|From this week's Barron's:|
Looking for Liftoff
Battered Hughes Electronics may stand a good chance of boosting its earthbound shares
By ANDREW BARY
The collapse in cable-tv stocks this year has spilled over into the satellite sector as Hughes Electronics, owner of DirecTV, the country's largest satellite TV provider, and Echostar Communications, have fallen sharply.
Hughes is controlled by General Motors. Its shares, which trade as a tracking stock, GM, class H and recently were at 9.60, are down 38% this year, way below their 2000 peak of 47. GMH is below where it stood in early 1998, when DirecTV had less than half its current subscriber base.
There is ample reason for Hughes's drop. Wall Street is shunning money-losing companies that are consuming cash rather than generating it, and Hughes posted a loss of $311 million in the first six months of 2002 on $4.2 billion in revenue. This year it is expected to consume about $1 billion in cash after capital expenditures.
A former favorite of growth-stock fans, Hughes lately has lured value-oriented investors, who argue that the stock looks cheap, especially if the company completes its merger with its only satellite rival, Echostar Communications, to create a dominant U.S. satellite company.
"Hughes is attractive, deal or no deal," says Bill Jacobs, an analyst for Chicago-based Harris Associates, which runs the Oakmark fund, a Hughes shareholder. "If you get the deal with Echostar, it's a home run." Jacobs values a stand-alone Hughes at 20 a share and even higher if the Echostar deal occurs because of the enormous operating benefits that the merged companies would be able to achieve.
After long negotiations with Rupert Murdoch's News Corp. and much internal debate, General Motors, which owns about 30% of GMH's 1.38 billion shares, agreed to sell Hughes to the smaller Echostar last October. Initially, the deal was valued at $25.8 billion; it's now worth about $15 billion
The transaction is given a low likelihood of gaining needed antitrust and regulatory approval, with one takeover arbitrager saying last week that it was "dead on arrival" in Washington. A major reason: fear among lawmakers from rural areas -- where cable TV often isn't available -- about price-gouging of consumers by a single monopolistic satellite company. The market skepticism is apparent in the wide, $1.50 spread between the current value of the Echostar offer of 0.73 of its shares for each GMH share, now valued at about $11, and GMH's share price of 9.60. Echostar trades at around 15. The federal antitrust decisions are expected in the fourth quarter.
Bill Nygren, who runs the Oakmark fund, says the value of satellite-TV subscribers simply is too low relative to depressed valuations in the cable industry. As the accompanying table shows, Hughes's DirecTV subscribers are valued at little more than $1,000 each, less than half the average of the four big cable TV providers, Comcast, Cablevision Systems, Charter Communications and Cox Communications. Cox's 6.3 million subscribers are valued at more than $3,000 each. The Hughes calculation assumes that Hughes assets other than DirecTV are worth around $2 billion. The company's current market value is $13.2 billion.
The satellite-TV companies often have traded at a discount to their cable peers, because satellite companies incur much higher costs to gain new subscribers and because satellite operators haven't been able to offer services such as high-speed Internet connections successfully. "The satellite discount is way too large," says Nygren. "The market also is according virtually no possibility to the completion of the Echostar/Hughes merger. We think the probability is much greater than zero."
Hughes' attributes include a market-leading position in the U.S. satellite-TV industry with 10.7 million subscribers, against an estimated 7.5 million for Echostar, solid growth prospects and a strong balance sheet. The larger Hughes has a bigger presence than Echostar in urban areas, but Echostar, run by its shrewd, entrepreneurial founder, Charlie Ergen, is viewed as leaner and better managed. Echostar is expected to generate free cash flow in 2002, a year before Hughes.
Hughes' financial strength contrasts markedly with much of the cable TV industry. Debt-burdened Adelphia Communications is in bankruptcy. Charter Communications, controlled by billionaire Paul Allen, may be heading for a financial restructuring, and highly leveraged Cablevision Systems is under pressure to sell noncore assets to plug its projected 2003 funding gap.
In addition to balance-sheet strength, the satellite-TV players have several other major advantages over cable. The satellite subscriber base is growing, albeit more slowly than in 2000 and 2001, while cable operators such as AT&T and Cablevision are losing subscribers. DirecTV, started in 1994, is expected to generate about a million new subscribers this year; Echostar, 1.2 million.
It should be said that DirecTV had disappointing net subscriber growth of 202,000 in the second quarter, below its projection of 225,000 to 250,000, and it may well fall short of the third-quarter goal of 250,000 to 300,000 because of the weaker economy and slow sales by some DirecTV distributors.
Unfettered by defined geographic boundaries, the satellite companies can sell their services anywhere in the country. They also have much lower capital requirements than cable operators, which have spent billions to upgrade their systems. DirecTV services the U.S. with seven satellites.
The main knock against satellite companies is the high cost of attracting subscribers. DirecTV laid out $530 to attract a new subscriber during the second quarter. For each new customer, DirecTV has to pay a commission averaging about $275 to vendors such as Circuit City and Radio Shack and defray the cost of the satellite dish, set-top boxes and installation. This amounts to $1.6 billion annually. Cable companies such as Comcast spend just $40 per new subscriber.
The satellite-TV providers used to be disadvantaged because they didn't broadcast local stations, but increased capacity has changed that, with DirecTV now offering local stations in 47 markets. If the Echostar deal gains approval, the combined company will be able to offer local service in all 210 TV markets around the country.
"Now that the satellite players have local stations, an intriguing situation has developed," says Rob Gensler, manager of the T. Rowe Price media and telecom fund. "You essentially have a duopoly with satellite and cable. The cable guys have little incentive to deal a knockout blow to satellite."
Gensler says cable operators have pursued a strategy in recent years of boosting revenues and cash flow through price increases for the basic services and products such as digital TV and high-speed Internet access, rather than through trying to take market share from the satellite operators. Cable rates have risen at a 5% annual clip during the past five years.
The result is that the cable industry is stuck at about 60 million subscribers, while the satellite business, with 18 million subscribers, continues to expand. DirecTV, which once was priced at a premium to basic cable, now is very competitive. It has, for instance, a 130-channel digital package, including local stations, priced at $39.99 a month. Extra TV sets are an additional $5 each per month.
Hughes' main asset is its U.S. DirecTV operations, but it also owns DirecTV Latin America, which has 1.7 million subscribers; Hughes Network Systems, a provider of satellite services to corporate customers and a producer of set-top boxes for DirecTV; and a small high-speed Internet access business. Hughes also controls 81% of the publicly traded PanAmSat, a major provider of satellite services.
Hughes now has about $2.6 billion of net debt after reflecting the cash on its balance sheet. But it will sell PanAmSat to Echostar, regardless of whether the overall merger occurs, netting $2.7 billion. Hughes also stands to receive a $600 million breakup fee if the Echostar deal dies. Hughes, however, could be liable for payments to Boeing, stemming from the sale of its satellite manufacturing business to the big aircraft maker for $3.85 billion. Boeing argues that it overpaid for the business and is seeking nearly $1 billion from Hughes; the dispute is in arbitration.
"If we don't get regulatory approval for the merger, we'll be in incredibly strong financial shape with no net debt" and an ability to fund all projected capital spending, Mike Gaines, Hughes chief financial officer, told Barron's last week.
One of the main knocks against Hughes is that it produces only a modest amount of pretax cash flow, defined as earnings before interest, taxes, depreciation and amortization (Ebitda); and that it's consuming cash after capital expenditures and interest costs. This complaint is valid, but it's important to recognize that Hughes's cash flow is depressed by losses outside DirecTV and that results are expected to improve markedly in 2003 and 2004.
It's also notable that Hughes expenses nearly all of its heavy subscriber-acquisition costs, which depresses reported results. Harris Associates' Jacobs says if DirecTV decided to aim for slower subscriber growth, its cash flow would rise because of lower subscriber-acquisition costs. One of Hughes's main goals is to reduce monthly churn, or subscriber losses, now running at 1.7%, because of the high cost of getting new subscribers. Hughes has a churn goal of about 1.5%.
This year, Hughes projects it will generate $750 million to $850 million in pretax cash flow, up from $389 million last year. A better 2002 cash flow estimate is about $200 million, excluding the $580 million projected for PanAmSat, which is due to be sold. As the table shows, Hughes' valuation looks high based on that meager cash flow. But Hughes' pretax cash flow, excluding PanAmSat, could rise to $1.2 billion next year and $1.8 billion in 2004, according to Morgan Stanley analyst Vijay Jayant.
With capital spending expected to fall to as little as $600 million in 2003 from $1.9 billion this year as Hughes completes its next-generation corporate satellite service network called Spaceway, next year the company could generate free cash flow of $600 million and positive earnings per share of about 25 cents.
Hughes is under investor pressure to dump its unsuccessful high-speed satellite Internet service, called DirecTV DSL, which had just 133,000 subscribers at the end of the second quarter. The company also is being urged to sell or merge Latin American DirecTV, which is bleeding cash. Together, these two business have projected negative cash flow of about $250 million in 2002. Domestic DirecTV is expected to generate more $500 million in cash flow this year and potentially $1 billion or more in 2003.
Hughes Chief Executive Jack Shaw, reiterating comments made during the company's earnings conference call in mid-July, said last week that Hughes is taking a hard look at the Internet and Latin American businesses.
"DirecTV Latin America is a big cash user. That can't go on forever," he said, noting that Hughes needs a partner in the region, which has been beset by economic trouble.
The obvious partner is the other major Latin American satellite operator, Sky TV, controlled by Rupert Murdoch's News Corp. Shaw said last month that decisions on these matters probably will be made around year end in conjunction with the resolution of the Echostar merger situation.
One risk with Hughes is that if the Echostar deal dies, GM will again approach Murdoch about merging Hughes with News Corp.'s global satellite operations. Yet it's hard to imagine that Hughes shareholders would be much worse off with Murdoch than with GM.
At a time when the cable-TV industry is out of favor on Wall Street, the satellite stocks trade at a steep discount to the downtrodden cable shares.
Hughes fans argue that the downside risk in the stock is small because of the company's strong balance sheet, and appreciation potential is significant if cash flow surges in 2003 and 2004 and if Hughes scales back its money-losing operations.
And if, against the odds, the Echostar deal gets antitrust approval, Hughes could be flying as high as one of its satellites.