Description

Valuation

• $16.50 per share. LTM low was $8.34 on 11/20/08, and YTD low was $9.07 on 3/5/09 (same week we hit 666 on the S&P), so stock has roughly doubled from the lows. The stock peaked on 10/16/07 at $45.98 per share - we have subsequently heard from multiple well-informed sources that AT&T made a real bid for the Company around this time in the $50 - 60 zip-code and was rebuffed by Ergen who was holding out for still higher
• 3.6x LTM EBITDA; 3.4x '09E
• 10.9x LTM P/E; 7.4x '09E
• 14.5% LTM FCF Yield (excluding working capital)
• $770 per sub

Comps

• DTV - 5.8x LTM EBITDA; 20.1x LTM P/E; 6.2x% FCF Yield; $1,300 per sub
• CMCSA - 5.1x EBITDA; 16.8x P/E; 9.9% FCF Yield; $2,660 per sub
• TWC - 5.3x EBITDA; ~15% FCF Yield; $2,590 per sub
• VZ - 6.1x EBITDA; 13.7x P/E; 13.5% FCF Yield
• T - 5.2x EBITDA; 12.1x P/E; 11.9% FCF Yield

 Investment Positives

• Valuation is the primary positive; at 3.6x EBITDA, DISH trades at a 30 - 40% discount to the cable / telco comp group and its most notable competitor, DTV (the same is true on EV per sub). The Company generates $1.0 - 1.2bn of Free Cash Flow per year (~15% FCF Yield)
• Catalysts:
• o One would be simply meeting estimates for a few quarters consecutively w/o any major upsets - this is a Company that has not had its "day in the sun" on an earnings release for over a year now (churn problems, piracy problems, negative net adds, Tivo controversy, AT&T-DTV contract, etc.) No news will be good news from these guys
• o Two is a Tivo resolution - discussed in more detail below. The overwhelming consensus is that DISH & TIVO will reach a settlement between now and the end of the year that will be a better deal for Tivo vis-à-vis its other licensing deals because they have more leverage given the circumstances; however, likely terms of any settlement should not present an undue burden for DISH given their cash hoard and FCF generation, and the sooner there is a concrete resolution the better in my opinion. I believe the Tivo overhang makes DISH un-investable to some mutual fund managers, so even a resolution that is one-sided in favor of Tivo may prove to be a positive catalyst for DISH trading if it removes the uncertainty
• Take-Out Scenario - the dream scenario remains that AT&T or VZ pays a take-out premium to acquire DISH and complement its suite of telecom offerings / offer DISH service where U-Verse is uneconomical to build-out. Unfortunately, with John Malone and Greg Maffei at the helm of Liberty / DTV (Maffei is in the running to become CEO of DTV), DTV seems better-positioned to be the first mover in any acquisition story. There are two schools of thought on what would happen in this instance:
• o The pessimistic view is that only one telco will buy satellite, and so DTV is the winner and DISH is the loser
• o The optimistic view, and one I subscribe to, is that if AT&T or VZ buys DTV, the other telco will be compelled to eventually buy DISH. The primary reason for this would be that if AT&T buys DTV, it gives them the ability / wherewithal to market a TV product outside of their wireline territory and encroaching on VZ's, something they have traditionally not done before (of course, both companies compete nationally in wireless). Therefore, I think VZ would be compelled to buy DISH to stay even in the arms race. If nothing else, if / when DTV is bought, it should set an attractive relative value benchmark against which DISH's public market equity price should look even more starkly inexpensive
• Defensiveness - in this particular instance, the prospect of 30 - 50+% upside scenarios in the stock (based on comp valuations and / or take-out scenario) is juxtaposed against what we believe is relatively limited downside in the stock, should this rally at some point peter out and the wounded economy reassert itself. Subscriber-based businesses have shown their resiliency the past year (see SIRI/XM, CLECs, cable networks, etc.), and DISH is no different - over the past year's economic woes, they have lost 231k subscribers (1.7% of their starting base), grown revenues by 3.5%, and grown EBITDA by 0.5%. Furthermore, keep in mind again that the FCF Yield is currently ~15%, so every year the Company generates cash worth 1/7 the equity market cap
• Liquidity / Balance Sheet - they have >$1.1bn of cash & securities on hand (some of which will likely be paid to Tivo, more on this later), no secured debt, and no bond maturities until 2011. They have 1.7x turns of bond debt, bonds are trading at ~7% yields. Depending on the use of proceeds, there would be rabid demand for a new bond deal from this Company at 7.5 - 8.0% yields, if they ever found themselves in need or raising some capital

Investment Negatives

• TIVO - the Company is currently involved in patent infringement litigation with TIVO, and TIVO has the upper hand
• o Judge Folsom of the Texas District Court ruled in April'08 that DISH had violated TIVO's patents and ordered them to pay ~$103mm of damages and turn off the devices. DISH countered that they had a "workaround" that avoided patent infringement and continued to operate.
• o In June'09, Folsom essentially called bullshit on DISH's workaround and declared them in contempt of court, giving them 30 - 60 days to shut off all offending devices (estimated 6 - 8mm subscribers out of DISH's 13.6mm sub base), which would be disastrous
• o In July, DISH received a stay from the Federal Court of Appeals, which will listen to DISH's arguments late this year and likely rule in January
• o In the interim period, the consensus view is that DISH and TIVO will reach a settlement, involving (i) an upfront fee for offenses incurred to date (TIVO is seeking $1bn in damages and disgorged profits from the period Apr'08 - present); and (ii) a monthly recurring license fee per sub per month (TIVO gets $0.60 from Comcast and $1.00 from Cox & DTV, but they are in better financial health today than when those deals were negotiated, and they have a real sword over DISH's head if the Federal Appeals Court does not overturn Folsom's ruling to shut off the DVRs
• TIVO (cont'd) - if you assume a "base case" scenario in which DISH pays TIVO damages of $500mm and a $2.00 per month per sub royalty (roughly ~$168mm EBITDA hit per annum, or ~5%, less any amounts that could be recouped by passing along the royalty fee to subscribers), then the valuations above increase to only 4.0x EBITDA, $850 per sub, and a 13% FCF Yield - in other words, the valuation still seems attractive
• Capital Allocation - Ergen's priority is not on returning cash to shareholders, but in investing in his product and the next product (e.g. SlingBox, Terrestar, 700MHz purchases). He has some vision for the future of Mobile TV - a potentially hugely capital-intensive build-out for which the customer demand model is not well-defined. He also clearly over-played his hand by not selling DISH to AT&T two years ago, and may not feel at all compelled to sell today, even at a huge premium to the current trading price of the stock, if it doesn't meet his previous price threshold (3x current price)
• Long-Term Standalone Prospects - DISH remains a one-product firm today and has clearly ceded the pole position in satellite TV to DTV; while I am more sanguine on the inertia of DISH's subscriber base, there are longer-term secular questions on whether or not satellite TV can thrive as a standalone platform

Q2'09 Summary

 Highlight of the quarter was that DISH grew its sub base by +26k net adds, vs. general consensus for a loss of subs on the order of ~100k.  This was driven by both gross adds and churn:

• Gross adds of 731k, improved sequentially from 653k in Q1 (but down slightly y/y from 752k prior year) despite the fact that this was the first full quarter that DISH has no longer held the satellite partnership with AT&T (deal expired in February and new contract was awarded to DTV). Company benefited from the digital transition and from some aggressive promotional subsidies, more on this in a second
• Churn of 1.73% improved sequentially from 1.83% prior quarter and 1.87% prior year in what is usually a seasonally high-churn Q2. This appears driven by (i) investment and implementation of anti-pirating technology and software; (ii) retention promos & subsidies; and (iii) mix shift towards more dealer-generated subscribers due to the higher-churn profile of the previous AT&T subs

The negatives are that, not surprisingly, DISH has had to pay for the better-than expected subscriber growth by giving up some of the economic value per sub (in the form of lower ARPU, higher SAC expense, etc.)

• ARPU of $70.73 increased +1.9% y/y (from $69.38 prior year) and increased sequentially from $70.03 in Q1; however, ARPU growth lags the 3 - 5% y/y improvement seen by the other cable & satellite cos, most likely due to promotional subsidies to attract and retain customers
• SAC of $708 increased slightly y/y and increased +$50 from prior quarter ($659) - primarily appears to be driven by higher customer subsidies (most likely free installations & set-top boxes, etc.) and higher advertising expense (Company has been much more active in the media recently, for instance with its "Why Pay More for the Same Product" campaign vis-à-vis DTV)
• SG&A increased from ~$135mm per quarter to ~$155mm - if you recall, several quarters ago Charlie Ergen admitted taking his eye off the ball and allowing operations to get lazy under his watch, there appears to be renewed focus (and spending) on personnel training, anti-pirating investments, customer retention & customer service efforts, etc. and this is costing the Company higher SG&A

In aggregate, higher SAC (both on a per gross add basis as well as just because gross adds were higher than expected) and higher SG&A cost resulted in EBITDA coming in at $709mm, down -19% y/y (from $873mm prior year, the record EBITDA quarter) and down from $801mm prior quarter.  I think investors will accept that in a pre-pay model subscriber-based business, if you outperform on sub adds you are going to (temporarily) under-perform on profits during the quarter, but still this provides some fodder for the bears.

My back-of-the envelope calculation based on Q2 subscriber economics suggests that the NPV of each subscriber is roughly $1,050 - 1,100 per sub.  This compares to the SAC per Gross Add that DISH is paying (currently $708), suggesting that on the margin, it pays for the Company to be slightly more aggressive in campaigning to win subscribers - though I would caveat that the specific incremental NPV per sub add to acquire, for example, customers who only transitioned due to the digital transition and are very averse to paying up for services, may be much lower than this from a mix perspective.

At $1,050 per sub, my target price would be about ~$25.00, +25% from here.

Regarding TIVO, DISH provides a brief synopsis of the case, and goes on to mention that most recently on 8/3/09, the Patent & Trademark Office issued an initial office action rejecting the software claims of the TIVO patent as being invalid in light of two prior patents; this may provide some ammunition for DISH to argue in Federal Appeals Court that the work-around they engineered to get around the TIVO patent is in fact valid:

"On August 3, 2009, the Patent and Trademark Office (the "PTO") issued an initial office action rejecting the software claims of the '389 patent as being invalid in light of two prior patents. These are the same software claims that we were found to have infringed and which underlie the contempt ruling now pending on appeal. We believe that the PTO's conclusions are relevant to the issues on appeal as well as the pending sanctions proceedings in the District Court. The PTO's conclusions support our position that our original alternative technology is more than colorably different than the devices found to infringe by the jury; that our original alternative technology does not infringe; and that we acted in good faith to design around Tivo's patent."

Catalyst