EchoStar's Stock, at 6x 2007 Cash Flow, Could Double (DISH)

Newsletter Value Investor Insight carried an interview with Fairholme Capital's Bruce Berkowitz (pictured left), Larry Pitkowsky and Keith Trauner in its April 28th edition. The Fairholme Fund has returned 18.7% per year since its launch in 1999, versus a 0.4% annual loss for the S&P 500. Here's the segment of the interview in which they explain why they are long EchoStar (DISH):

Your next idea, EchoStar [DISH], is in a much less popular sector at the moment.

BB: The market basically went from thinking Charlie Ergen could do no wrong to saying he doesn’t know what he’s doing and that EchoStar is the odd man out.

LP: But through all that the company has continued to grow profitably, when almost no one else in the business has. They’re now the third-largest pay-TV provider after Comcast (CMCSA) and DirecTV. They added over a million net subscribers last year and the subscriber base has tripled since 2000, to just over 12 million at the end of last year. You can’t get better proof of the value proposition than that.

Isn’t a big knock on EchoStar that it’s vulnerable to competition from voice, Internet and TV packages being rolled out by cable and phone companies?

BB: Yes, but we’ve seen this before. Years ago in financial services everybody thought to win you had to offer everything – banking, insurance, credit cards, brokerage. It turned out the financial supermarket concept was pretty much a bust.

Now you see the same argument in the media and telecom business – you have to offer telephone, broadband and TV in one package or your business is going to hell. I just don’t believe that’s how people buy. They want the best TV experience, product and service. They want the best broadband offer. They want value for money. They don’t care if it all comes from one place. Just look at who’s growing and who isn’t growing. Old ways are much stickier than you think.

LP: EchoStar has worked very hard to be the low-cost television provider. A basic package, with local channels, from EchoStar is about $35 per month, while the comparable package from Comcast or Cablevision is over $50. In mid-tier and high-end packages, EchoStar consistently has a $20 per month price advantage over cable – and the cable offers aren’t even all digital.

KT: One of Wall Street’s fears about pay television is a rate war, led by the phone companies. But amid all this concern, everybody in the industry raised prices a few months ago. We just don’t believe the cable or phone companies can afford a price war, especially against the satellite companies.

Jim Chanos (VII, July 29, 2005) says that in a digital world, content distributors are at risk of being disintermediated by the Internet. Does that concern you?

LP: The flaw in that argument is that the content still has to get there somehow and the content providers have to make money. There’s no way an HBO or an ESPN is going to make as much money on an a la carte basis as they do under the current system. That wouldn’t at all be good news for them. We actually think the more the industry moves toward a la carte pricing, distributors get stronger and the content providers weaker. How important is management in your appraisal of EchoStar?

BB: We think Charlie Ergen is a great jockey who has done an unbelievable job, who clearly has skin in the game with 240 million shares. He was the last guy into the business and he’s now got 12 million subscribers.

LP: They’ve been excellent operators. They’re always looking at the math of adding subscribers and, if at some point it doesn’t make sense, they’ll do something else. It’s rare to hear management say that, but it’s even rarer that they actually do it.

EchoStar has been great about upselling. They have the most attractive introductory package, but their average revenue per subscriber shows that they’ve done a good job of gradually inching people up through attractive offers.

What else gives you confidence he’s positioned the company well for the future?

LP: They have very nice options on the upside. They’re great engineers and make their own set-top boxes, with technology not unlike what Cisco just paid billions for in buying Scientific-Atlanta. While they sell some boxes to a Canadian pay- TV operator, they have more potential here. They’ll also certainly have a broadband Internet solution, as soon as it’s economical enough to provide it. In many ways we believe satellite technology is superior. It’s better for providing high-definition TV on a national basis. Look at how the capital expenses scale: a few $200 million satellites in the sky allow you to deliver video programming to the entire nation, which is quite compelling vs. the cost of laying fiber to reach fewer people. In an increasingly wireless world, with 14 satellites now up, we think they have very valuable real estate in space. They just for the first time named an executive vice president of fixed-satellite services and are talking about providing wholesale satellite service to other companies. This makes sense to us as a natural add-on business.

How troubling was the recent court ruling that EchoStar had infringed on Tivo’s (TIVO) digital video recorder patents?

LP: It doesn’t change our thesis at all. In the doomsday scenario, EchoStar has to pay treble damages on the $73 million award, and then pay some sort of licensing fee going forward. Even if that happens, they can easily absorb the cost without missing a beat.

But there are a lot of reasons to believe the end result of all this will be very different from that first ruling. EchoStar has a lot of experience with intellectual property and technology development, and we think they’re right when they say the ruling is just the beginning of a very long process.

EchoStar shares, at just under $31, are at the same level they were five years ago. What do you see as the upside?

BB: If they continue to grow as they are, we expect them to generate free cash flow of around $4 per share this year and over $5 per share, pre-tax, next year. (By the end of next year they will have used up their remaining net operating loss carryforwards.)

So for 6x next year’s free cash flow, you get a company growing nicely, buying back stock and with some interesting upside options. We would not at all be surprised to see the share price double in the next couple of years.