somewhat *OT* (long -part 1) CSFB on DISH:
EchoStar Communications Corp. BUY
LARGE CAP
Price Target Raised to $150, with the Potential for DISH
$200 in 2000
DISH
Ty P. Carmichael, Jr., CFA
· DBS industry consolidation continues to have a better-than-expected
impact on subscriber growth. We raised estimated 1999 DISH net sub-scriber
adds to 1.35 million from 1.2 million.
· Magnitude of valuation discount assigned to EchoStar relative to cable
is grossly inconsistent with relative projections for subscriber levels and
key value drivers.
· Valuation discount reflects in part the continued perception that DBS is
a niche service that will go away. Inherent capital cost advantages,
positive feedback loop, and bundling render this view inaccurate.
· Smaller portion of valuation discount reflects near-term operating chal-lenges
faced by EchoStar, which is justified. However, we believe that
any weakness in the stock price from current levels caused by these
transitory issues creates an excellent buying opportunity.
Investment Summary
We have raised our price target to $150 from $100 based on three factors:
· Increased subscriber projections.
· Fewer than originally anticipated shares should be issued to News Corp. and
MCI WorldCom.
· Expansion of the EchoStar competitive advantage period that would be trig-gered
by legislation that allows satellite TV companies to transmit local TV
channels into local markets, which appears highly likely to become law, soon.
We have enhanced our valuation through an analysis of the relationship between
three highly related value drivers—ROIC, economic profit, and free cash flow—
and the current market value assigned to the top-three cable companies and Echo-Star.
Through a comparable analysis, we find that the market currently values
cable assets higher than DBS (direct broadcast satellite) assets, probably not a
surprise and, in our view, justified at this time. However, the magnitude of the
valuation disparity is grossly inconsistent with projections for the key value drivers
and the increasing likelihood that EchoStar will have a subscriber base of compa-rable
size to that of Comcast and MediaOne by the end of 2000.
From this perspective, EchoStar appears considerably undervalued, providing
tangible support to the valuation conclusion derived from our value-based dis-counted
cash flow analysis. As the EchoStar subscriber base continues to ex-pand
and the economic power and consequent competitive advantage of the
DBS model become more widely understood, we would expect EchoStar's stock
prices to rise, narrowing the valuation gap.
We believe the valuation discount assigned to EchoStar relative to cable reflects
in part the reality that many still perceive DBS a niche service that will go away as
cable introduces bundled voice, video, and data services. This view is inaccurate.
In fact, we expect DBS operators to not only survive but prosper in the face of an
improving cable product. Three factors serve as the basis for this outlook: inher-ent
capital cost advantages, positive feedback loop, and bundling.
It is important to note that this report does not attempt to position DBS as “better”
than cable. Further, we agree with the “cable” investment thesis put forth by
CSFB's cable analyst, Laura Martin, which has been very early and very right.
The purpose of our work is to highlight the valuation upside to EchoStar by doing
the following:
· Incorporating the top-three public cable companies into our analysis to estab-lish
a context for our valuation scheme and the target price we assign to
EchoStar.
· Expanding our investment thesis to include inherent capital cost advantages,
the emergence of a positive feedback loop, and potential bundling as the ba-sis
for our assertion that EchoStar should become an entrenched provider of
multimedia services to an increasing number of homes and soon make a ton
of money in the process.
Two meaningful operational challenges facing EchoStar over the next 12 months
account for a smaller portion the valuation disparity. First, EchoStar V and Echo-Star
VI must be placed in service without a hitch. The satellites are scheduled to
be launched in August and December, respectively.
Second, the EchoStar business plan will require the company to repoint its
installed base of antennas during 1999. Upon completion of the transaction with
News Corp. and MCI, EchoStar will own 29 DBS channels at 110 WL versus 21
at 119 WL. Given the greater capacity at the former orbital position, EchoStar will use the slot to transmit the core video programming, requiring the installed base
of antennas to be repositioned toward 110 WL. The satellites at 119 WL will be
used to deliver local channel programming and the advanced services that should
emerge over time.
Repositioning more than 2.5-2.7 million antennas represents an incredibly chal-lenging
task that could have a negative impact on churn and net subscriber
growth during this period. However, close to half of the antennas that should be in
the field by the end of 1999 are likely to have been installed by customers, sug-gesting
an equal amount could assume responsibility for repointing the dish.
This “project” could be avoided by entering into a transponder-sharing agreement
with DirecTV, a deal that would benefit both entities.
Reflecting the reality of these challenges, we are conservative in our operating
and cash flow projections for 2000 and 2001. Our estimates would increase to
levels that justify a $200 stock price in 2000 if:
· EchoStar V and EchoStar VI both are successfully launched and become
fully operational without any in-orbit difficulties.
· EchoStar survives the process of repositioning more than 3 million antennas
better than we anticipate or forges a transponder-sharing agreement with
DirecTV, either at 110 WL or 119 WL, that removes this burden.
Any weakness in the stock price from current levels caused by these transitory
issues creates an excellent buying opportunity.
Comparable Analysis Implies Significant Valuation Upside
We have enhanced our valuation through an analysis of the relationship between
three highly related value drivers—ROIC, economic profit, and free cash flow—
and the current market value assigned to the top-three cable companies and Echo-Star.
Economic profit (ROIC - WACC) indicates the amount of shareholder value
expected to be created as a business grows.
Table 1
Valuation: EchoStar versus Cable
Through a comparable analysis, we find that the market currently values cable
assets considerably higher than DBS assets, probably not a surprise and, in our
view, justified at this time. Based on the current stock prices, CSFB's cable ana-lyst
Laura Martin estimates that the values assigned to the cable assets of Time
Warner, Media One, and Comcast are $61.9 billion, $28.5 billion, and 24.5 billion,
respectively (see Table 1). Comparatively, our analysis indicates that investors
currently value EchoStar's DBS business at $7.7 billion, based on the current
stock price.
The magnitude of the valuation disparity is grossly inconsistent with projections
for the key value drivers and the increasing likelihood that EchoStar will have a
subscriber base of comparable size to that of Comcast and MediaOne by the end
of 2000.
From this perspective, consequently, EchoStar appears considerably underval-ued,
providing tangible support to the valuation conclusion derived from our
value-based discounted cash flow analysis. As the EchoStar subscriber base
continues to expand and the economic power and consequent competitive ad-vantage
of the DBS model become more widely understood, we would expect
EchoStar's stock price to rise, narrowing the valuation gap.
Return on Invested Capital (ROIC)
Return on invested capital essentially reflects the cash-on-cash returns achieved
by a business—i.e., cash inflow relative to all cash outlays. Since the relative
value of a business will be a function of the cash generated per dollar invested,
we believe ROIC represent the most accurate and objective means of comparing
the value of two entities.
To underscore the insight derived from a ROIC-based comparable valuation
analysis, we provide a basic example (for those familiar with the valuation impli-cations
of ROIC, bear with us). Hardware Store A (HA) and Hardware Store B
(HB) each sell essentially the same products and required an initial investment of
$500 to get started. However, HA realizes a ROIC of 20% while HB's ROIC is
5%. In dollar terms, the respective ROIC's imply annual after-tax free cash flow
produced by HA and HB totals $100 and $25, respectively. Which business would
you want to own? As illustrated by this example, ROIC is a conceptually basic,
but extremely powerful valuation tool.
Applying a ROIC valuation framework to the top three public cable companies
and EchoStar yielded conclusive results—EchoStar continues to be undervalued.
Beginning in 2001, EchoStar should generate a considerably higher ROIC than
MediaOne and initially start to outpace Comcast and Time Warner.
EchoStar's ROIC should be 13% in 2001, roughly 1.19 times, 2.13 times, and
1.04 times higher than the respective ROIC projected for Comcast, MediaOne,
and Time Warner in the equivalent year. By 2003, the ROIC achieved by Echo-Star
should reach 36%, approximately 2.8 times, 4.3 times, and 2.3 times greater
than the respective 2003 ROIC expected to be achieved by Comcast, MediaOne,
and Time Warner. Although EchoStar should produce significantly more cash per
dollar invested, its business is currently valued at discounts of 69%, 73%, and
88% to the respective cable assets of Comcast, Media One, and Timer Warner.
Based on our ROIC analysis, the magnitude of the valuation differential implies
EchoStar continues to be undervalued, not that cable is overvalued. Despite the
recent surge in EchoStar's stock price, it appears the company has been over-looked
by most of Wall Street in the midst of the hype surrounding a potential
evolution of the cable service.
Economic Profit
The concept of economic profit, an integral component of CSFB's proprietary
VBA methodology, expands beyond ROIC to include a charge for the capital em-ployed
to generate after-tax free cash flow. In essence, an economic profit cal-culation
deducts all capital costs (WACC * invested capital) from after-tax free
cash flow (NOPAT = ROIC% * invested capital) to account for the risk associated
with a business plan and provides a more comprehensive understanding of the
economic value of an entity.
Capital costs should be viewed as a floor, or the minimum level of after-tax free
cash flow that must be produced in order to justify a perpetuation of the business
model. Real shareholder value is created only if the free cash flow emanating from a capital base exceeds the charge for using that capital (WACC * invested
capital); otherwise, value is destroyed. On this basis, we believe there is a direct
relationship between economic profit and valuation—the greater the future eco-nomic
profit that will be produced by a business model, the greater the value of
the company.
Evaluating EchoStar within this framework highlights the economic power of DBS
relative to cable, and underscores the erroneousness valuation disparity that cur-rently
exists between the two businesses. After incurring considerable start-up
expenses, EchoStar should enter a period of powerful value creation in 2001,
when NOPAT (EBIT + goodwill amortization - cash operating taxes) initially sur-passes
capital costs by $20 million. In subsequent periods, economic profits
should explode, reaching $298 million in 2002 and $543 million in 2003.
Comparatively, MediaOne will likely fail to produce a single dollar of economic
profit over the next five years, and consequently will destroy value during this pe-riod.
After-tax free cash flow generated by Comcast should first exceed capital
costs in 2000, one year earlier than EchoStar. However, the economic profit ramp
for Comcast will be much slower than that experienced by EchoStar. Specifically,
Comcast's economic profit should be $210 million in 2001 and $290 million in
2002, which is roughly equal to our 2002 projection of $298 million for EchoStar.
Economic profit data are not available for Time Warner.
Based on our economic profit analysis, the current size of the valuation differen-tial
between EchoStar and the top three public cable companies appears unjusti-fied.
Moreover, our VBA work provides data points that would support an
assertion that EchoStar could ultimately be valued on an equal level with the
cable assets of Comcast and MediaOne, not at discounts of 67% and 72%,
respectively.
Cash Flow
The last aspect of our comparable valuation analysis focuses on the absolute
levels of cash flow. However, we believe absolute cash flow will often have lim-ited
utility when attempting to determine the relative value of a business since it
does not reflect the total capital deployed to generate that cash flow. Neverthe-less,
we recognize that other investors may use an absolute cash measure flow
to compare value.
Reflecting corporate structure, the cash flow generated by the cable segments of
Time Warner and Comcast is estimated by subtracting cable capital expenditures
from cable EBITDA. After-tax free cash, a more accurate measure of value, can be
computed for MediaOne. We provide both measures of cash flow for EchoStar.
In each year from 2000-03, EchoStar should produce considerably more after-tax
free cash flow than MediaOne. EchoStar's free cash flow generation should trail
that of Comcast and Time Warner during most of the forecast period, but the gap
begins to quickly narrow in 2002 and 2003.
Consistent with our ROIC and economic profit analysis, the respective cash flow
projections suggest that the inherent worth of EchoStar is not 69% and 72%
lower than that of the respective Comcast and MediaOne cable assets. On this
basis, consequently, we believe EchoStar remains undervalued.
DISH Continues to Grow in the Face of an Improving Cable
We believe the valuation discount assigned to EchoStar relative to cable reflects
in large part the misperception that DBS is a niche service that will ultimately go
away. The potential for a 750 Mhz cable plant to deliver a bundled package of
voice, video, and data appears to have added credibility to this view, which has
been embraced in some circles as evidenced by the misguided short interest in
EchoStar.
While the potential for broadening service functionality heightens the competitiveness
of cable, we do not believe it will have a meaningful, negative impact on EchoStar. In
fact, we expect DBS operators not only to survive but also to prosper in the face of an
improving cable product. Three factors serve as the basis for this outlook: a powerful
positive feedback loop, bundling, and capital cost differentials.
Positive Feedback Loop
Extremely high consumer satisfaction rates together with critical mass create a
positive feedback loop that should become an increasingly powerful driver of DBS
subscriber growth. On the consumer front, two high-profile studies indicate that
DBS enjoys extremely high satisfaction rates. This conclusion is supported quan-titatively
by a DBS churn rate that is roughly half that experienced in the cable
industry.
Table 5
DBS Consumer Study
STUDY (1998) FINDINGS
J.D. Power & Associates · DBS consumer satisfaction rating average 129 vs. 100 for cable.
· 7.2 million homes are likely to change video providers over the next
12 months, with cable customers twice as likely to switch to a satel-lite
TV service.
Yankee Group · 84% of DBS households would recommend the system to a friend.
· DBS households give their satellite service provider higher ratings
than any other service provider.
· Friends and relatives represent the most influential source of infor-mation
about DBS.
While a satisfied customer base is absolutely necessary for the development
of a positive feed back loop, critical mass is equally importantly. In Frontiers of
Strategy (Volume 3), CSFB's Michael Mauboussin efficiently explains the concept
of critical mass:
Critical mass it the key to atom bomb detonation. When the unstable
nucleus of uranium breaks up, energy is released. Neutrons emanating
from the breakup of one nucleus may hit another and cause it to break up,
but most neutrons miss other nuclei and are projected harmlessly into
space. On the other hand, if the quantity of uranium is appropriately
condensed—critical mass—the typical neutron leaving one nucleus will hit
another nucleus and so on, causing a chain reaction.
Currently, one out of every ten Americans receives DBS television services, a
ratio that is quickly increasing. We believe the vast majority of the DBS subscrib-ers
are located in rural areas of America, creating a considerably more concen-trated
and necessarily more powerful mass. Pegasus Communications estimates
that DBS penetration of rural America totals 17%, or roughly one out of every six homes. In larger urban regions, where penetration has reached an estimated 5%,
DBS “seeds” have been planted in the form of early adopters.
So, in our view, the combination of critical mass in rural America and high cus-tomer
satisfaction rates has sprung a positive feedback loop that accounts for a
large portion of the rapid DBS subscriber growth during the second half of 1998
and early parts of 1999. As the DBS “explosion” expands beyond rural America,
we would expect the seeds of the early adopters to take root and strengthen the
“positive feedback loop,” enabling higher than currently expected DBS penetra-tion
of the mass market.
The benefits of a positive feedback loop driven by an expanding critical mass
should not be underestimated—it is a powerful market dynamic. Amazon.com,
widely viewed as the leading Internet commerce company, has achieved phe-nomenal
growth in its customer base primarily through word of mouth. The man-agement
of Amazon.com asserts that “recommendations,” not banner ads or print
and media advertising, have been the primary reason the company attracts new
customers at a blinding pace. We believe this phenomenon is beginning to take
hold in the DBS industry.
Bundling
Conceptually, we do not argue that a bundled package of voice, video, and data
services would provide cable operators with an extremely compelling product. In
our view, however, the broadened functionality of a cable plant will not create a
competitive advantage that eliminates the viability of other service providers to
the home. Rather, if the AT&T vision proves successful, the full spectrum of com-peting
services would likely be bundled, creating a similarly dynamic voice, video,
and data product for the home.
With robust video functionality and emerging Internet and data services, we
would expect DBS to represent an integral, differentiating component of any bun-dle
of services designed to compete against cable. Through various strategic alli-ances,
a foundation has already begun to develop that would enable a highly
integrated package of voice, video, and data services to the home. Several of the
RBOCs have established relationships with DirecTV and we expect EchoStar to
secure similar alliances before the end of 1999. Microsoft's Web TV has forged a
partnership with EchoStar and desires a similar relationship with DirecTV. AOL
has agreed to partner with SBC Communications and Bell Atlantic to offer its
members high-speed access via DSL and recently aligned itself with DirecTV. An
AOL/EchoStar relationship could emerge in the future.
Today, a bundled DBS/RBOC/ISP service would be able to offer comparable
functionality to that planned by ATT, lacking (in most cases) only high-speed two-way
Internet connectivity. This shortfall, however, should largely be eliminated
with the RBOC deployment of ADSL equipment, a process that has recently ac-celerated.
Additionally, EchoStar will soon be introducing advanced data and
Internet-related services unique to a DBS network. Such services should include
multicasting and video streaming, two applications representing key elements to
the next stage of the Internet “evolution.”
Thus, EchoStar could be a major beneficiary of the recent AT&T transactions.
Conceivably, DBS could become the preferred means of delivering video services
to the RBOC customer base, which appears to have a downside of approximately
60 million homes.
Capital Cost Differentials
Finally, and perhaps, most decisively, DBS operators enjoy an inherent capital
cost advantage versus cable operators that should ensure not only continued
operation as a going concern but future prosperity as well. The capital efficiency
of a DBS business relative to cable represents a unique competitive advantage that would enable EchoStar to employ aggressive pricing schemes to affect churn
and subscriber growth, variables critical to the longer-tem viability of the industry.
Benefiting from the ability of a single DBS satellite to transmit digital content to
every CONUS (continental United States) home (100 million), the asset base
required to support a DBS operation is considerably smaller than that of cable
on an absolute basis (see Table 6). The disparity is dramatic on a relative basis,
which we measure as invested capital per home passed (see Table 6).
After EchoStar completes its pending acquisitions, capital invested in the busi-ness
will total roughly $2.4 billion. Per home passed, the pro forma invested
capital base of EchoStar equates to $25. For the three largest public cable com-panies,
the average capital invested in a cable plant currently totals $1,929 per
home passed, 80 times greater than that of EchoStar.
The capital inequality provides DBS with a competitive advantage that is sus-tained
by the reality that market efficiencies will ensure future capital flows into
avenues offering the highest potential return. Smart managers, cognizant of this
phenomenon, will strive to develop and maintain business models that maximize
return in order to attract incremental investments required to support the existing
business and finance growth. Therefore, the invested capital differential between
cable and DBS effectively creates a return hurdle for cable companies that would
limit their ability to respond to pricing initiatives from DBS operators. The return
hurdle should continue to expand over the next five years as the capital required
to drive a service evolution is considerably greater for cable than DBS.
Through a value-based analysis that emphasizes return on invested capital, we
compare Comcast and EchoStar to underscore this point. For the purpose of the
analysis, we assume Comcast and EchoStar realize 25% NOPAT margins. If
Comcast successfully captured 100% of homes passed, becoming the absolute
dominant service provider in the region, the company would achieve a ROIC of
20% by securing $108 per month from each household for its bundled package of
services.
To achieve the same ROIC, EchoStar would only need to generate $11 in
monthly revenues from 15% of the homes passed by its DBS network. Alterna-tively,
if EchoStar captured $80 in monthly revenues (roughly 26% below the level
required for Comcast to generate 20% ROIC, if it secured 100% of the potential
subscriber base) from 15% of its potential customer base, ROIC would reach ap-proximately
150%, with annual NOPAT totaling $3.6 billion. Expanding the analy-sis
to incorporate other cable operators and different assumptions (see Table 9)
for subscriber base size, monthly revenues, and ROIC provides further evidence
of the tremendous pricing advantage afforded to EchoStar by the economic effi-ciency
of the DBS model relative to that of cable.
Based on this analysis, it is evident that the economic power of the DBS business
model would support the utilization of pricing schemes to accelerate DBS pene-tration
in the midst of an improving cable product, effectively creating a larger
critical mass of satisfied subscribers. At this point, robust end-market demand for
DBS services renders aggressive price-based strategies unnecessary.
However, program-based promotions (essentially a short-term pricing scheme)
could represent the most effective means of leveraging the relative capital effi-ciency
of the DBS model to drive future subscriber growth. This approach effec-tively
locks in a customer at a reduced revenue level but allows for the potential
to extract increasing revenue from a household over time, effectively generating
incremental cash flow without a corresponding capital expenditure. The man-agement
of Pegasus Communications has shrewdly employed program-based
promotions to quickly grow its subscriber base in an economic fashion.
Although we do not have the benefit of a formal study on the price elasticity of
demand, we point to the accelerating pace of subscriber additions, a churn rate
roughly half that of cable, and a rising revenue per subscriber as the basis for an
intuitive assertion that DBS demand and churn trends would respond favorably to
price reductions. Consequently, we believe the unique competitive advantage
derived from the relative capital efficiency of the DBS business model almost
guarantees a role for EchoStar as an integral provider of multimedia services to
the home, with the level of future success primarily a function of management
strategy and execution, not the potential for a vastly improved cable service. |
