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An Industry Metronome

8/22/2009 2:00 AM Eastern

In the 15 years since General Motors launched DirecTV, the direct-broadcast satellite company has become the world’s largest multichannel-video provider, with more than 24 million customers in the U.S. and Latin America.

Now, for the first time in its history, DirecTV is on the verge of standing alone, rather than existing as a division of a larger entity.

At its 1994 launch, few pay TV industry observers could have predicted that DirecTV would ever be the country’s No. 2 multichannel-service provider, with 18.3 million customers. The conventional wisdom held that the entire DBS sector wouldn’t exceed 25 million customers — and many analysts thought those numbers were wildly optimistic. Automaker GM had to be cajoled into backing the venture, even after the Federal Communications Commission gave subsidiary Hughes Aircraft permission to build the DBS service.

But the satellite sector, and particularly DirecTV, has exceeded those initial expectations by leaps and bounds, said Leichtman Research Group president Bruce Leichtman. And DirecTV keeps gaining customers as other multichannel-TV providers lose them. No. 1 provider Comcast lost 214,000 cable customers in the second quarter; Time Warner Cable lost 57,000 customers; and rival satellite-TV provider Dish Network added 26,000 new customers after five straight quarters of losses.

Conversely, DirecTV brought in a whopping 224,000 new customers during the historically slow second-quarter period. And most of those signing on are coming from cable companies, interim CEO Larry Hunter told analysts during the company’s second-quarter conference call held earlier this month.

“DirecTV is simply the best operator in the industry,” said Sanford Bernstein senior cable and satellite analyst Craig Moffett. “Quarter after quarter, what stands out for DirecTV is the sheer predictability of their solid results. They are the metronome of the pay TV business, and I mean that in the most flattering way.”

DirecTV’s stellar growth numbers and low churn rates have some analysts looking forward to its impending coming out party as a standalone company. Liberty Media, which purchased a 48% voting stake in DirecTV last year, is combining its interest in DirecTV with Liberty Entertainment.

Some analysts, including David Joyce of Miller Tabak, expect DirecTV to eventually be sold to AT&T, which is currently offering DirecTV’s video service with its broadband and voice product as a triple-play option in areas where it isn’t selling its U-Verse TV product. Richard Greenfield of Pali Research is also confident that DirecTV is a sellout candidate and expects a telephone company to buy the company, but said he thinks it could be either AT&T or Verizon Communications, which is also selling DirecTV in areas where it hasn’t launched its FiOS TV service.

“[Liberty Media chairman John] Malone is always searching for the next tax-efficient transaction to maximize his own/public shareholder value. DirecTV is yet another pawn in his 'game,’ ” Greenfield wrote in a report after picking up DirecTV’s stock with a “buy” recommendation in June. “We believe a sale of DTV could occur within the next 12 to 18 months, if not considerably sooner.”

Other experts aren’t so sure. Though he didn’t dismiss a buyout altogether, The Carmel Group chairman and chief service officer Jimmy Schaeffler said he doesn’t expect to see one for several years. “DirecTV still has three to five years of legs left,” he said. “It’s a good business and it brings in strong cash flows, and John Malone [who will retain a 24% voting stake in the new company] always likes cash flow.”

Moffett isn’t convinced the company will be sold at all and doesn’t think the logic of a telco buyout is as strong as other analysts believe.

Whether the company is sold or not, Schaeffler and Collins Stewart analyst Tom Eagan believe being a standalone company will be good for DirecTV’s operations and give the company more control to chart its own destiny.

Hunter said some people believed News Corp. (before it sold its DirecTV stock to Liberty Media a little over a year ago) and now Liberty have influenced DirecTV’s decisions in their favor over other public shareholders. But, he noted, that has never happened and he doesn’t expect the company to operate any differently as a standalone than it has as a division of a larger company.

DirecTV is already well-managed and operated, Hunter asserted, and he sees little need to make changes regardless of the ownership structure. But some change is inevitable as DirecTV searches for a new CEO.

Chase Carey, who had served as DirecTV’s top executive since 2003, when News Corp. bought GM’s stake in parent Hughes Electronics, stepped down in May to rejoin his old boss Rupert Murdoch as News’s chief operating officer. The news was a blow to investors and employees who respected his operating style — and the results that were derived from them.

A special committee comprised of Malone and non-employee directors Neil Austrian and Charles Lee was formed earlier this month to conduct a national search for a new CEO. There have been reports that Liberty chief operating officer Greg Maffei or DirecTV Latin America’s CEO Bruce Churchill have the inside track, but the official word is that the search is wide open. Hunter, who served as executive vice president, legal, human resources and administration before being tapped interim CEO, demurred when asked whether he was aiming for the job. Regardless, he is calling the shots until a permanent replacement is named.

Whoever replaces Carey will have the benefit of a well-run organization. The company has been firing on all cylinders this year and has improved its profitability since Carey took the wheel. For instance, DirecTV’s revenue per video subscriber — $83.16 a month — is among the industry’s highest and its churn — 1.51% in the second quarter — is below that of rival Dish, which reported a second-quarter 1.73% churn rate, as well as the cable industry’s average of 2.5%, according to Eagan.

DirecTV’s customer base has been less affected by the recession, said Eagan, so it has been able to insulate itself from the vagaries of the downbeat economy better than many of its competitors. DirecTV has lower overall churn because it has less voluntary churn — those people who are enticed to move to other providers — mainly due to its exclusive sports packages, as well as its extensive lineup of high-definition channels. And by attracting more high-end consumers, DirecTV’s customers tend to have more discretionary income and are less likely to be facing foreclosure or the inability to pay their bills, he said.

To be sure, DirecTV’s growth in the last year has been goosed by its partnerships with AT&T, Verizon and Qwest Communications International, all of which market DirecTV’s video product as part of their triple play in areas where they cannot offer wireline video. Those arrangements have proven to be very powerful for DirecTV, Hunter said. Today, about 25% of DirecTV’s sales come from those partners.

AT&T reported that it had added about 100,000 new DirecTV customers in the second quarter and Verizon recently began pumping DirecTV’s “NFL Sunday Ticket” sports package over the Internet when customers bundle it with its high-end DSL products. To qualify for such a bundle, customers must sign a one-year Verizon commitment and a two-year DirecTV agreement that includes a hardware lease. The promotion is expected to run through September.

“While we are not yet clear how much of the [Verizon] promo, if any, is being subsidized by [DirecTV], we believe it bodes well for DTV subscriber adds in Q3,” Greenfield wrote in a research note on July 29.

Teaming up with the telcos is a bit of a double-edged sword for DirecTV, Hunter admitted. However, he is pleased with the partnerships and expects them to be long-lived. Despite this, in areas where they do offer wireline video service, AT&T and Verizon are fierce competitors.

“Our alliances with the telephone companies have been a significant plus for us,” Hunter said. “Our interests are aligned today and I think that will continue and become even more so in the future, especially as 4G wireless broadband services roll out. We’ll be the rich video source for them.”

DirecTV has been criticized as a one-trick pony with its video-only service and some analysts believe the company is hog-tied by not having an in-house triple-play option. Without a controlled broadband option, Moffett said, DirecTV faces structural problems with its one-way product.

“DirecTV has a lot of issues it must deal with right now,” Schaeffler added. “One of their biggest challenges is going to be creating a product that is competitive with cable operators’ and telcos’ triple-play bundles. Technology isn’t on their side with this issue.”

But Greenfield isn’t buying it. “Despite the strength and supposed 'value’ of cable’s triple-play bundle of video, data and voice, during the past two quarters (when the economy has been at its weakest in years), DirecTV was able to add 761,000 subs in the U.S., at the same time the major public cable operators lost 543,000 basic subs,” Greenfield wrote in June after initiating coverage of DirecTV with a “buy” rating. “While broadband is clearly a competitive advantage for cable MSOs and RBOCs, with over two-thirds of U.S. households already on broadband, DirecTV appears to have weathered the worst of the broadband threat — not to mention, as we look out over the next few years, wireless broadband may further mitigate cable’s bundling power.”

Hunter said DirecTV doesn’t need to own the broadband pipe to be successful in the online space. The pipe, he contended, is simply a commodity. It’s the content that really determines that pipe’s value to consumers.

Greenfield agreed: “DirecTV only does one thing, video, and they simply do it better than others by putting the consumer first and 'super serving’ video consumers in every way possible,” he wrote.

However, the picture for DirecTV is not all rosy or as clear as the high-definition channels it delivers to consumers. The company missed analysts’ expectations for the second quarter posting $407 million in income, or 40 cents a share, down from the $455 million, or 40 cents a share posted last year, and off from analysts’ earnings prediction of 43 cents a share. Operating margins fell to 13.5% this year from 16.7% a year ago, due to marketing costs to attract new customers and a continued drop in the number of customers subscribing to premium channels.

During DirecTV’s second-quarter conference call earlier this month, chief financial officer Patrick Doyle predicted revenue per subscriber would rise about 1% to 2%, down from the previous forecast of 3% due to declining customer interest in pay-per-view and premium programming.

“More customers are finding less value in premium channels, particularly because of the tough economic environment,” Hunter said during the conference call. “We’re pushing a rock uphill at this time. If our customers can’t afford their premium channels, we are trying to work with them. [But] we are assuming a continued acceleration in the reduction of our pay take rates.”

Even as the premium programming sector slows, other revenue-generating areas of the business are beginning to pick up speed or are getting turbocharged for future growth. For instance, there is a growing push to sign up commercial establishments to DirecTV service, said chief sales and marketing officer Paul Guyardo.

“We realized two years ago that we were extremely underrepresented in this category,” Guyardo said. “We think about 90% of bars and restaurants have less than 100 seats and we weren’t servicing that business at all. And it has so much potential.

“What sports bar isn’t going to want DirecTV’s sports-programming packages? Our whole team is working on this right now. We believe we will be quite successful in tapping into that market.”

DirecTV is also setting its sights on providing service to multiple dwelling units. Until two years ago, the company didn’t have a technological solution to compete in that arena, Guyardo said. “But now we have the technology that will enable us to deliver on our promise of the best video experience and we’re getting behind it in a big way.”

The company is being quite deliberate when it comes to determining where it wants to put its MDU equipment. Like its overall marketing strategy, DirecTV is directing its energies toward A-list buildings and communities.

“We have honed it down and we know exactly which buildings we want to attack in the top 15 markets around the country,” Guyardo said.

So even though the pay TV market is becoming saturated and new customers are becoming harder to come by, DirecTV executives remain bullish that growth is achievable and even inevitable as they stretch their tentacles into new service opportunities. That will be necessary to satisfy shareholders who want strong returns on their investment as well as consumers who are continually expanding their appetites for video in non-traditional venues inside and outside the home.

Meanwhile, losing a CEO is generally not considered positive, but Greenfield believes DirecTV’s management team is deep enough to weather any changes that lie ahead.

“DirecTV,” he wrote, “has maintained a singular focus on its video product offering proprietary programming (NFL Sunday Ticket), a superior user interface, better customer service, innovative technology, and the best marketing in the industry to attract higher-end consumers enabling it to consistently outperform the cable industry.”

September