStar or somebody else."

DOJ's options

Shapiro said the DOJ has two options — reject the deal outright, or reject it with conditions. The question is whether EchoStar chairman Charlie Ergen is willing to meet those conditions.

While Ergen has answered the competitive question by vowing to keep pricing low, especially in rural markets, Levin said that the DOJ would likely require some kind of divestiture of satellite spectrum.

That could be solved by Cablevision Systems Corp.'s proposal earlier this month to obtain 17 satellite transponders from EchoStar to round out its own planned DBS offering, dubbed HD-SAT.

Cablevision has pitched the idea to the FCC, claiming that obtaining the spectrum would allow it to offer a nationwide service with 276 channels.

"The problem with that is, if cable can compete with much less spectrum, what is the justification for the [EchoStar] merger?" Levin said.

The other alternative would be to force EchoStar to give up a full-CONUS slot, which would cover the continental United States. Levin said that it is even more unlikely that Ergen would give up that spectrum.

And that wouldn't solve the competition problem, Levin said, because a combined DirecTV-EchoStar would have a 20 million-subscriber head start on its new rival.

"The other guy is just going to get killed," Levin said.

There is also the Ergen factor. A fierce competitor — he started EchoStar with one satellite dish in the back of his car — Ergen is expected to fight any regulatory denials vigorously in court.

"If the government blocks the merger, we think that EchoStar will not go away quickly nor quietly," Morgan Stanley satellite analyst Vijay Jayant said in a research report.

According to the merger agreement, both parties are expected to challenge an unfavorable DOJ ruling until it is final and no appeal is possible, Jayant wrote, adding that he expected such litigation to drag on for a year or longer.

Litigation also could help EchoStar opt out of the $600 million breakup fee it agreed to pay if the deal was blocked by regulators.

"The first check Ergen writes is not to Hughes, but to his lawyers," Levin said.

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