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DIRECTV Group, Inc. (NASDAQ:DTV)

Q1 2006 Earnings Conference Call

May 4th 2006, 2:00 PM.

Executives:

Jon Rubin, Vice President, Investor Relations

Chase Carey, President, Chief Executive Officer

Michael Palkovic, EVP, Chief Financial Officer

Analysts:

Vijay Jayant, Lehman Brothers

Doug Mitchelson, Deutsche Bank Securities

Katherine Styponias, Prudential Equity Group

Jeffrey Wlodarczak, Wachovia Securities

Douglas Shapiro, Banc of America Securities

Jessica Reif Cohen, Merrill Lynch

Benjamin Swinburne, Morgan Stanley

Tuna Amobi, Standard & Poor's

Andrew Baker, Cathay Financial

Operator

Good day and welcome to the DIRECTV Group's First Quarter 2006 Financial Results and Outlook Earnings Call. Today's conference call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to the Vice President of Investor relations, Mr. Jon Rubin. Please go ahead, sir.

Jon Rubin, Vice President, Investor Relations

Thank you, operator, and thank you, everyone, for joining us for our First Quarter 2006 Financial Results and Outlook Conference Call. With me today on the call are Chase Carey, President and CEO; Mike Palkovic, CFO; Larry Hunter, General Counsel; and Pat Doyle, Treasurer and Controller. In a moment I'll hand the call over to Chase and Mike for some introductory remarks. But, first, I'm obligated to read to you the following.

On this call we make statements that may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve known and unknown risks, uncertainties, and other factors that could cause actual results to be materially different from those expressed or implied by the relevant forward-looking statements. Factors that could cause actual results to differ materially are described in each of the DIRECTV Group's and DIRECTV U.S.' annual reports on Form 10-K, quarterly reports on Form 10-Q, and other filings with the SEC which are available at www.SEC.gov.

Additionally, in accordance with SEC's Regulation G, that requires companies reporting non-GAAP financial measures to reconcile these measures to the most directly comparable GAAP measure, we provide reconciliation schedules for the non-GAAP measures. These schedules are attached to our earning release and are posted on our website at www.DIRECTV.com. With that I'm pleased to introduce Chase.

Chase Carey, President, Chief Executive Officer

Thanks, Jon. I'm just going to make a few comments to open then really turn it over to Mike to take you through the quarter in more detail. Then I'll come back and probably make a few additional comments looking at '06 overall beyond the first quarter and leave most of the time for questions hopefully.

First quarter I guess it certainly describes a solid quarter for us. Clearly the highlights in it, I think, for the top and bottom line growth, I mean revenue cash, profits, continued to grow and continued to deliver, in line with our expectations of driving those forward. I think the quarter results are important. We started to make real progress on some of the key metrics we've talked about in the past. I mean, something like churn where we are moving churn to where it should be. And the initiatives we've been undertaking in the past few quarters start to begin to take traction. I guess I want to spend a minute talking about I guess three key areas in the quarter that we didn't quite hit our targets and give a little bit of, and again, really what our targets are.

Give a little bit of color commentary on those. First, SAC. And I guess on SAC we were probably about $10 to $15 higher than our target on SAC and really probably two factors drove that. First, hardware costs, really predominantly around the new DVR and HD. I think as -- as we know, when you have new products, the initial cost of a new generation of products has additional costs. We had a few early stage bugs we had to debug out of that product. And that affected the timing. We ended up with some costs like air freight for the early boxes that we had to get into the marketplace.

Just the hardware costs and that first generation, those first deliveries of those new products were a bit higher. As we worked through the inventory, we do think those costs will come, by the end of the second quarter will be in line with our expectations. We successfully debugged the -- and addressed the issues in both boxes. So we think that's probably behind us and really just now work through the inventory. But that added a bit. And the other area that added a bit to SAC was marketing. Where our marketing spend was actually on line with our target but because the subnumbers were a bit lower, the amortization rate of marketing into SAC was a touch higher than expected. So overall again, I think a lot of the areas in SAC we're continuing to move in the right direction. And I think overall SAC we continue to feel pretty good about. But those were a couple of issues we worked through in the quarter.

Second area to touch on is gross ads, where we didn't quite hit our targets. Again, I'd say we're about 50,000 short of what we targeted for the quarter. In many ways, that number is -- in the shortfall driven -- has got probably a lot of positives inherent in it. Realistically, it's a part of our ongoing focus on quality subscribers. I think as Mike will take you through, I think we've been very successful in driving towards higher quality subscribers. And I think one of the consequences we've worked through this shift to bring our focus to higher quality subscribers is some growing pains and some shifting pains through the sales channels. Certain channels, I guess particularly the third-party dealer channels, I think have struggled a bit to sort of reorient and refocus on higher quality subs from lower quality subs. We're working through that process with our dealers. And I think as we continue in the next couple of months to tweak comp structures and other arrangements to focus on quality subs, I think we feel, certainly second half of the year we'll get the dealer organization oriented. And focused on the right -- the right types of subscribers and get ourselves in line with our expectations. But again, I think the sub number which was a bit short in the quarter was really a part of the process of focusing on higher quality subs which overall is our number-one priority in that area.

In the third area that was a touch above our target was retention marketing. Which while down a bit from the fourth quarter was probably still about $15 million higher than what is shot for. The quarter does include a little bit, that 10 million in change, little over 10 million of MPEG 4 swaps in it. But beyond that there are really two issues that we had to deal with in the quarter. One is the hardware costs I mentioned in talking about SAC. And the second was sort of a different issue, but related to the new HD and DVRs, that because the very first boxes had some bugs we probably had a higher level of replacement and for a few months there worked through the transition of debugging those boxes and replacing more boxes than we would have. Again, that's a problem that's behind us. So we had a couple of issues in the retention marketing area to work through. That we've got behind us that -- that ended up with a few extra costs there, though again, I think we feel we're pretty well on top of it.

So I think overall, when you look at the overall results for the quarter, there were a few tweaks there. Directionally, certainly, continuing to move us to where we want to be. And I think there have been a handful of issues. I think we feel pretty good about being on top of and in the process of addressing. So with that I'll turn it over to Mike and he'll give you a bit deeper look at the quarter. And then I'll come back to make some comments.

Michael Palkovic, Executive Vice President, Chief Financial Officer

Thanks, Chase. Starting at the top the revenues for DIRECTV U.S. increased by 14% to 3.2 billion. Similar to recent quarters the revenue growth came from the continued growth in our subscriber base along with strong ARPU growth of 6% to $69.75. Most of the ARPU growth came from price increases on our programming packages in addition to more boxes in the home including DVR and HD receivers, as well as higher advertising revenue. Before moving onto operating profit, I'd like to remind you that we started our lease program on March 1st. Consequently our first quarter results reflected the financial impact from one month of this new program.

In the quarter, we capitalized about 87 million of equipment, 46 million for new customers, and the balance for existing customers. As a result, both our operating profit before depreciation and amortization as well as our CapEx increased by $87 million. Both of these increases will be much larger beginning in the second quarter, our first full quarter under the new program, and for the balance of the year. The full-year impact of this change will be roughly $1 billion, an increase operating profit before depreciation amortization and the corresponding CapEx.

Operating profit for depreciation amortization is 2.5 times last year's results for the same quarter at 545 million. And when you look at it without the benefit of the lease model, our results more than doubled. The biggest drivers of this increase were reduced acquisition costs resulting from the lower gross subscriber additions, increased gross margin on the higher revenues, and the effect of the capitalized equipment costs. The lower gross adds coupled with increased fixed marketing costs were the main contributor to the higher cash SAC of 668 in the quarter, when you compare it to the same quarter last year. In addition to more DVR and HD boxes.

These increases were partially offset by the ongoing hardware cost reductions and the benefit we are now getting from the up-front fees we collect from the high-risk customers. For those who are interested, we do provide a table on our earnings release showing how the cash SAC of 668 is calculated. Pre-SAC margin of 34% was down slightly from last year. Again, this comparison is on an apples-to-apples basis, meaning that it excludes the benefit from capitalizing equipment on a lease program. The primary contributors were the higher upgrade and retention costs and, to a lesser extent, programming cost, and these were mostly offset by benefits gained primarily from subscriber services expenses, as well as other areas of the P&L. These are the kinds of improvements in margins we expect to get each year as we demonstrate the operating leverage of our platform.

In addition to the costs Chase described earlier, the increase in our cash upgrade and retention costs to 334 million were largely due to higher HD sales to existing customers and, to a smaller degree, more subscribers using our movers program. The first piece was mostly due to our efforts last year to minimize marketing of Legacy HD boxes which we are now fully marketing, and the second part, the movers increase is due both to the size of our base growing, and our continued belief that this is a good investment for us to make. In terms of our HD focus, we had twice as many total HD transactions this quarter than last year. In addition, we started the process of swapping out those customers who have old HD boxes for new MPEG 4 boxes. We spent approximately 10 million in the first quarter which is included in our upgrade and retention cost. We expect this to be around 150 million for the full-year and for the total swap program to be completed in the two to three-year time frame.

Turning to subscribers, while our total gross additions are down 19% versus Q1 last year, the number of higher quality adds are up by 13% or 85,000. Last year, 39% of our new adds in the quarter were what we deemed to be poor quality. And this year that number is now down to 14%. This improvement is due to the effect of the changes we made throughout last year to focus on quality, and we'll continue to monitor all of these quality tactics to make whatever adjustments are necessary to ensure we are investing in higher quality, profitable, new customers. It is also no coincidence that these higher quality subscribers are acquiring DVRs and HD at a record rate. In the first quarter, about 25% of our gross adds took a DVR, HD, or both. This earnings represents our highest level ever and compares to a 12% take rate a year ago and 20% last quarter. And as we've shown in previous presentations, the return on these subscribers is significantly higher than those who take a basic box only.

The improved quality of our subscriber base has also contributed to our goal of lowering churn, evidenced by this quarter's churn rate of 1.45%. One of the lowest levels we've seen in the few years. And while the first quarter has been historically low for our platform, this is better than last year, and significantly down from the prior two quarters. We expected this kind of performance because the vast majority of our higher churn over the past couple of years has been associated with the involuntary churn of high risk customers, particularly in their first year of service. It is these subs who now represent a much smaller and declining percentage of our subscriber base. The involuntary churn was 30% for the quarter, which compares to 44% last quarter, and 34% last year.

Finally, we had another strong quarter of cash flow before interest and taxes of $211 million or more than three times last year's results. For DIRECTV U.S., we report cash flow before interest and taxes as we believe it reflects the true operating performance of the business. And based on the financing structure of our businesses, we managed interest and taxes on a consolidated basis at the group level. So at this time I'd like to turn the call back over to Chase.

Chase Carey, President, Chief Executive Officer

Okay, thanks, Mike. Just a couple comments looking at the year. I mean, the reality is February at the investor conference we gave you, I think a pretty good look at what we expect for '06 and sort of the next three years. And generally that picture's still pretty accurate. So I'm not going to -- I'm not going to bother to repeat it all. I guess just a couple of tweaks to it. Probably as you look at this year, I'd say SAC will probably be a touch higher than we targeted. That's for the reasons, I spoke to. Although still it will be in the 650 and the change range. So it's certainly still in the range we've talked about. I think on the net sub side, again, for the reasons talked about, I'd probably say net subs would be more like a touch under 1 million than up, then a touch over 1 million. But overall, certainly a year we still expect to grow, profits, and cash flow.

Really the growth in all the metrics and the progress and all the metrics we've talked about. Clearly a year where a lot's going on. We're continuing to move forward on an array of initiatives, launching HD locals as -- as we launched in -- the series in April. Launching another group in June. Continuing forward the HD-DVR box coming this summer. Content initiatives that we've launched and continue to build on. A new marketing campaign with some new initiatives inside that. Continuing to build and focus the sales channels both on quality, and as we said, I think getting more targeted as we go. And whether that targeted means geographic, demographic, content categories, what have you. Is all part of managing that side of the business.

Overall, we certainly recognize we're competing -- we're in an increasingly competitive environment. The broadband bundle pricing continues to get, more aggressive. Although the reality is our RBOC relationships continue to be quite strong. And certainly continue to be a very strong part of -- of our ability to compete with the broadband bundle. And we expect that to continue. And so while we see an impact, again, I'd probably use a phrase I've sewed before, it's an impact at the margin. And I think as we continue, really, for us it is about continuing to build our strengths. Focus on our key objectives. And position ourselves to build in those strengths. And over time continue to build on the relationships, partnerships, and the like to compete in a broader context.

So I think overall as we look at '06, again, it's pretty much the picture we had there. And we feel the initiatives we've got in place will drive us to where we -- we'll start -- we'll deliver the opportunities in front of us for both the bottom and the top line -- top and bottom line of the business.

A couple areas just to touch on before turning to questions. Broadband, which I know will be -- is an area everybody likes to ask about. And I'm sure I'll get a question about it. I'd be happy to address it. I mean, but I'll say up-front there isn't a lot new to say about it. Continues to be an area we spend significant time on. And as we've said we will move forward and do something when and if we get to a place that we have an arrangement that makes sense for us. The -- we're certainly on top of the opportunities, and again, we continue to work through those. But there isn't anything particularly new from prior -- from our prior discussions to add to that.

And then I guess just an update on the buy-back. And as of yesterday, close of yesterday, we've bought back just under 122 million shares and spent just about $1.9 billion in the -- in doing so. So certainly the buy-back program we've had in place, you know, we have been actively moving forward with. So with that, I'll turn it over to questions.

Question-and-Answer Session

Operator

Thank you.

Jon Rubin, Vice President, Investor Relations

Just quickly, I just wanted to mention, investors should note that we have members of the media on this call in a listen-only mode. I'd like to remind the media they're not authorized to quote any participants on this call either directly or in substance other than the representatives of the DIRECTV Group. In addition we are webcasting this call live on the internet. And an archived copy will be kept on our website. Finally, I'd like to ask all callers to limit your questions to only one or two until everyone has had a chance to ask their questions. Thank you, operator, we're ready now.

Operator

Thank you. Operator Instructions And we have our first question coming from Vijay Jayant of Lehman Brothers.

Q - Vijay Jayant

Thank you. I have actually a couple of questions. First, Chase, given the delay in the NDS boxes for the HD-DVR and your current deployment of, I think, the TiVo, the Direct TiVo boxes, which is I think an MPEG-2 box, so, once that MPEG-2 box comes will that be a transition? And is there any magnitude you can share with us on how many HD-DVR TiVo boxes you've deployed? And secondly, in terms of just this accounting change that's happening, can you just sort of tell us, on the retention side how much the costs were expensed?

A - Chase Carey

On the --.

A - Michael Palkovic

Second part, Vijay, was 41 million retention costs went onto the balance sheet. 46 million SAC. That makes up the $87 million.

Q - Vijay Jayant

Thanks.

A - Chase Carey

In terms of the boxes, you're right. The HD-DVR, the HD-DVR box we are currently still distributing in the marketplace is the MPEG 2 TiVo box. As I said this, summer we will transition to an MPEG 4 HD-DVR. The universe I think today we've got somewhat north of 250,000 in customers HD-DVRs. And so that will add a few before we get to the new HD-DVR this summer. And that -- at that point that will fully transition us. Obviously we've had the MPEG 4 HD box since the end of late '05. So once we get there we will be deploying MPEG 4 box across the board and continue forward with transition out of those legacy and MPEG 2 boxes to MPEG 4.

Q - Vijay Jayant

Thank you.

Operator

Thank you. Our next question is coming from Doug Mitchelson of Deutsche Bank Securities.

Q - Douglas Mitchelson

You highlighted in the past the HD capacity advantage you'll have over cable once you launch the last two satellites that go up next year, I think. I'm trying to figure out when that HD capacity becomes an important marketplace advantage. I don't see a flood of national HD channels that would tap out the capacity of most cable plans. Could you just spend a little time walking me through this issue?

A - Chase Carey

Yes. I mean, first, give you our timing on it. I mean, we launch those -- we launch those satellites beginning of '07. So probably, say, a year from now is where we'll really have that capacity fully on line. We'll be pretty widely in local HD before that. I think we expect to be close to three quarters of the country with HD local by the end of this year. And again, to recap the capacity, it will give us -- essentially gives us if we -- if we truly could bring HD locals to every market in 150-plus Conus HD. I think you will see, clearly we're not going to launch 150 Conus HD right out of the box. But I think as you look at it today, you see an -- an increasing number of channels that I think over the next couple of years will move to -- will launch HD versions other channels. So I think you'll actually if you look at by the end of '07, I think you're certainly going to have HD channels that are in the -- are numbered in the dozens. I mean, you obviously get some of the paid services and the ability to have multiplex pay services. So -- and that's not really including things like the boom-type content and the like, which is, I think the more specialized. Have to determine how big a market is there for this sort of the -- the channels created only in HD. But I'm talking, therefore, traditional, established channels. I think you'll see a pretty, a pretty significant sort of over really the next two to three years, a pretty rapid migration of most of the successful channels.

Launching HD content. And you look at the cable world, and I think you've got a pretty big chunk of the cable world that really isn't in place to handle anything even close to that level. You know, I'm not saying, obviously cable it's always difficult to have a one-size-fits-all statement because they're in different shapes and forms and configurations. But it is -- but certainly a large, large chunk of the cable industry I think will continue to -- for a period of time continue to struggle with the capacity demands of that system from an array of directions including HD. So I think you're going to have enough channels coming on that you'll have -- that there will be real issues, and will give us a real advantage to compete with the cable guys. And to some degree we use the capacity intelligently. I think there are ways to create an array of appealing services to take advantage of that capacity while maintaining the flexibility to add more channels as they go. So I think you will -- you will see from us a very exciting, very dynamic, clearly industry-defining HD plan as we get that capacity that will take advantage of it. And I think the fact of the matter is, -- I think that is a challenge that -- and an opportunity that is incumbent for us to take advantage of. Is how do we use that capacity to redefine what is leadership in HD, in the marketplace. I'm not going to sit here and tell you now because I'm not going to give the cable guys 12 months to prepare for it. But I think you'll see from us a strategy and a content offering that takes advantage of that capacity that, you know, that really differentiates us from everybody else in the marketplace in '07.

Q - Douglas Mitchelson

Thank you very much.

Operator

Thank you. Our next question is coming from Kathy Styponias of Prudential.

Q - Katherine Styponias

Hi thanks, I have two questions. Chase, you've completed about 2/3 of your $3 billion buy-back. You said it would take a little over two years to complete. You've done some of it in the first quarter alone. What's the likelihood that you complete the rest of it in the near future and/or would you increase that authorization and use your balance sheet to do so? And then the second question, could you hypothetically speak to the likelihood that a DISH-DIRECTV combination would be more likely to get approved now than a few years ago? What your thoughts are on that? Thanks.

A - Chase Carey

Sure. On the buy-back, yes. Obviously there is a -- we're as far along as we are because of the deal we did with the pension fund. Obviously we bought up the 100 million shares from the pension fund. So there is a -- it's difficult to handicap the swings. I mean because in many ways if we just continue through the market, you can sort of time that out. There's trading volume, and you can lay out what that is. So probably the unknown, obviously the pension fund continues to sit there on 100 plus million shares. I know we talk to them regularly, but at this point, all they ever say to me is they're happy shareholders. I guess we'll see where they go. But it's pretty difficult to handicap timing when -- like I said, I could handicap the part of it that is what we do in the market. I can't really speak for the pension fund and their decisions. So that then we continue to talk to them. And, therefore, I'm probably not going to get too far out in speculating on what ifs about what happens on how the pension fund decides to move forward as a shareholder in DIRECTV, and we'll see. So we'll deal with that when we get to the place and closer to a place in time that we have to. Today, we've obviously still got $1 billion and change of money committed to the buy-back that we haven't yet used. In terms of DISH, I mean, from a regulatory perspective, which I think is what you asked, I think there's no question you've got a different regulatory environment. I mean, if you look at the -- consider this the consolidation and then the cable business which continues or the -- as Adelphia today as we're all aware of, or in the Teleco-business as you get AT&T and MCI and BellSouth all moving along or new competitors coming in from be it Google, Yahoo!, who add to IP-TV and the like. So you're pretty clear you've got a marketplace that has continued to consolidate on one level with bigger players. And on another level, have new entrants that may certainly coming into it. Or entrants that had talked about it before like the RBOCs that are obviously now doing it. So, three years ago, four years ago, whenever it was last time they were talking about competing. Today they're laying fiber in the ground. So I think you clearly have a significantly different environment than you did a few years ago that would obviously be relevant to any -- anything like a merge between DIRECT and DISH.

Q - Katherine Styponias

Thank you.

Operator

Thank you. Our next question comes from Jeff Wlodarczak of Wachovia Securities.

Q - Jeffrey Wlodarczak

Hey, guys, that was close on the name. Two questions -- I'm used to it. Chase, can you talk about the competitive environment. I mean Cablevision, Time-Warner, Comcast generated record basic video subgrowth in the first quarter. How much of an effect did this have on your results? And I guess the extension in the same context. Can you talk about your experience in a specific market where someone is highly upgraded like Cablevision? Thanks.

A - Chase Carey

I think as I just touched on, I mean, there's no question we're in a marketplace of increasing competition. And I think we all expected that. And in some way, we're increasing like I was talking a few minutes ago in HD. We're bringing our own new dimensions to the marketplace to compete. I guess I'd say on the bundle, in competing with it, it becomes, I think as we go along, it becomes a more -- at the margin, more competitive dynamic we deal with. So again it's really -- it's really more at the margin. I mean, I guess you look at the flip side, and looking at the numbers on DSL and cable broadband. And if anything DSL continues to take, more of the market -- more market share than cable. And so I think on one level it's certainly a more competitive environment. I think there's no denying it. I think, that for us, and I think we expected it. So it really doesn't change, I think, our expectations or views of the business. I think we recognize it. It means why we have to pursue the things we have to do. Leadership in HD. Leadership in DVRs and content. On the sales side, to be more targeted and take more advantage of places whether it's in sports leadership or geographic markets where we have unique strengths. And I think that is all part of the process to take advantage of our partnerships with the -- with the RBOCs. Because the reality is while they're building fiber, certainly you look out next three years the number of homes they're going to lay fiber to is still going to be a pretty small fraction of the country. By and large, these DSL customers are a great place for us to be a part of a bundled offering to them. So, I think it is a more competitive marketplace.

I think in terms of people don't look at the other side as sort of the competitive dynamics and opportunities we have again to either capture -- take advantage of niches we have and strengthen ourselves. And -- and in key competitive aspects or ally with players who are looking to -- that we have complementary interests with. So I think we feel pretty good about our ability to compete in an increasingly competitive marketplace. And again, a quarter where we add over a quarter million subs, still feel pretty healthy growth rate. So it's, I think, again speaks to the strength of our business. And realistically again a lot of thing we'll have, we're still in the process of launching in the coming months and quarters. I think as it gets to specific markets, the -- there clearly are differences. And again, I think as we've talked about being targeted. Not dramatic differences. So it's not from sort of one end of the spectrum to the other. But certainly markets where you've got strong cable operator, versus a week cable operator, they're not the same. But again, I don't think that's a -- dramatically different, than it's been in the past. And I think we all know, you can name the handful of markets people talk about where the cable operators built these particularly strong position. And there are others that -- not sure there's anything, particularly illuminating about it. Again, I think it's a factor we deal with. I think we expect as we go forward, if I was guessing a year from now, I'd say sort of planning and expecting a year from now. I think, again, as we get more targeted, probably marginally, we -- you will end up having the -- one geographic market versus another. That variance increases a little bit. And markets were strong and be a bit stronger. And markets where cable is strong can be a bit tougher. And I think that probably will be a part of the dynamic. But today, again, it's really not that different than it's been. And it's -- again, a fact we deal with at the margin.

Operator

Thank you. Our next question is coming from Douglas Shapiro of Banc of America Securities.

Q - Douglas Shapiro

Yeah thank you. I also have two things. Chase, just when you look at the retention marketing, even if you pull out the MPEG 4 costs you cited, and what you also cited was what you thought the overage was relative to budget of around 15 million, it still would mark the first time in the last five quarters that the retention marketing is up a little bit as a percentage of sales year-over-year. So just regarding your overall target for '06, that number should be no higher than flat as a percentage of sales. Do you still feel good about that forecast I guess is the first question. And then the second question was you mentioned the 25% take rate of advanced converters. I believe that was for gross ads. But I was wondering if you could just give the split of advanced converters deployed in the quarter between gross ads and retention?

A - Chase Carey

Well, on the first question, actually, I feel quite good about sort of our ability to manage retention marketing as we planned. Yeah, we had some things -- launching new boxes, yes. You know it and, probably in some ways, it's a little bit like our timing of launching DVRs, as much as maybe you get -- learn over time, there always seems to be a few more bugs than you plan , and there are consequences to the bugs. It just is, -- we were late on getting a DVR to the market. A few months it takes to debug a box. So those early boxes we had, I don't know what the return rate was, 10% of the boxes getting for a couple of months that had a glitch. And we fixed those problems. So we had a, -- we did in the quarter have some items we dealt with. In terms of the overall ability to manage the -- manage the retention marketing, what, again, we talked about was sort of marginally above what it was in '05. I think it's still a number I feel very good about. I actually feel, you know, and I feel, you know, sitting here today. We're, you know, pretty well on top of certainly what we want to do and how we want to manage retention marketing. I don't know if Mike's got--.

A - Michel Palkovic

The 25% is roughly 230,000 thereabouts. We had about 300,000 between DVR and HD from the existing base. So it was -- in absolute numbers higher, as a percent of our base. Probably only about 1%. But that's because the base is so much larger.

Q - Douglas Shapiro

Okay that's great. Thank you.

Operator

Thank you. Our next question is coming from Jessica Reif of Merrill Lynch.

Q - Jessica Reif Cohen

Thank you. Two questions. One, Mike mentioned that advertising was higher. Just wondering if you could give us some numbers this year versus last year -- and for the full year. And Chase, do you have any change in your goal for subscribers? You had given a number of 20 million. The market dynamics seem a little more competitive. This year it looks like you said, you might be just under a million instead of over a million.

A - Michel Palkovic

Yeah. Jessica. On add sales, we're up again year over year. We were running north of 50 a quarter last year. We're now just into the low 60s. So we'll probably go up $40 million or $50 million in that ballpark year-over-year. So we continue to do extremely well on that side of our business.

A - Chase Carey

And I guess in terms -- I guess let me make two comments on the sub number. I think 20 is still -- and it's not a target. Then again, I think what is -- a judgment of what the opportunity is there. And I still -- yes. I still feel or very much believe that sort of an appropriate -- in a realistic vision of the business. And again, I -- while it's more competitive, again, I don't think it's actually much more competitive than I expected it to be. So where we are today is not -- the competitive environment we're in today is not that different than our expectations and what we've been looking at. And I think the part of it that, again, doesn't get recognized is the number of things we're going to -- that we've been putting in place. I mean our DVR, the HD and DVRs, which are cornerstones to a lot of the things we're doing, were launched in the last three months. I mean, reorienting the sales channels and building more niche-targeted sales channels to strengthen those. We are still in the early stages. So there are a lot of opportunities for us to compete in this marketplace.

We will compete aggressively. And in some ways have increasing strengths as we go forward. And again, I guess leaves the number of increasing opportunities when you look at some things like the growth in DSL and what that opens up for us in the marketplace. I guess the comment I want to make on the flip side of it which is always somewhat debated from a 10,000-foot level is -- reiterate that our goal in subs is to sort of capture the subs that are profitable subs and that make send for us to catch. And it's not the Chase sub number we have to chase. And I think I said in February, that we talked about a number of 18 and said effectually the number ended up being 17 million subs instead of 18 million subs it wouldn't bother me that much if that was the right place for us to be. And I think the 20 million number is a place that today looking at the market, looking at what we have, and looking at the things, the opportunities we'll have to compete in the marketplace. I think it's a realistic place to be. But at the end of the day, we got a very strong profit business whether it was 18 or 20. There's not a magic number we have to get, and this amount of magic number we have to chase.

To some degree we'll take the subs that we can capture, on the right terms. Because of the strength of what we have in the marketplace. No that doesn't mean, again, we're in a competitive marketplace and, therefore, competition is always going to affect us and -- if offers get more aggressive, it's part of what we have to deal with. And clearly they're very valuable subs. And as people focus in competing for those valuable subs, it's a part of a dynamic we have to deal with. So I'm not saying we live in a vacuum. We obviously live in a competitive environment. But we're not chasing a sub number. So in sort of reiterating 20, I don't want to miscommunicate somehow there's a sub number we're chasing. What we're doing is we're taking advantage of subscribers that we think are good subscribers that we can capture based on the strengths of our business.

Q - Jessica Reif Cohen

Thank you.

Operator

Thank you. Our next question is coming from Ben Swinburne of Morgan Stanley.

Q - Benjamin Swinburne

Good afternoon, everybody. I've got two questions. Chase, when we heard from the cable companies this quarter and yourselves talk about the strength on the set tops across the board and your ARPU was up I think 6% year-on-year, partly driven I think by activations and up-front fees, does the demand for HD and DVRs and particularly HD with relatively limited content out there make you feel better about ARPU growth over time as well as maybe charging your customers upgrade for these boxes? And then secondarily there's been some noise in the market on the Home Zone product, which is the AT&T Dish-integrated box. You guys have, I think, have a plan down the road to bring a broadband pipe into your set top, but it's currently not combined or marketed or integrated with an RBOC offering. Any thoughts on moving in that direction if that does anything for you guys down the road? Thank you.

A - Chase Carey

Yeah. The -- in terms of HD and DVR and sort of what is I guess was the -- if I understood it just behind what does it mean in terms of ARPU growth, at the end of the day, yes, I think there are a lot of opportunities. I think you can continue to -- you can continue to certainly charge for a period of time for these advance services. Again, you may decide how do you package it, how do you bundle it. It may end up being the best way to charge for it is to give it away free for buying a higher packet. Give you HD or DVR away if you buy a whole bunch of sports packages and premium packages. So again, I think it doesn't mean necessarily -- I mean, you will capture incremental value for it. I think we have to be smart and will be smart about how do package it and get the most bang for it. But clearly, you will get, I think it is certainly not going to get buried in price.

You're going to get incremental value. And it clearly opens up other avenues, be it advertising, be it VoD. You get a wider penetration of those sorts of services that will give you real opportunity. And again, particularly as we move towards higher quality subscribers who are probably the sweet spot for advance services. That I think we will continue to find ways. Again, I'll use the example I've used before, like SuperFan ticket, the SuperFan pack that's on top of Sunday Ticket. To create, take advantage of these technologies both indirectly and directly to drive ARPU. Again, competition is probably the unknown in this and sort of where does it go. And certainly on the core, the competition today mostly seems to be on up-front promotions. So I don't see it coming at the core packages, so then again the more in the promotional side. But I think these devices directly and indirectly I think give us real opportunities over time to continue to drive ARPU. On the second question, what was the second question?

Q - Benjamin Swinburne

Home Zone.

A - Chase Carey

Oh, the bundling --. Yeah, I mean we will have, I guess our box at the end of the year will have the capability to integrate broadband into the experience. And I think that's an ongoing conversation. With the RBOCs of what are the opportunities to create an experience that takes advantage of whether it's the cost, the efficiencies, the appeal of that. They're obviously issues as you get into that type of a relationship, and -- there's some -- if you add it to a bundled box, there are clearly things that belong to us, things that belong to them. You certainly get a -- you get a pile of stuff in the middle that you got to wrestle through. I think we are certainly open-minded about trying to figure out other ways to do things to make sense for us. But, it's probably too early at this point to sort of handicap any of that other than to say I think it is an opportunity that -- you know, that is there for us and certainly we've had -- certainly we've had conversations about it to sort of started to talk through with an array of partners about the issues. But I think we have to see how we go as we take those forward. But it is an area of opportunity for us as we are focused on it.

Operator

Thank you. Our next question is coming from Tuna Amobi of Standard & Poor's.

Q - Tuna Amobi

Thank you very much for taking the questions. I had a few as well. On the first one, clearly your credit policy has been well received. And my question is can you update us on where you stand regarding the impact of this policy on your customer segmentation strategy? I understand that about 1/3 of your customers recently accounted for about 2/3 of your profit. So how do you see that evolving given these gains that you're reporting as well as in terms of the percentage composition of high risk and low risk subscribers? And secondly, how do you see the announcements of the AT&T-BellSouth acquisition? How does that change your current strategic relationship with BellSouth? And do you think that could be a significant factor when the acquisition closes? And finally, couple of cable operators are reporting very good successes with the testing of a network DVR. And there's actually a school of thought that this network DVR could change the dynamics of the categories. I was wondering if you could share thoughts on whether this could be a threat to your -- to the model that you're deploying right now over the longer term? Thank you.

A - Chase Carey

I'll talk to the latter two. Let Mike talk about the credit policy. In terms of AT&T and BellSouth, I guess the direct issue out it which is we have agreements with BellSouth. That's not an issue certainly. In the short term is what has an effect has it -- the relationship we have with BellSouth today for bundling services. And I think that is something, as you go through the next year or so we'll have to continue to talk to BellSouth and AT&T. And determine where and how they're going to deal with it. At this point, they -- I think probably understandably their focus is on the core merger. They're aware of this. I think should not be lost. We've had a -- you look at the results for BellSouth, we've had a very successful relationship with BellSouth. And clearly for whatever reason there's been a bit more of a struggle to make it work on the AT&T side. But I think that's -- I think that's -- I think we'll have to see as those conversations evolve over the next year-plus.

And the entities complete the merger and move forward and try and determine what strategies they're going to pursue and how to pursue the marketplace. I think there is a lot of time between now and any decisions and probably a lot of issues that will get raised between now and any decisions that we'll have to see. So certainly short term, year or two, I don't see any impact. I think we'll have to see as we go longer term what does it mean. And I think that's difficult to handicap. I think in terms of the network DVR, I mean, I don't think there's any -- can't call it success. But I think they announced a plan to do something. I don't think they have the test out there yet. And I think -- again from a broad perspective, we're in a marketplace where I continue to expect an array of -- certainly I'm sure between now and the end of '06 there will be announcements of new -- of technological changes, other shifts. This is a marketplace, you're going to -- a year ago, it was all IPT, now network DVR.

We have to move forward with our own technological developments. I don't know that this is that dramatically different than any other part or sort of competing in an environment with shifting technologies. I think as it relates to the network DVR that they've talked about, there are clearly issues that they have to work through, whether they are legal issue, capacity issues, technology issues. It's a pretty sophisticated plan. So I think we'll see -- I think we'll see as it goes. But I think there's a long way between here today and deployment in a meaningful way so that device. But I think we're certainly aware of it. And I think it's as with a lot of thing part of the world that we'll compete in. And I think it sort of becomes incumbent on us to continue to build and find ways to find a better solution. I think in many ways as we can bring down DVR costs, improve the quality of DVR, DVRs, and provide DVR experience that is reliable in the home, doesn't require a whole level of out-of-home infrastructure and technology, because that there are a lot of competitive advantages to the type of experience we'll deploy. And I think it will highlight some of the differences that we'll move forward with. That began putting the experience more reliably in a consumer's home at their control. And not dependent upon the uncertainties and challenges of managing an out-of-home infrastructure.

And I think these costs are going to move down. And the capabilities are going to move up that we're going to be able to put a richer and richer experience with a lot more flexibility and a lot more speed and a lot more agility into the marketplace than these capital intensive, expensive, difficult to manage, difficult to implement out-of-home technological solutions. But you know, really it's just part of the overall competitive landscape we're going to deal with.

Operator

Thank you. And we do have time for one final question. Our final question will be coming from Andy Baker of Cathay Financial.

Q - Andrew Baker

Thank you and congratulations on a good quarter. Just had a couple of questions on your programming costs. I noticed that the programming costs as a percentage of sales ticked up. And I think programming costs per sub was up 8% versus the same quarter last year. Can you give us some sort of discussion about how the -- how you see trends and programming costs moving forward. How much of this is coming from your own attempts to build a better experience, and put in proprietary programming out there versus higher costs from your suppliers? And then for Mike, are there tax implications of the lease program? In other words, are you accelerating depreciation of the boxes versus -- quicker than you're depreciating them for book purposes?

A - Michel Palkovic

Second question is probably a little quicker. The tax -- follow the IRS guidelines for tax depreciation which really buckets the types of assets you have into different lines, and we'll follow that, factor in lessons and recovery guidelines and things like that. It's probably slightly longer than what we're doing on the book side. But again, we're one month into it. So we need some experience to apply to it to see what the timing difference is. But my expectation is it won't be a significant difference between tax and books. On the first one, programming costs typically go up, a percentage of revenue a little bit. Even if you can get your contracts down to, historically what would be perceived as pretty good annual increases at 5%, 6%, or even 7%, as long your ARPU's going up a percent lower than that, you're going to take a little bit of a margin hit. I think our focus on the programming side is -- has been very successful. It was only a few years ago, we were in double-digit annual increases. And now we're talking about levels that are more like 5%, 6%, 7% that has a category. So we continue to work that pretty hard. We look at the value proposition between all the people that hold the programming services. And I think we do a fairly good job of getting good deals for DIRECTV today. And we'll continue to do that. But there will probably always be that slight erosion at the programming margin line until we can get the two percentages to converge.

Q - Andrew Baker

Thank you.

Operator

Thank you, ladies and gentlemen. Thank you, ladies and gentlemen. That does conclude today's call. Please disconnect your lines at this time. And have a great day.

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Source: DIRECTV Group, Inc. Q1 2006 Earnings Conference Call Transcript (DTV)
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