Pegasus Spreads Its Wings
By Jane Black
DirecTV has long been viewed as the ultimate satellite success story. In 1994, it launched its first digital satellite television service and with it a satellite TV industry that today is worth more than $7.4 billion. DirecTV (GMH ) is now the largest digital broadcast service (DBS) in the U.S., with 9.8 million subscribers across the country. DirecTV certainly deserves the kudos. But in hindsight, it appears the company made one crucial misjudgment. And No. 3 player Pegasus Communications (PGTV ), which focuses exclusively on rural subscribers, is going to be the beneficiary.
Here's what happened. Early on, DirecTV decided its strategy would be to target the heavily populated urban markets by selling service and equipment through big consumer-electronics stores. In 1992, two years before it launched, DirecTV signed a $100 million agreement with the National Rural Telecommunications Cooperative to allow small rural affiliates to resell DBS to millions of rural homes across the country. In addition to that $100 million payment, the companies selling in rural areas agreed to pay DirecTV a 5% royalty for any service sold.
Rural markets proved to be anything but marginal. Today, they're the sweet spot of the satellite market. In large parts of rural America, many homes can't get cable or TV signals, so satellite is the only game in town -- or anywhere near town, for that matter. That's where Pegasus comes in. Selling in rural areas has been its raison d'etre. Today, the company is set for continued growth in both traditional video and new broadband Internet services.
Pegasus estimates that net revenues for 2001 will be $1 billion, up from just $30 million in 1996, when it went public. But more important, Pegasus is a likely acquisition target for DirecTV, which is eager to get its hands on the 1.5 million loyal rural subscribers that Pegasus serves. A deal isn't imminent, but one could happen any time after DirecTV's parent company GM decides how to restructure its profitable satellite subsidiary. At the moment, it's fielding bids from Rupert Murdoch's News Corp. and is also pondering spinning off the unit as a separate company.
Pegasus is a good buy in its own right. The company's stock has plummeted the past year as investors, fearing that satellite growth was reaching saturation, fled the sector. Shares of Pegasus are hovering at around $21, down from a high of about $58 last May. But the target share price for the end of 2001 is $49, according to First Call.
Investors' fears are partly justified: It's unlikely that the number of satellite subscribers will continue to grow at the rapid rates of the late 1990s, when the industry saw customers skyrocket from zero in 1996 to 15 million in 2000 (see, BW Online, 5/3/01, "Satellite Stocks Don't Deserve to Be Shunned"). But the market is hardly saturated, especially in the rural areas Pegasus serves.
Indeed, in many of these places, satellite video service is customers' only option. And that trend is going to accelerate as small cable systems find it's not economically viable to upgrade a cable network for digital services such as broadband, interactive TV, and the much-hyped 500-channel services. Witness the recent news about Classic Communications, a rural cable company. On Apr 18, auditors expressed doubts about the Tyler (Tex.) company's ability to remain a "going concern" because it doesn't have the funds to upgrade its network.
Since cable-video service costs about the same as satellite, customers have no reason to stick with a cable company that offers fewer and less-sophisticated entertainment options. Pegasus predicts that by 2006, 50% of 33 million rural customers will get video service from satellite, shrinking cable's overall market share from 185 million to about 115 million.
But Pegasus' potential as a strategic asset is that it's a real opportunity for investors. Most analysts believe that any deal that removes GM as a controlling shareholder of Hughes, of which DirecTV is a part, will pave the way for a Pegasus acquisition. Pegasus' rural subscriber base is complementary to DirecTV's largely urban core. Significant economies of scale are possible by combining Pegasus and DirecTV.
"Hughes thought that the place to be was urban markets. It's not," says CIBC's Jeff Wlodarczak. "The quickest way to get up to speed is to buy Pegasus, which has enormous distribution and competes well against EchoStar." As Pegasus develops its broadband and interactive businesses, it could be even more appealing as a potential takeover candidate. Pegasus says it's not putting itself up for sale. And Hughes did not return phone calls regarding a possible acquisition.
BRANCHING INTO BROADBAND.
Moreover, Pegasus has just launched an aggressive new broadband Internet service, Pegasus Express (see BW Online, 4/17/01, "This Is Only the Bottom of the First"). According to Bear Stearns, the market for satellite broadband is expected to be worth $2.1 billion by 2004. A big chunk of that will come from rural areas where cable-modem and DSL service are not available. "The value of a broadband connection -- even a narrow-band connection -- will be a very liberating thing for people in rural areas. In a metro area like New York, if you need something, you just go down the road to the mall. In some rural areas, you have to drive 30 to 45 minutes," says CEO Mark Pagon.
Of course, DirecTV would have to pay a premium for Pegasus. Though Pagon has said he would consider any offer that would benefit shareholders, Pagon himself holds a majority stake in the company. That leaves the decision to sell firmly in his hands -- and makes a hostile takeover virtually impossible. "Pegasus has some leverage, and they'll use it," says one source close to the company. "If Hughes were spun off from GM, it wouldn't be as intriguing as say if Rupert Murdoch owned the company."
Nevertheless, it appears some groundwork is being laid for a possible buyout. In February, Pegasus set up a separate holding company and put its broadband and video assets into separate divisions. The moves mean Pegasus could sell off its video customers but hold on to the broadband division if it really takes off.
When could a takeover happen? Analysts agree that they expect some deal before February, 2002. That's the date a court has scheduled to hear a class action from Pegasus and other rural satellite providers against DirecTV, which is contesting the rural providers' right to sell space on new Hughes satellites that are scheduled to be launched sometime around 2007 or 2008. The court recently rejected DirecTV's motion to dismiss the suit. Analysts speculate that DirecTV would rather buy the company than renegotiate a contract that only earns it a small royalty fee for rural subscribers.
It's always possible that the case will go to court and Pegasus could lose its legal challenge. Without the right to sell space on DirecTV satellites, the company would be forced to launch its own satellite platform, an expensive proposition. It's also possible that satellite broadband may not take off as quickly as expected. The service is still very expensive: In addition to the $70 per month fee, subscribers need to buy a separate $499 dish and pay about $200 to have it installed. And while existing satellite subscribers may stay put during the economic downturn, finding new customers could be a lot harder until a recovery is further along.
Overall though, analysts are uniformly bullish on Pegasus' prospects -- whether it goes it alone or is taken into a restructured Hughes. The enterprise value per subscriber for Pegasus is a mere $1,500 compared to nearly $2,500 for DirecTV. That's cheap for a company that's poised to offer new services such as broadband and interactive services. But more important, it might be a hidden door into a stronger, more powerful DirecTV.
Black covers technology for BusinessWeek Online in New York
Edited by Beth Belton