Growth Comes at a Cost

DirecTV is growing but needs expensive customer incentives to do it

Once Rupert Murdoch finally got his hands on DirecTV, the mandate was clear: Acquire customers at the fastest pace possible. So far, DirecTV is achieving that but at the expense of short-term profitability. That has analysts on alert.

Getting new customers in the DBS or cable business is tough sledding. Virtually everybody who is going to buy cable or DBS has already done it, so DirecTV has to spend heavily on persuading customers to switch. And to get them to stay, it has to spend millions in upgrading equipment. That is all expensive.

DirecTV doubled its spending on customer retention and marketing to nearly $1 billion in 2004. That includes making good on such offers as providing a free receiver for every TV in the house and upgrading users' TiVo digital video recorders (DVRs) as technology improves. While that increased spending has boosted growth, it has also cut into profits.

From a growth perspective, spending works. The third quarter was the first time the company added more than a million new subscribers. The company, which took in $10.1 billion in revenue in 2003, had 13.5 million subscribers as of Sept. 30.

But that figure takes a little explaining. Because of customer churn, one of cable's and DBS' biggest problems, DirecTV lost 725,000 customers during the same period, giving it a net gain of 456,000 new users.

It's the bane of the business, customer churn. DirecTV's churn rate is 1.67% a month. By comparison, its DBS competitor, EchoStar, had a churn rate of 1.77% in the third quarter.

“We've now attained higher gross adds in five consecutive quarters, with each one establishing a new record at that time,” DirecTV CEO and President Mitchell Stern told analysts during the company's third-quarter conference call. “Over the last 12 months, DirecTV has added about 1.8 million net subscribers, which is the largest number of subscribers we have ever added over any 12-month period.”

But customers also cost money—in new equipment, marketing and efforts to retain them. EchoStar spends less to grab a customer—$600 per subscriber versus DirecTV's $617—in equipment, upgrades, special deals (like providing extra set-top boxes for other TVs in a home) and programming. Getting the churn rate and the customer-acquisition rate in balance is the name of the game.

Multichannel providers like DirecTV base their business on keeping churn rates and subscriber-acquisition costs low, while keeping average revenue per unit as high as possible. DirecTV takes in an average of $66.50 per customer. At that rate, it takes about six years to make money from a subscriber. That's too long for many analysts.

“That's their business model, but the market doesn't seem to be too fond of it,” says Andy Baker, a media analyst for Cathay Financial. “They were doing a good job with profitability, but then Murdoch arrives on the scene and says do a land grab and get subscribers at any cost.”

Still, even with these economics in place, analysts put the company's return on investment at about 33%, and that's good news for any business. Whether that figure will continue depends on a continued low churn rate or lower costs for getting customers.

“No matter how you slice it, the multichannel-video market is a mature market,” says Cannon Carr, executive director and senior analyst at CIBC World Markets. “It's more difficult to find profitable and desirable customers, and it's getting more expensive to win subscribers. If Rupert Murdoch wants heavy growth, he's going to have to spend heavily to do it.”

Analysts and executives peg much of DirecTV's growth to the company's rapid rollout of local channels in local markets. DirecTV started the year with 64 markets available, covering 72% of the country. Today, it offers 130 markets, covering 92%.

Over the next three years, DirecTV plans to spend $1 billion to launch a local high-definition satellite service—an imperative if the company wants to stay competitive with cable. While that service may attract hard-to-reach customers, it also will add to DirecTV's cost of acquiring customers. Analysts are watching closely.

DirecTV added more than 1.4 million subscribers—at exactly $1,000 per subscriber—when it closed earlier this year on the $1.4 billion purchase of DirecTV's subscribers through Pegasus Communications and the National Rural Telecommunications Cooperative (NRTC) in August.

These aren't typical DirecTV customers, says CFO Mike Palkovic. “When you are buying an existing subscriber base, particularly one that's already connected to your billing system and requires no transition costs other than the acquisition dollars, that's a guaranteed revenue stream from day one,” he explains. “And a lot of those customers,” he adds, “have been with Pegasus for years.” Some 20% of new customers come in with risky credit and end up churning out faster.

But will DirecTV's major effort to grab new subscribers pay off?

“They are spending a lot of money to acquire these customers, and they are not going to see the benefits until down the line,” says Cathay Financial's Baker. “If that customer leaves within five to six years, DirecTV lost money on that customer.”

Adds CIBC's Carr, “The incremental economics aren't near as good as they were a year ago. Gaining market share and stealing share from cable is getting more expensive to do. That's going to force companies like DirecTV and EchoStar to reevaluate their business plan.”