Steady Wins Race In Valuing Satellite TV6/09/2006 8:00 PM Eastern
Stabilizing subscriber growth may boost the cash flow of DirecTV Group Inc. and EchoStar Communications Corp., but depress the value of the direct-broadcast satellite providers at the same time, according to a report by Sanford Bernstein & Co. cable and satellite analyst Craig Moffett.
The reason: conventional measures of cash flow are “virtually useless” in allowing investors to figure out what a company's business is worth, according to Moffett.
In his May 30 report, Moffett claims that signing on fewer new subscribers each quarter has a short-term positive effect on the most common measurement of cash flow — earnings before interest, taxes, depreciation and amortization — because with fewer new customers, there are fewer signup and installation expenses.
|Cash Flow: Steadying How It Goes|
|Sanford Bernstein analyst Craig Moffett calculates the “steady state” cash flow of a satellite company by including the costs of replacing lost customers, but not the costs of growing the overall customer count. Here's how his measures of “Steady State Cash Flow” compare to the more conventional measure of cash flow known as Earnings Before Income Taxes, Depreciation and Amortization.|
|Subscribers = End of period subscribers | EBITDA adjusted to exclude certain one-time items
DirecTV = U.S. DBS segment only (i.e. excluding PanAm Sat, etc.) | DirecTV Subscribers include NRTC prior to 2004
SOURCE: Sanford C. Bernstein & Co.
To cut such expenses further, cable companies and lately satellite companies have chosen to capitalize the cost of acquiring subscribers. In accounting, subscriber-acquisition costs can be “capitalized” when incurred and then expensed over the life of the subscription.
The right way to judge how these companies have performed, though, is to differentiate between the cost of replacing customers — maintaining a steady state — and not to penalize them for the costs of actually growing the customer base, Moffett contends.
This is done in a metric he calls “steady-state cash flow,'' which he introduced a year ago. Steady-state cash flow shows whether, for instance, a company has to spend more to just keep the amount of subscribers steady.
|EBITDA VS. SSCF|
|EBITDA: Revenue minus expenses, excluding tax, interest, depreciation and amortization.|
|SSCF (Steady State Cash Flow): Revenue minus expenses, excluding tax, interest, depreciation, amortization and subscriber acquisition costs. Then subtract acquisition costs associated with replacing lost subscribers.|
|SOURCES: Investor's Dictionary; Sanford C. Bernstein & Co. LLC|
BIG EBITDA JUMPS
Here's the problem: DirecTV and EchoStar reported big jumps in EBITDA, the normal measure of cash flow, when they began to capitalize their subscriber acquisition costs.
DirecTV's EBITDA in the first quarter was $545 million, up 153% from $216 million a year earlier. But even that, Moffett notes, does not show the full impact of the decision to capitalize acquisitions. That decision came in March, with two-thirds of the quarter gone.
“The huge [first quarter of 2006] jump in EBITDA margins, for example, shed no light whatsoever on whether the business was getting stronger or weaker,” Moffett wrote. “In short, EBITDA and EBITDA margins are virtually useless in evaluating the health — and the relative health — of the [satellite] business.”
Indeed, as the subscriber rolls of satellite companies get bigger, the cost of just staying even goes up. If, for instance, a satellite company loses 2% of its customers every month, it has to get 100,000 new subscribers just to stay even, if it has 5 million subscribers. If it has 10 million, it has to get 200,000, just to stay even.
Churn appears to be growing at EchoStar and DirecTV, according to Moffett. At DirecTV, customers lost to churn increased from 632,000 in the first quarter of last year, to 841,000 in the third quarter, a jump of 33.1%. At EchoStar, the trend was similar: customers lost to churn numbers 471,096 in the first quarter of 2005, rising 35.7% to 639,189 in the third quarter of that year.
Churn has dropped or leveled off in the last two quarters. DirecTV, the largest of the two satellite companies, lost 664,000 subscribers in the first quarter, down from 765,000 in the fourth quarter. EchoStar lost 562,080 subscribers in the fourth quarter and 567,084 in the first.
GROWTH RATES DECLINING
Part of the cause: growth rates for both companies are declining steadily.
For example, according to Moffett's research, DirecTV's annualized subscriber growth rate has dipped from 14.4% in the first quarter of 2005 to 6.5% in the first quarter of 2006. The same has held true for EchoStar — subscriber growth fell from 14.2% in the first quarter of 2005 to 9.2% in the first quarter of 2006.
So far, those declines in subscriber growth have had little impact on steady state cash flow for either company. Since 2002, DirecTV has more than doubled its steady-state cash flow from $306.2 million to $628.2 million, while EchoStar increased its steady state cash flow from $290.1 million to $532.95 million, or 83.7%.
The bulk of the growth in steady state cash flow occurred between 2002 and mid-2005, when subscriber additions were still robust (see chart). Now that the growth is leveling off, Moffett wrote that steady state cash flow will follow suit.
Putting further pressure on steady state cash flow margins will be marketing spending. That is expected to tick up as DirecTV and EchoStar roll out HDTV service in more markets. That will mean replacing customers' satellite dishes and putting in MPEG-4 enabled set-top boxes.