Hughes Communications Inc. Q3 2008 Earnings Call Transcript

Hughes Communications Inc. (HUGH)

Q3 2008 Earnings Call

November 6, 2008 11:00 am ET

Executives

Deepak Dutt - Vice President of Investor Relations

Pradman P. Kaul – President, Chief Executive Officer

Grant A. Barber – Chief Financial Officer

Analysts

James Ratcliffe - Barclays Capital

Scott Malat - Goldman Sachs

Chris Quilty - Raymond James & Associates

Presentation

Operator

Good day ladies and gentlemen and welcome to the third quarter 2008 Hughes Communications Inc. earnings conference call. My name is Erika and I will be your coordinator for today. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Deepak Dutt, Vice President of Investor Relations. You may proceed, sir.

Deepak Dutt

Thank you very much, Operator and good morning, everybody. Welcome to our third quarter 2008 earnings call.

Before we begin, I want to remind everyone that this conference call including the Q&A session may contain statements that are forward-looking and that are defined by the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management’s thorough beliefs as well as assumptions made by and information currently available to management and are subject to risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements and we refer you to the documents filed time to time with the SEC, specifically our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our periodic 8-K filings including the one filed with this press release and our registration statements on Form S-3.

In addition to reporting financial results and reporting in accordance with the General Accepted Accounting Principles or GAAP, Hughes reports non-GAAP financial results. Investors are encouraged to review the reconciliation of these non-GAAP financial measures with comparable GAAP results that can be found on our earnings release and on our investor relations website.

I will now like to introduce the management team joining me on this call, Pradman Kaul, President and CEO and Grant Barber, Executive Vice President and CFO. We will start with a business overview by Pradman followed by a financial overview by Grant. Pradman will then make closing comments and we will follow this with a Q&A session. So let me turn the call over to Pradman.

Pradman P. Kaul

Thank you, Deepak. I’m delighted to report that Hughes had another outstanding quarter with strong growth in revenue and adjusted EBITDA. Hughes revenue has increased by 16% in the third quarter over the same quarter last year to $272 million, a new record for third quarter revenue. In the same period, adjusted EBITDA grew by an impressive 15% to $39 million, also a new third quarter record.

We also had another strong quarter in terms of new order bookings. Our new order bookings were $272 million in the third quarter and this performance was strong across all of our business segments. It has resulted in a healthy firm backlog of $861 million from the non-consumer parts of our business. As you may recall, we do not report backlog in our consumer business even though we generally have 24 months of service commitments from our subscribers. This strong backlog continues to give us great visibility and predictability of our revenues in the coming quarters and has positioned us very well for the rest of 2008 and beyond.

In North America, our consumer business continued its tradition of solid growth performance. The number of gross adds was 44,000 subscribers which represents a 19% growth over Q3 ’07 and ARPU was $66 compared to $63 in the third quarter of ’07. This resulted in the revenue from consumer services growing by 20% in this quarter over the same quarter last year.

As you may recall, our objective has been to grow our gross subscriber acquisitions by 20% quarter-on-quarter, year-to-year. Churn during the quarter increased to 2.6%, up from 2.3% in the second quarter of 2008. We believe that much of the increase in churn is a result of the deteriorating credit positions and the economic slowdown and we continue to monitor it very carefully. Overall, we believe this business will continue to grow and that SPACEWAY will help drive this growth as we continue to be the largest satellite-based broadband Internet access provider in the world.

The North American enterprise business also had a good quarter in revenue and new orders and consequently, the backlog has also gone up nicely. Revenue increased by 14% over the third quarter of ’07 and the backlog went up by 36% over the third quarter of ’07 also.

We had some major new order bookings in this segment, the most significant being an order for $33 million from Chevron for the continuation of broadband services to their gas stations and convenience stores across the United States. The contract includes the provision of satellite capacity and field maintenance and the operations of the private telecommunications infrastructure.

We also received significant orders from Conoco Phillips, YUM Brands, NuStar, PetroSun, True Blue, the Social Security Administration, and for the U.S. government’s training network called GETN. Our Hellus subsidiary also received a major order from York Telecom.

Our international enterprise group continued its strong growth story in the third quarter, with revenue growth of 22% and operating income growth of 58% over the third quarter of ’07. As in Q2, our European service facility contributed a significant part of this quarter’s growth primarily to a successful rollout of the Camelot lottery project in the UK with approximately 21,000 terminals installed. This quarter, the revenues of Hughes Europe were up by 68%, the India subsidiaries were up by 25% and Hughes Brazil was up by 26% over the third quarter of ’07 - an all-around success story in all of our international services businesses. We also continued with strong new order performance with major orders from Camelot, Copel, Altegrosky, the Oman Ministry of Foreign Affairs, Copel, Telemar in Brazil and Canara Bank in India. The telephone system segment also had a good quarter with major new orders from Sat2k, Glocom, Thuraya, and Hughes Telematics.

In summary, we are very pleased with our strong performance in the third quarter of ’08 despite the adverse economic conditions that are prevailing globally. It is especially gratifying to note that we saw double-digit revenue growth across all of our various domestic and international businesses.

I would like to now turn it over to Grant for his presentation after which I will come back with some closing comments.

Grant A. Barber

Thank you, Pradman and good morning.

As Pradman mentioned in his comments, we’re pleased to have completed another excellent quarter and end Q3 in strong financial shape. The financial performance of our third quarter of 2008 showed strong revenue and profitability growth in all operating segments over the same period in 2007.

At Hughes, revenues for the third quarter of 2008 were $271.8 million, an increase of $38.1 million or 16% over the third quarter of 2007. We experienced year-on-year growth in all of our major reporting segments. The North American VSAT segment’s revenue of $169.4 million in the third quarter of 2008 showed an increase of $21.2 million or 14% above the third quarter of 2007. This increase was once again driven by strong performance in our consumer business which grew by 16% to $95.8 million.

Our North American Network and Equipment Services business was $73.6 million, an increase of $7.9 million or 12% above the third quarter of 2007. This primarily reflected growth in sales to our government customers.

The International VSAT segment revenue of $60.1 million increased $11 million or 22% above the third quarter of 2007. The telecom system segment delivered revenue of $42.3 million, an increase of $5.9 million or 16% above the third quarter of 2007. This increase was driven by both the terrestrial microwave and our mobile satellite systems businesses.

From a services/hardware mix perspective, our third quarter growth was driven by increases in both components. Our services component was up $19.5 million or 14% above the third quarter of 2007 to $156.9 million. Hardware revenues in the quarter were $114.9 million, an increase of $18.6 million or 19% above the third quarter of 2007. The services component, continuing the trend we discussed on previous calls, was 58% of our overall revenue in the third quarter of 2008.

Gross margins for the third quarter of 2008 were 25.4% of revenue, a decrease of 7/10ths of a percentage point from the third quarter of last year. This overall decline was entirely attributed to the depreciation charges of $6.4 million related to SPACEWAY 3. As you will recall from last quarter’s call, we started commercial service on SPACEWAY 3 in April 2008 and as a result, we began depreciating the satellite and related items.

Operating expenses for the quarter which includes SG&A, R&D, and amortization of our intangibles were $50.5 million or 18.6% of revenue compared to $40.2 million or 17.2% of revenue in the third quarter of 2007. Operating income for Hughes was $18.4 million for the third quarter of 2008 or 6.8% of revenue.

Net income for the third quarter of 2008 was $3.2 million or $0.15 a share on a fully diluted basis and this compares with net income of $11 million or $0.57 a share in the third quarter of 2007. This decline of $7.9 million or $0.42 a share is more than made up by the depreciation and interest charges starting in April 2008 with the launch in service of SPACEWAY 3. These two items make up $10.7 million of cost.

A table of reconciliation in both adjusted net income and adjusted EBITDA are attached to the press release. We believe that these non-GAAP measures provide useful information by excluding specific items that are not indicative of our core operating results. Adjusted net income has been adjusted for the long-term cash incentive retention program in 2008 and the equity incentive plan compensation charges in both 2008 and 2007.

Non-GAAP adjusted net income for the third quarter was $5.4 million as compared to $12.1 million in the third quarter of 2007. Again, this decline reflects the improved volume in the gross margin offset by increased depreciation, operating expenses and the interest expense as previously discussed.

Adjusted EBITDA was $39.3 million or 14% of revenue for the third quarter of 2008, an increase of 15% or $5.2 million over the third quarter of 2007. Again, this increase was primarily due to increased margins and prudent control of operating costs.

Turning to the year-to-date performance, we are pleased to report that revenues for the first three quarters of 2008 were $774.6 million, an increase of $83.6 million or 12% above the first three quarters of 2007. This increase was driven by both the higher services revenue that increased $68.5 million or 18% above the same period of 2007 and the hardware sales which increased $15.2 million or 5% above the same period of 2007.

From a business perspective, our North American VSAT segment grew 8% driven by growth in our consumer business which was $37.2 million or 15% above the first three quarters of 2007. Our North American Network Equipment and Services business was essentially flat at $207 million. Our International VSAT business grew $31.6 million or 23% above the first three quarters of 2007 and our telecom systems segment increased $15.3 million or 15% above the same periods of 2007.

Gross margins increased $23 million to 26% of revenue reflecting the volume increase and improved margins of 2/10ths of a percentage point above the first three quarters of 2007. Operating expenses increased to 20% of revenue versus 18% in the first three quarters of 2007. As we commented on the last quarter’s call, the main components of this increase were a $9.9 million charge related to a one-time retention program in connection with the April 22, 2005 transaction between DirectTV and Skyterra, increased selling, advertising and customer service costs of approximately $7.9 million to support our growth and approximately $5.1 million of operating expenses at our new Hellus subsidiary acquired earlier this year.

Net income for the first three quarters of this year was $5.7 million, which is $17.9 million below the same period of last year, reflecting primarily the improved operating performance offset by the $9.9 million long-term retention program and $21.8 million in depreciation in interest and margins as I discussed earlier. Adjusted EBITDA for the first three quarters of 2008 was $106.3 million, an increase of $15.9 million or 18% above the same period last year.

Moving to Hughes Communications’ cash and balance sheet, we generated net cash from operations of $39.9 million for the nine months ended September 30, 2008. Capital expenditures for the third quarter were $12.6 million, well below the quarterly average of $25.5 million in the first half of this year. We ended the third quarter of 2008 with a cash and marketable securities position of $208.1 million compared to $191 million at the end of the second quarter 2008. This increase reflects our continued focus on working capital management, prudent CapEx investments, and OpEx control.

In addition and in light of the deteriorating capital market conditions, we transferred most of our cash investments to safe U.S. Treasury and government agencies securities to focus on principal preservation rather than yield.

As we outlined in the headlines of the press release for the third quarter, we booked new orders of $272 million. Revenues increased 16% to a record $272 million and adjusted EBITDA increased 16% to $39.3 million. In summary, we continue to execute on our plan and deliver strong operating performance and capital management.

At this time, I would like to turn the call back to Pradman for further comments.

Pradman P. Kaul

Thank you, Grant.

You’ll recall that in the second quarter, we announced speed enhancements to the three existing consumer subscriber plans with no increase in price. We also announced three new elite plans with download speeds of up to 5 megabytes per second, an unprecedented speed in satellite communications. These new plans provide an unprecedented rate of speed that will cater to a complete range of consumer and small and medium business needs.

We’ve also announced an exciting new private networking solution for small and medium businesses with SPACEWAY. This quarter, we also announced a new rental offering that reduces the upfront start-up fees by 75% and makes our high-speed broadband offering even more affordable to our consumers.

We also announced new offerings that provide enterprise rates, security and performance and backup solutions to small and medium businesses. We expect that this complete suite of offerings would result in an expansion of our consumer and enterprise markets.

As we said previously, we continue to see SPACEWAY as the primary growth engine going forward for our North American businesses, both enterprise and consumer. In addition, the significantly lower cost of the space segment should have a major positive impact on our margins in the next few years.

From that perspective, 2008 is a transition year with the fixed costs of the satellite operations to be offset by the lower occurring space segment costs. Obviously, going forward in 2009 and beyond, we would start seeing the positive effects on our margins.

Before I close, let me take a moment to comment on what is clearly on everyone’s mind and that is the impact of the current economic environment on our business. As you’ve seen, our performance in the third quarter continued to show robust growth across all of our businesses led by our international enterprise service businesses and the domestic consumer business. Our domestic enterprise business has also had great success this quarter with some major new orders. Our order backlog which is an important leading indicator continues to show strength. The diversity of our business model is clearly having the expected benefits despite our adverse external conditions.

As Grant mentioned, we also have a very strong balance sheet and are well-positioned in terms of future funding. However, the economic picture continues to look uncertain so we will take prudent and necessary steps to control our operating expenses and capital expenses while continuing to invest where it is necessary to fuel the growth of our business.

Thank you and I will now turn it back to Deepak.

Deepak Dutt

Thank you, Pradman. We are now ready to start the Q&A portion of the call. If there are any follow-up questions after the Q&A session, please direct them either to me through our Investor Relations line or members of the media can contact Judy Blake. The contact information for both is available on our website, Hughes.com. We will take a few moments to get the Q&A process started after which the operator will take over and coordinate the session. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of James Ratcliffe from Barclays Capital. You may proceed.

James Ratcliffe - Barclays Capital

A couple questions. First off, if we can talk about international being a major growth engine for you guys, how does the recent strengthening of the U.S. dollar affect that business in terms of the way in which the contracts are executed, currencies and costs during the particular transponder lease contracts? Do those match to the currency of the contract, are they local currency? Can you give us a read on that?

Pradman P. Kaul

Most of our costs of our international subsidiaries are in the local currencies including transponder leasing costs. About the only major cost that is in dollars is typically the equipment they buy from us here in Germantown. In some cases, we are protected that way with forward contracts. We’ve not really had a cost problem with the strengthening of the dollar. The impact that you do see is when you convert the revenues and profits into dollars for our reporting purposes. There is obviously an impact on that because of the depreciation of the Euro over pound or Brazilian real over rupees, it reflects on our lower revenue and profit.

James Ratcliffe - Barclays Capital

Do you have any read how much of that 20% increase in international revenue in 3Q was currency-driven versus organic?

Grant A. Barber

In the year-over-year basis, James, the currency for Q3 for the entities that we operate on, primarily British pounds and the rupees, we’re actually down on a year-over-year basis. Most of the movement in the U.S. dollar was to the currencies that happened since September. So we had a slight tickup in Q1 and Q2 in revenue, we actually had a drop in Q3 on currency, modest in total.

James Ratcliffe - Barclays Capital

But currency was a drag in 3Q for you?

Grant A. Barber

Yes, it was a drag in Q3.

James Ratcliffe - Barclays Capital

Secondly, given the climate that we’re all aware of, how does that affect your thoughts for an incremental satellite? I know you have been talking about putting it up potentially this year, moving forward on one of those. How does it affect in terms of decision-making and potentially deployment and payment?

Pradman P. Kaul

Obviously, as we mentioned, we have the cash that we have on hand and the cash that we expect to generate from our businesses. We are very comfortable that we have the cash to invest for the next satellite. We are working hard on finalizing the arrangements and just because we are being prudent with dotting the “i”s and crossing the “t”s, I expect we will be making an investment on the new satellite somewhere by the end of the fourth quarter.

James Ratcliffe - Barclays Capital

Third, then, you were talking about the consumer SMB business. Since you started offering the lease plan, how much a driver of gross adds has that been and what share of the gross adds coming onboard and with plans that are available what have been lease versus buy?

Grant A. Barber

If you recall, we always had upfront plans that consumers paid approximately $300 up front for the equipment, and we had a plan earlier that enabled them to defer that upfront plan and pay that $300 over approximately 18 months. But we put it in place in the middle of September, so it had relatively minimal impact on the quarter. It enabled us to provide an offering to the consumers that were reticent to spending that upfront cash, hardware costs so that they could continue to lease the product from us similar to some of the satellite television TV companies as well.

We expect or think that in a few months, it will replace what we call our deferred plan upfront and potentially get around to 40% of our business that will be on that rental plan as opposed to the upfront buy.

Operator

Your next question comes from the line of Scott Malat from Goldman Sachs. You may proceed.

Scott Malat - Goldman Sachs

You noted in your release a reduction in the transponder capacity lease expense for the consumer group. I wasn’t aware that we were going to get the savings this early. I was wondering if you could help us to quantify the savings so far and where are we in how we’re trending compared to the original plans?

Pradman P. Kaul

I think we are consistent with our plans so far. I think we have reduced the number of transponders leased by three. Probably over the next few quarters, we will be continuing at that rate. As we see churn in the Ku reducing our requirements there and all new subs will be going on SPACEWAY.

Scott Malat - Goldman Sachs

So three a quarter is a good rate that we can think about?

Pradman P. Kaul

Yes, probably, for the next few quarters.

Scott Malat - Goldman Sachs

As I just look at the marketing spend which is up around 20% year-over-year in recent quarters, is there any way you think about your incremental marketing spend per gross addition or is there any target for this number, maybe just how you judge the effectiveness of your marketing spend?

Grant A. Barber

We have a combination as you know, Scott, of direct marketing plus what some of our channels do for us. We’re pretty fine-tuned at this point. We know exactly what the incremental mailings, or spot advertising or incentives do for us, for the channel. That is what we continue to adjust to acquire new subs.

Scott Malat - Goldman Sachs

But you have been doing in the neighborhood of $200-$300 of incremental marketing expense per incremental gross addition. Is that the right way to think of it?

Grant A. Barber

We specifically haven’t given the amount and I don’t think we’re going to change that model going forward on the channels that we had in the past. They have been effective, they have been working with us and we will continue at about the same level of spending in the channels.

Scott Malat - Goldman Sachs

Just the risk of stating the obvious, as we head into the holiday, I would expect to see a big pick-up in marketing as we have seen in other years.

Grant A. Barber

I don’t want to call it exactly what our plans are going forward but I think you’re going to see the same patterns that we have had on both our spending and sub counts as in the past.

Operator

Your next question comes from the line of Chris Quilty from Raymond James & Associates. You may proceed.

Chris Quilty - Raymond James & Associates

Surprising upside there on the North American Enterprise business. Can you tell us, one, was the Chevron contract, was that a new customer or just a upgrade of existing infrastructure, and two, is it fair to assume that we should see a moderation in the growth rate of that business on a go-forward basis?

Pradman P. Kaul

The Chevron contract, Chevron has been a customer since almost 1990, so they have been a customer for 18 years. This was a renewal of the existing contract with us for five more years. So it is wonderful to have. They have been a great customer. To get this kind of focused revenue for five more years is very positive for us.

As you know in the past, the enterprise business in North America has been relatively flat. As we have been working hard on creating some growth potential for that business and I think we are starting to see the results of that payoff. As you may recall, we’ve always said that once we get SPACEWAY going, we expect to see some growth in the small and medium business as well as medium enterprises. As we are beginning to see some interesting stuff there, we have increased our focus with government sectors. It is also beginning to pay off on the engine of growth in Q3. I think we expect the North American enterprise business to start growing again like it has in the third quarter.

Chris Quilty - Raymond James & Associates

Specific to the government business and the services for enterprise, have you announced any specific SPACEWAY-related services for the large enterprise category?

Pradman P. Kaul

Our focus primarily with SPACEWAY is for small and medium enterprises because the characteristics of SPACEWAY apply to that segment but we couldn’t serve very well with the Star Network capability that we had in the existing K-u satellite. That probably represents the biggest advantage that we can show a customer is in that segment. I think we are focusing primarily on that at this stage with SPACEWAY.

Chris Quilty - Raymond James & Associates

Shifting over to the consumer business, what have you seen in the first month of the quarter in terms of the churn rate or was there specific timing related to the financial crisis that may help you project out with the return to the more normalized 2.3% or whether we’re at a new static level we should expect for the next quarter or two?

Grant A. Barber

I think it’s early, Chris, to tell, but we have been watching as Pradman has said, it is common in a challenging environment on the consumer side. We had in the latter part of the quarter continue to see healthy and robust sign-ups up-front from the consumers. The churn has ticked up from the 2.3% we had been averaging to 2.6% so it’s something that we’re watching. To put in perspective, the extra 0.3% on 415,000 average subs for the quarter is about 1,200 subs a month. At $66 a sub and a 30% margin, it is about $25,000 a month. While it’s not significant on a month-by-month basis, this is a trend that we are watching and that is a big part of why our North American enterprise guys were ahead of the curve in announcing the rental plan for those people that needed another option if the financial situation impacted them personally. I think we are in the early stages of that but I think we will continue to watch it and adjust accordingly.

Chris Quilty - Raymond James & Associates

Have you picked up any sense of customer shift from WildBlue or pick-up based upon their capacity constraints?

Pradman P. Kaul

No, and that is something that we have real anecdotes on but it is not backed up with real data. Obviously, if there is a beam that they have shut down, it becomes a little easier in those areas. I don’t have any strong data to conclude definitively in the area.

Chris Quilty - Raymond James & Associates

Grant, on that past transfer of the cash into treasuries, when was that done and were you able to overweight any write-downs in the interim that you had?

Grant A. Barber

Yes, we had, and I think that’s something Deepak has been doing very well for us as the year went along, just monitor the risk association with the portfolio. We moved most of them the middle of the third quarter. So in the July and August time frame, we have never taken a write-off on our investment portfolio and we continue to watch it.

Chris Quilty - Raymond James & Associates

And mix of treasuries, what should we model in terms of interest income, for interest rate on the cash?

Grant A. Barber

I think if you assume the interest rates that we achieved in the third quarter, it is probably a good run-rate for the next couple of quarters at least.

Chris Quilty - Raymond James & Associates

I think you were about 3% though.

Grant A. Barber

That was earlier on in the year. We’re less than half that for the third quarter as the treasury rates have come back and we have moved more into treasuries.

Operator

We have no further questions in queue. I would now like to turn it over to Deepak Dutt for closing remarks.

Deepak Dutt

If there are no questions, I would just like to thank everyone for taking the time to listen to our call. I think there may have been some issues earlier in signing on under the number or whatever. My apologies if that’s the case. I am glad that everyone was able to get on. Thanks again and have a good day.

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