DISH Network (Corporate Bonds) DISH
December 15, 2008 - 1:00pm EST by
mark744
2008 2009
Price: 74.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 4,805 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

 Every few years or so, the credit markets present compelling opportunities with equity-like returns, relatively low risk, and positive convexity (low dollar price) that skews the potential upside vs. downside payoff in investors’ favor. Such I believe is the current pricing of DISH’s senior notes. At 74 cents, the DISH 7 3/4% Sr. Notes due May 2015 yield ~14%, or a spread of 1,230 bps over treasures (over 1,000 bps is considered distressed). This assumes a hold-to-maturity time horizon. In the real world it is highly likely that within 2-3 years, the credit markets will return to more normalized levels, and a higher quality high-yield (Ba3/BB- rated) credit like DISH would likely trade at a 7%-8% yield (as it has historically), which would imply a dollar price closer to 95 - 100. If my thesis is correct, the total return potential within a compressed timeframe (2-3 years) could easily be 20+ points of price appreciation (from 74 to the mid-90s) and pay a 7 3/4% cash coupon for a combined total return of 40%-50%+  return over that timeframe). If the credit markets take longer to correct, you are holding the fixed income securities and clipping a yield of ~14% for a company that has very low leverage (1.5x net debt/EBITDA or 1.1x market adjusted if you assume current bond market pricing of 74 cents), generates significant free cash flow far in excess of bond coupon payments, has no need to access the capital markets, has no significant near-term debt maturities, no debt covenants and like DirecTV, has debt/subscriber metrics that are much lower vs. cable companies (at $320MM vs. $1,000+ for BBB cable companies such as Time Warner Cable and Comcast).
 
While DISH equity in and of itself also looks very compelling based on valuation at 3.0x EV/EBITDA and a levered FCF yield of (15%+ depending on estimates), there are numerous headwinds to the growth story (which is what equity market is discounting) vs. the credit story (price reflects more of overall credit markets). By investing in the bonds, you get a decent yield w/upside potential and even under draconian assumptions of DISH losing several hundred thousand subs per year off its current 13.8 MM sub base (which as described below, is not a foregone conclusion), the company would be able to pay off all of its debt in approximately 8 years (or about 6 years if cash flow remains flat). So on a risk/reward basis, I believe the bonds appear to offer the most compelling value.
 
With a YTD return of -70%, DISH equity has been hit on several fronts that are challenging the former growth thesis of the company. The EV/subscriber is around $680, which is actually LESS than it costs DISH to acquire a subscriber (slightly over $730).   In contrast, DirecTV, which has focused on the higher-end urban vs. suburban/rural customer, and upgraded their broadcasts to HD much earlier than DISH, is trading at ~$1,550 per sub, 5.3x FY08 EBITDA, and enjoys a FCF yield of ~8%. This also compares to the cable MSOs at 5x-7x EBITDA (CMCSA &TWC at 5.0-5.8x, CVC and MCCC at ~6.5x-7x). There are many reasons for this divergence of DISH vs. its competitors: 1) declining gross adds and for the second quarter this year, negative net adds (-10K in 3Q, -25k in 2Q); 2) the loss of the AT&T marketing agreement (which was responsible for about 15% of DISH’s gross adds historically); 3) delayed HD programming/bad management execution and a couple of satellite launch failures over past 1+ year; 4) lower end subscriber base is more economically sensitive; 5) DISH had been a victim of higher piracy of signals vs. DirecTV and has belatedly cracked down on this, which has increased churn; 6) overall churn has crept up to above 2% vs. ~ 1.6% for DirecTV; 7) EBITDA declined for the first time in the Company’s history during 3Q (was down 10%, which was unexpected as Co. ramped up subscriber retention spending including a new call center to improve customer service, 8) Uncertainties regarding the final outcome of TIVO’s litigation with DISH, and what are DISH’s long-term wireless plans (owns 700mHZ spectrum that will eventually have to be build out or sold).
 
 
I will address the above in focusing on the cash flow stability, balance sheet strength, ability to meaningfully de-lever even with worse than expected performance, and that difficult to ascertain factors such as the Tivo litigation outcome and use of the Specturm are not likely to be credit impairing events.
 
 

Millions $

Dish Network Corp.

DIRECTV Group, Inc.

Cablevision Systems Corp.

Mediacom Communications Corp.

Time Warner Cable Inc.

Comcast Corporation

Charter Communications Inc.

Credit

Ba3/BB-

Ba3/BB

B1/BB

B3/B-

Baa2/BBB

Baa2/BBB+

Ca/CC

EBITDA (LTM)

$3,109

$4,919

$2,262

$497

$6,106

$12,884

$2,237

Interest

($378)

($307)

($821)

($222)

($900)

($2,440)

($1,883)

Taxes

($626)

($932)

($137)

($58)

($765)

($1,764)

($214)

Capex

($1,219)

($2,212)

($861)

($262)

($3,600)

($5,611)

($1,284)

FCF

$886

$1,468

$443

($45)

$841

$3,069

($1,144)

Cash

$1,433

$2,988

$343

$33

$3,580

$2,917

$569

Total Debt

$5,981

$5,850

$11,979

$3,308

$15,748

$33,688

$21,103

Market Cap

$4,913

$24,094

$4,283

$274

$19,305

$45,069

$54

EV

$9,462

$26,956

$15,920

$3,549

$31,473

$75,840

$20,588

FCF % of Total Debt

14.8%

25.1%

3.7%

-1.4%

5.3%

9.1%

-5.4%

Debt/EBITDA

1.9x

1.2x

5.3x

6.7x

2.6x

2.6x

9.2x

Net Debt/EBITDA

1.5x

0.6x

5.1x

6.6x

2.0x

2.4x

9.2x

EV/EBITDA

3.0x

5.5x

7.0x

7.1x

5.2x

5.9x

9.2x

Total Subscribers (MM)

13.8

17.0

18.0

1.3

13.3

24

5.1

EV/Sub

686

1586

884

2730

2366

3160

4037

Net Debt/Sub

330

168

646

2519

915

1282

4026

Levered FCF/Sub

64

86

25

-35

63

128

-224

Debt Payback/Sub (# yrs)

5.1

1.9

26.3

-72.3

14.5

10.0

-17.9

Cash Bond Yield

13.9%

9.8%

12.6%

18.5%

8.2%

8.10%

100.0%

Bond

7 3/4% of 2015

 7 5/8% of 2016

 8.5% of 2016

8.5% of 2015

5.85% of 2017

5.85% of 2015

11%% of 2015

$ Price

74.0

88.5

81.0

62.0

86.0

88.5

84.0

5-yr Credit Default Swap (bps)

520

400

750

875

425

315

10500

 
 
Relative value on the credit is compelling: When looking at the DISH bonds, there are some interesting relative value relationships that demonstrate that the credit undervalued relative to comps.    1) DISH has a payback period per sub (Debt/Sub divided by levered FCF/Sub) of only 5.0 yrs vs. 26 yrs for similarly rated Cablevision, and 10-14 years for Comcast and Time Warner (both BBB-rated); 2) While DirecTV’s credit stats are better vs. DISH, John Malone has stated that DTV remains underlevered and over time is targeting a debt/EBITDA ratio of around 3.0x (once credit markets open), and DISH yields 400 bps more vs. DirecTV bonds; 3) Looking at credit default swaps, the market is pricing in lower risk for DISH vs. the cash bonds, as DISH CDS trades only 95 bps wider vs. Time Warner Cable and 80 wider vs. DirecTV, yet the DISH cash bonds yield 400-580 bps more than each of those two credits; 4) DISH cash bonds are cheap (130 bps) to similarly-rated Cablevision, which has higher leverage and a much longer debt-payback; 5) By owning DISH bonds, you are giving up 450 basis points vs. Mediacom bonds, which is generating no FCF, is 6.5x levered, and has debt/sub of $2,500.    
 

The economics of the business are still sound - DISH is trading at an EV/sub of $680, which is lower than the current amount it costs to acquire a new subscriber (around $730). The question then becomes, is adding a new subscriber generating meaningful returns? The chart below shows that even under elevated subscriber acquisition costs (or SAC, about 30% of which runs through the income statement, while the rest is capitalized) and churn rates (churned subscribers must be replaced, and are assumed to be replaced at the current all-in subscriber acquisition cost, which includes all CPE or customer premise equipment + marketing spending). The table below shows that the unlevered pre-tax return per acquired subscriber is still attractive (between 15%-16%). 

 

Monthly ARPU

$70

Yearly ARPU

$840

EBITDA Margin (pre- SAC costs)

36%

EBITDA per sub per year

$306

Monthly Churn

2.0%

Yearly Churn

24%

# of total subs

            13,780,000

# of subs churning/yr

             3,241,056

SAC (includes capitalized CPE)

$730

Cost to replace Churned Subs

$2,365,970,880

Capex (excl. capitalized CPE)

$280,000,000

Total Spending

$2,645,970,880

Total Spending/Sub

$192

FCF per sub per year

$114

Unlevered Pre-Tax Return on SAC

15.6%

 Can DISH lose net subs (i.e. what if can’t replace churned subs due to competitive forces)? Since DISH net lost -10k subs in the 3Q (better than the -25k lost in 2Q) one of the key issues is what if they continue to lose subs. The sub losses thus far reflects several factors, all of which should improve over the next 1-2 years:

  1. DISH has been late to the HD game. A little over a year ago, DTV became the first service provider to go to market with a robust (100+ channel) HD offering and aggressive marketing campaign centered on HD. The delay was due to management initially not focusing on the initiative, which was then exacerbated by 2 satellite launch failures over the past 1+ year. DTV benefited from this at the expense of DISH. The cable companies responded by improving HD channel availability and emphasizing HD video-on-demand. It was not until late August that DISH launched its own robust HD product and marketing campaign, which in the long-run should help reduce churn and improve gross adds.
  2. Launch of the new Eastern Arc Service: Eastern Arc is a 100% MPEG-4 (HD) service delivered by satellites serving three orbital slots in the Eastern US, with higher look angles than was previously attained. Historically DISH has not been as competitive in the eastern vs. western/central US, partly because rooftop dishes had to be positioned at such low angles in order to be pointed at the satellites and rendered signals more prone to interference from weather, trees, houses/buildings & other obstructions. This caused many customers in the US from taking (or keeping DISH’s service). The all-MPEG-4 service is currently being launched across 32 markets, which will continue into next year, with the completion of a recent satellite launch. Again, over time, this should also help DISH better attract and retain subscribers.
  3. Piracy has been a big issue for DISH vs. the competition: Signal theft has been a growing problem for DISH over the past couple of years, due to far inferior encryption/security technology & measures. People could purchase illegal smart cards/set top boxes and obtain DISH service for free. DISH has started to ship new smart cards to its customers and piracy should virtually be eliminated by year-end 2009, once customers receive the new smart cards and old encryption is shut off. While the transition will result in higher churn (exact amt. undisclosed by mgm’t, it is also resulting in a better quality (and more profitable) subscriber base.
  4. Digital Transition: The transition to all-digital is scheduled to occur in Feb. 2009. There are currently 13MM over-the-air households that are not connected to any form of pay-TV and the digital transition will require a significant portion of these households to subscribe to some form of pay-TV because many of them are not able receive a digital over-the-air signal due to their physical location (despite being able to receive an analog over-the-air signal. Comcast estimates that at least 20% of the over-the-air homes within its service area cannot receive a digital signal. Thus at least 2.6MM households will likely sign up for pay TV when the transition is complete DISH is well positioned to exploit this opportunity given its distribution network, historically low price point/strength serving low end of the market with several entry level-programming tiers.
  5. Retransmission consent disputes: Retransmission consent disputes have grown ever more contentious, with several large recent disputes with cable operators and TV station owners resulted in signals going dark for a period of time. DISH has been paying its broadcasters for retransmission consent for years, whereas the cable operators are comparatively early in beginning to pay for retrans consent. In cases where signals go dark, DISH will be able to exploit the situation and be in a good position to acquire new customers.
  6. Charter Communications is on the brink of bankruptcy: Last week Charter Communications announced it will pursue debt for equity swaps to reduce its debt burden and many believe it may file for CH 11 reorganization given that the credit markets are effectively shut down. Charter has some of the worst customer service ratings in pay-tv and its upgrade capex has been constrained because of its debt-laden capital structure. Further financial difficulties are likely to make CHTR’s situation (and thus its customers’ experience) worse vs. the current situation, and a substantial % of CHTR customers are in more suburban/rural markets (which is prime DISH territory). 
  7. The “Wal-Mart” effect: Related to #4 #5 & #6 , DISH has some of the cheapest basic offerings in Pay TV. To the extent that the situations above materialize or the economic situation further deteriorates, Pay TV customers may potentially trade down to lower-cost alternatives (where DISH has strong positioning). Recently Time Warner Cable management stated that the company’s RGU growth has “dramatically slowed” reflecting customers’ not purchasing as many ancillary services (data, voice, HD, DVRs). While satellite’s relative disadvantage vs. cable has been the lack of a triple-play offering, a deteriorating economy will likely reveal that services other than basic video have a more significant discretionary component.

While it will take a while for DISH’s churn, gross adds, and net add statistics to improve, there should be some headways being made by the 2H of next year. CEO Charlie Ergen (50% economic/80% voting control) believes he is making the right decisions for the long-term health of the company. To paraphrase from my notes of the 3Q call, Ergen stated: “As I got a bit more involved in the day-to-day operations, I realized that some of the investments we were making were short-term and we needed to make some longer term investments. The longer term investments were a more expensive vs budget because budget was based on where management thought we should be spending. I have five rules around here, but one of them is think long-term and when you really got management thinking long-term, they came back with different places they wanted to spend their money, and I think the right places to spend money. And when you  spend for the long-term it typically is more expensive than short-term money. It pays dividends for you long-term, and you get a return on investment if you do it right, but it doesn't show up in 2008 for sure. It’s my fault, but we probably had too much of a short-term outlook at the lower levels of our company. And I just wasn't aware of that, to be honest. Everything about what we do is we should be thinking about long-term and where we are 5 or 10 years from now as opposed to where we are next quarter. And you can always have an eye on next quarter but you really got to think about where you're going to be in the years ahead. I have great confidence that we're one – we are one of the few companies that can think long-term”.

I think that a reasonable growth rate to expect for the satellite business longer term is the rate of household formation or about 1% per year. Cable companies have lost 30%+ market share over the past 10 years however their revenues have increased by over 50%, a significant portion of which was driven by pricing power on basic video services. DISH, being the lowest priced service in most of its markets, actually has a greater ability to raise prices without being uncompetitive (Ergen mentioned this on the 3Q call).
 

Even if I’m wrong, and DISH continues to lose net subs and cash flows decline over the long-term, the company will likely to be able to pay all of its debt over the next 7-8 years.

The sensitivity below shows full paydown of all the Company’s debt assuming EBITDA declines about 6% per year, which means that by 2016, the company will be generating 40% less EBITDA vs. today (40% subscriber losses, offset by pricing increases of 5% per year, reduced capex on fewer subs and reduced SAC due to lower equipment costs)

 

Millions $

2008 E

2009 E

2010 E

2011 E

2012 E

2013 E

2014 E

2015 E

2016 E

   % EBITDA Decline

-6.0%

-6.0%

-6.0%

-6.0%

-6.0%

-6.0%

-6.0%

-6.0%

EBITDA

$3,000

$2,820

$2,651

$2,492

$2,342

$2,202

$2,070

$1,945

$1,829

Capital Expenditure

($1,200)

($1,200)

($1,200)

($1,200)

($1,100)

($1,000)

($1,000)

($1,000)

($900)

Interest Expense

($340)

($336)

($302)

($247)

($207)

($168)

($126)

($85)

($47)

Taxes

($647)

($574)

($520)

($478)

($434)

($394)

($357)

($324)

($311)

Free Cash Flow

$813

$711

$629

$567

$601

$640

$586

$536

$570

   FCF Decline YoY %

 

-12.6%

-11.4%

-9.9%

6.1%

6.5%

-8.5%

-8.5%

6.3%

End of Year Cash

$600

$300

$300

$300

$300

$300

$300

$300

$300

Debt Balance (BOP)

$5,009

$5,009

$3,998

$3,369

$2,802

$2,201

$1,560

$974

$438

Debt Paydown w/FCF

($711)

($629)

($567)

($601)

($640)

($586)

($536)

($570)

Cash for Debt Paydown

($300)

Debt Balance (EOP)

$5,009

$3,998

$3,369

$2,802

$2,201

$1,560

$974

$438

($133)

Debt/EBITDA

1.7

1.4

1.3

1.1

0.9

0.7

0.5

0.2

-0.1

Net Debt/EBITDA

1.5

1.3

1.2

1.0

0.8

0.6

0.3

0.1

-0.2

 
   

 

Cash flows can even decline at a much faster rate for the company to maintain a reasonable leverage ratio of 2.0x . The sensitivity below demonstrates that EBITDA can decline by 12% per year and the company is still generating FCF by 2016 (w/ slightly lower Capex levels vs. scenario 1):

 

Millions $

2008 E

2009 E

2010 E

2011 E

2012 E

2013 E

2014 E

2015 E

2016 E

   % EBITDA Decline

-12.0%

-12.0%

-12.0%

-12.0%

-12.0%

-12.0%

-12.0%

-12.0%

EBITDA

$3,000

$2,640

$2,323

$2,044

$1,799

$1,583

$1,393

$1,226

$1,079

Capital Expenditure

($1,200)

($1,200)

($1,200)

($1,200)

($1,100)

($1,000)

($950)

($900)

($800)

Interest Expense

($340)

($336)

($305)

($261)

($237)

($219)

($203)

($192)

($189)

Taxes

($647)

($502)

($387)

($293)

($205)

($126)

($56)

$7

($12)

Free Cash Flow

$813

$603

$431

$290

$257

$238

$184

$140

$79

   FCF Decline YoY %

 

-25.9%

-28.5%

-32.6%

-11.3%

-7.3%

-22.9%

-23.8%

-43.8%

End of Year Cash

$600

$300

$300

$300

$300

$300

$300

$300

$300

Debt Balance (BOP)

$5,009

$5,009

$4,106

$3,676

$3,385

$3,128

$2,890

$2,706

$2,566

Debt Paydown w/FCF

($603)

($431)

($290)

($257)

($238)

($184)

($140)

($79)

Cash for Debt Paydown

($300)

Debt Balance (EOP)

$5,009

$4,106

$3,676

$3,385

$3,128

$2,890

$2,706

$2,566

$2,487

Debt/EBITDA

1.7

1.6

1.6

1.7

1.7

1.8

1.9

2.1

2.3

Net Debt/EBITDA

1.5

1.4

1.5

1.5

1.6

1.6

1.7

1.8

2.0

 
 

When one thinks about it, there is some flexibility in DISH’s cost structure. If subscribers flock to cable or telcos (VZ/AT&T), and adding incremental gross subs is an uneconomic proposition, then DISH can dramatically reduce its SAC costs (including marketing, equipment spend for new subscribers) as well as Capex (not as much need for new satellites which cost ~$300MM apiece; my base case model assumes one satellite launch every year for next 4 years and one launch every two years thereafter). Moreover, over time CPE will also decline (set top boxes are deflationary as technology is increasingly commoditized.

You can play around with the numbers quite a bit, but the overall conclusion is that even under stress scenarios, DISH can still generate decent free cash flow. Note that none of the street consensus numbers are anywhere close to my 1st scenario assumptions (consensus has long-term EBITDA increasing) and even some of the most bearish analysts on the sector are showing cash flow growth.

Other Risks worth noting, which have caused the stock to underperform, however, over time these should not be significant factors that would materially alter the credit profile/FCF characteristics of the company:

1.        3Q EBITDA declined about 10%--the first decline in several years. DISH lost 1--10k net subscribers, the result of both higher churn (2.0% vs. 1.9% in yr ago period) and lower gross adds (825k, down 8.7% yoy) ; net adds were modestly better than the -25K loss in 2Q, but still is much worse than the 110k net adds of 3Q07. ARPU and total revenues were better sequentially and yoy, but higher costs were reflected in higher SAC and retention marketing, including expenses related to relocating certain programming/channels, upgrading customers to new MPEG-4 compression technology, reducing piracy, disconnecting non-paying/delinquent subs, expenses related to opening a new call center, and overall operating inefficiencies as the company tries to deal with all these issues simultaneously. As mentioned above, I believe these to be short-term problems that should largely be resolved by the end of 2009.

2.        Loss of AT&T marketing agreement. In September, AT&T announced it will not renew its distribution agreement with Dish and will instead offer a bundling arrangement with DirecTV. This will reduce DISH’s gross adds beginning in 2009 (agreement w/AT&T expires in late Jan). The bundling arrangement accounted for about 15% of DISH’s gross adds in 2008. Of course, not all of these gross adds will be lost, as most customers will likely continue receiving DISH, however, the AT&T subs have experienced higher churn vs. DISH’s existing subs (company has not disclosed other than to say they are a “little higher”), so this when combined w/ the effects of piracy (starting to be resolved) and well as the belated HD rollout, in my estimation will likely result in a net loss of subscribers in 2009 and EBITDA to contract slightly or be down in the high-single digits (depending on assumptions). Street estimates have EBITDA increasing slightly in 09.

3.        TIVO litigation: TIVO has successfully sued DISH for patent infringement of TIVO’s “time warp” technology in its set top boxes. DISH claims that it installed a new software update that is in effect a suitable workaround complying with the injunction that DISH received earlier this year. TIVO disputes this claim and the matter should be resolved in February of 2009, when a court judge issues what is expected to be a final ruling. The market (when looking at both DISH and TIVO equity) seems to be discounting that DISH will lose the case and will have to pay damages to TIVO, as well as an ongoing royalty. DISH has already paid damages of $128MM, and TIVO claims that DISH should pay additional damages of $92MM. If DISH loses the case, it will likely have to pay the damages TIVO is claiming, plus DISH and TIVO will likely strike an agreement where DISH pays TIVO a royalty fee similar to what DTV and Comcast already pay to TIVO (not disclosed but assumed to be range of 75 cents - $1.25 per sub per month). Assuming a $1.50 - $2.00 per sub royalty is paid by DISH for the 4+MM infringing DVRs, that would mean an annual EBITDA impact of $77 - $103MM. Because DISH has lower pricing vs. DTV and its cable/telco competitors, it will likely be able to recoup most of that cost by passing it through to customers. Should negotiations become contentious or TIVO demands too onerous terms, it might be better for DISH to buy TIVO (current EV is around $480MM) and gain access to superior technology and royalty streams from DTV and other cable operators.

4.        700MHz spectrum. In early 2008, DISH acquired 168 licenses for spectrum in the FCC’s 700MHz spectrum auction, which covers 76% of the US population. DISH is looking to possibly do a mobile video or potentially a wireless data offering. Investors are fearful that DISH will be deploying significant cash into a dubious venture, however it is unlikely that Charlie Ergen would pursue uneconomic ventures. If the current credit crisis continues, as he stated on the 3Q conference call, DISH will conserve cash, run a more conservative balance sheet, and de-emphasize share repurchases. In such an environment, DISH could very well sell that spectrum.


I believe that DISH’s equity will be more sensitive to these issues and that the company’s free cash flow, solid balance sheet, and ability to withstand the bleeding of several million subscribers without overly negatively affecting the company’s credit profile render the thesis for being long the credit intact.
 

Catalyst

1) Expected improvement in subscriber metrics by late 2009 due to new HD offerings, digital transition, elimination of signal piracy, retransmission consent issues with other competitors; 2) High likelihood of credit markets returning to more normalized levels over next couple of years; 3) Continued FCF generation, cash conservation, balance sheet strength; 4) Co-founder/CEO Charlie Ergen (50% economic/80% voting) will likely pursue actions that will add net economic value over the long-haul
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