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The DIRECTV Group, Inc. (NASDAQ:DTV)

Q2 2009 Earnings Call

August 06, 2009 11:00 AM ET

Executives

Jon Rubin - Senior Vice President, Investor Relations and Financial Planning

Larry D. Hunter - Interim Chief Executive Officer

Patrick T. Doyle - Executive Vice President and Chief Financial Officer

Bruce B. Churchill - Executive Vice President and President, DIRECTV Latin America

Analysts

Jason Bazinet - CitiGroup Smith Barney

Richard Greenfield - Pali Capital

John Hodulik - UBS

Ingrid Chung - Goldman Sachs

Jessica Reif Cohen - Bank of America Merrill Lynch

Marci Ryvicker - Wachovia

Doug Mitchelson - Deutsche Bank

Bryan Kraft - Cross Research

Ben Swinburne - Morgan Stanley

Tom Eagan - Collins Stewart

Jeff Wlodarczak - Hudson Square Research

Matt Harrigan - Wunderlich Securities

Wang Spencer - Credit Suisse

Operator

Good day, ladies and gentlemen. My name Cindy and I will be your conference operator today. At this time, I would like to welcome everyone to The DIRECTV Group's Second Quarter 2009 Earnings Conference Call. All lines have been placed on mute, to prevent any background noise. After the speakers' remarks, there will be question-and-answer period.

It is now my pleasure to turn the call over to your host Jon Rubin, Senior Vice President of Investor Relations and Financial Planning. Sir, you may begin.

Jon Rubin

Thank you, operator, and thanks to everyone for joining us for our second quarter 2009 financial results and outlook conference call.

With me on the call today are Larry Hunter, our CEO; Pat Doyle, our CFO; and Bruce Churchill, President of DIRECTV Latin America.

In a moment, I'll hand the call over to Larry and Pat for some introductory remarks. But first, I'll read you the following. On this call, we make statements that may constitute forward-looking statements, within the meeting of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements involved known and unknown risks, uncertainties and other factors that could cause actual results to be materially different from those expressed or implied the relevant forward-looking statements. Factors that could cause actual results to differ materially are described in each of this DIRECTV Group and DIRECTV U.S.'s annual reports on Form 10-K, quarterly reports on Form 10-Q and our other filings with the SEC, which are available at www.sec.gov.

Additionally, in accordance with the 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 earnings release and are posted on our website at directv.com.

With that, pleased to introduce Larry.

Larry D. Hunter

Thanks Jon and thanks to everyone for joining us today. Since this is my first earnings call and many of you may not know much about me, so it'll be helpful to spend the couple of minutes confirming my priorities over the coming months.

First and foremost, we intend to continue operating DIRECTV much like you've seen over the past few years. In other words, you should expect us to continue focusing on creating long-term value by delivering the best television experience in America, prioritizing the acquisition of high-quality subscribers, continue to expand margins and of course, most importantly generating substantial cash flow.

Second, I'm supporting our Board in the research for a permanent successor to chase. Process there is proceeding as expected, but it will likely take a few months to complete, given the importance of the position.

So with that as an introduction, I would likely to briefly review our second quarter results, then turn the call over to Pat for a more detailed discussion of DIRECTV U.S. operations and outlook. After Pat, I'll ask Bruce Churchill to provide a summary of our results in Latin America. Then, I will conclude with a few operational priorities and a quick update on Liberty transactions.

All around, I thought DIRECTV U.S. had a very solid quarter in the second quarter, highlighted by strong subscriber growth and solid cost management, which drove substantial improvement in margins and cash flow growth, compared with the first quarter.

Looking first at subs, the momentum we have seen in recent quarters continued, as net adds increased 74% to 224,000, representing the best second quarter net add number in four years.

Really gratifying to see that we continue to be in market share, as consumers across the country continue to find value in DIRECTV's superior products and services. We also benefited from our first full quarter of marketing the AT&T/DIRECTV bundle, as well as continued strong performance from our direct sales channel.

In addition, we had a modest gain from a difficult transition process. However, this contribution was smaller than we saw in the first quarter. Perhaps some more important than the 17% increase in gross adds, was the credit quality and advanced product take rates of these new subs remained at high levels we've targeted in recent quarters.

Also pleased with our monthly churn rate of 1.51% in the quarter. Although that rate was slightly higher than last year, it was consistent with our internal target. We mentioned on last earnings call that we probably spent a bit more on retention marketing in the first quarter than we should have, and as a result our churn rate was somewhat lower than it should have been.

Second quarter results reflect a better balance between our churn rate and retention spending, and we believe these results are more representative of our expectations going forward.

Moving to the bottom-line, I thought we did a good job of managing the margins in the quarter, particularly considering the slower ARPU growth of 1.7%. Perhaps, this is best exemplified by our OIBDA margin of 27%, which increased about five points over the first quarter margin.

That improvement was mostly due to strong results in SAC, upgrade in retention marketing as well as G&A. Our cash SAC of $694 was the lowest level in six quarters, which is particularly impressive considering over 60% of new subs took HD or DVR boxes, up from mid 50% range a year ago and about a quarter of a new subs or twice the rate from year ago, activated with the more expensive HD-DVR combo receiver.

These favorable trends in SAC are primarily due to our continued efforts to rapidly bring down set-top box costs along with increasing benefits gained by utilizing refurbished boxes through our lease program.

Cash upgrade and retention marketing of $335 million was up modestly over last year, but down about 18% from the first quarter. That's consistent with our commitment to strike the right balance between churn and retention spending, small increase over last year's mostly due to more aggressive interest program, as well as more HD and DVR upgrades.

With these strong operating results and lower tax payments DIRECTV Group's free cash flow grew 47% to $550 million. I'd also like to point out, we achieved this growth despite spending an additional $90 million in acquisition costs to obtain 154,000 more gross ads than the prior year's quarter.

So with that, I'll turn it over to Pat and Bruce and then I'll come back finally more remarks.

Patrick T. Doyle

Thanks Larry. Overall, I believe we had a strong quarter and importantly, our results reflected our desired goal to balance top-line growth with cash flow growth.

As we discussed on our last call, the first quarter's results were a bit heavy in the areas of subscriber growth and spending, whereas in the second quarter I believe we struck a more appropriate balance between subscriber and margin growth.

Looking first at subscribers, the 74% increase in net additions to 224,000 subscribers was the best second quarter number in four years and was driven by a 17% increase in gross additions to 1.048 million.

On a day when Comcast announced a loss of over 200,000 subscribers in the quarter, it's nice to see that the strength of DIRECTV's brand, content and service continue to drive market share gains from cable.

The biggest contributor to the increase in gross adds was the Telco sales channel, mostly related to the first full quarter of marketing our bundle with AT&T. Although we do not disclose individual Telco company numbers, the entire channel contributed about 25% of our total gross adds, which is about twice the level of a year ago, when we lost the BellSouth distribution channel.

Looked at another way, the 25% is consistent with the Telco contribution in 2006 and 2007, when we marketed a bundle to the nine state BellSouth region, but not the remaining 13 states within the AT&T footprint.

The fact that we are still seeing the Telco channel contribute about the same percentage of gross adds, despite the bigger AT&T footprint, speak to the strength of our direct sales channel, which was also up on a year-over-year basis.

Other gains in the quarter, although more modest, came from the digital transition and DIRECTV MÁS, our Hispanic language service.

Churn in the quarter of 1.51% was up a couple of basis points over last year, but consistent with our expectations. Most of this increase was related to our goal of reducing upgrade and retention spending.

In the second quarter, we tightened up many of our offers to existing customers. As a result, fewer of our customers are receiving free upgrade and more of our customers are paying higher fees for equipment and rolls.

These new stricter policies will undoubtedly result in slightly higher churn but we believe to yield better financial returns. And we'd like to also point out that there is no magic formula for determining the precise level of retention spending. Since there is an often an element of subjectivity in fire customers and reps. That is they're having a constant challenge of balancing company profitability with the probability of a customer leaving.

Consequently, our policies may change on a monthly, if not weekly basis, depending on changes in the economic and competitive environment. I'd point this out only so you can appreciate the challenge we have in predicting with precision, our churn and retention spending.

Moving onto ARPU. Our growth of 1.7% in the quarter was higher than we had in Q1, but considerably lower than the 7% growth from a year-ago, as we continue to see the unfavorable impact from higher credits and lower premium channel take rates.

Relative to the first quarter, the higher ARPU growth was mostly related to timing of pay-per-view events and a smaller, unfavorable impact from credit, partially offset by continued weakness in premiums. I will have a bit more to say about ARPU growth when I update our outlook.

Turning now to the bottom-line, I thought we did an excellent job managing costs in the quarter, particularly in the areas of SAC, retention, upgrade and programming. Compared to Q1, OIBDA margin increased by 4.5 percentage points to 27.4%, which compares favorably to the roughly 3 percentage point increase from Q1 to Q2 last year.

This margin improvement is consistent with our goal to have more moderate subscriber growth, while showing greater discipline on the costs side to offset the impact from the slower ARPU growth.

Our cash SAC of $695 was the lowest level in six quarters, which is particularly impressive when considering that over 60% of new subs activated with HD and/or DVR services, and twice as many customers signed up for our combined HD DVR receiver than a year ago.

Looked at another way, we had almost 50% more advanced boxes leased to new customers compared to a year ago. Yet the total hardware component within SAC was at an all time low.

This favorable trend is due to the significant savings now being captured from refurbishing boxes, as well as continued cost reductions on new set-top boxes. We estimate that box savings in fact from our lease program were about $30 million in the quarter or three times the level of a year ago. The 18% decline from Q1 and cash upgrade in retention marketing to 335 million is consistent with my earlier remarks about tightening up our offers to existing customers.

Programming costs continued to increase at a slower than expected rate, due primarily to the lower sales of premium and pay-per-view events, as well as from benefits coming from favorable contract negotiations.

Subscriber service expenses on the other hand have hurt margins, as these costs continue to run a bit higher than the prior year and our targets. Higher costs are mostly related to an increase in customer service revs as we strive to achieve world-class service level.

As you know, this is one of our highest priorities and we're making steady progress. For example, in the first half of this year, we've seen material improvement in key call service metrics, including abandonment rates and average call handle times, leading to higher overall service levels.

Our focus now is to continue improving service but in a more efficient manner. With these strong results DIRECTV Group free cash flow grew 47% to $550 million. Also contributing to this growth was lower tax payment and a $60 million dividend from Sky Mexico.

The lower tax payments are mostly due to timing and lower EBT. We are however, expecting our full year cash tax rate to be equal to or lower than last year's rate. We're estimating the benefit from the 2009 economic stimulus plan at around a $180 million to $190 million this year.

However, that is partially offset by about a $50 million claw back from the 2008 package. In other words, the net benefit from the two stimulus packages is expected to be essentially flat at about a $130 million in both 2008 and 2009.

In terms of our stock repurchase program, we're continuing to buy back shares at a fairly aggressive rate. As of this week, we only have about $800 million remaining on our current authorization.

Now I'd like to spend a few minutes talking about our financial outlook. First, regarding the third quarter. We're expecting net adds to be similar to last year's third quarter. Although we're expecting higher gross adds in Q3, compared to the prior year, mainly due to the addition of the AT&T channel. We're anticipating much of this increase to be offset by a modestly higher churn rate than the prior year and tighter credit policy. Also, keep in mind that the second half net adds will not have the listing in the first half from the digital transition process.

In terms of our full year financial outlook, we do not have any major changes from our last earnings call, except for reducing our full year ARPU growth estimate by 1 percentage point to a new range of 1 to 2%.

The primary reason for the lower growth is that we're continuing to see more customers than expected, right size their bills, by purchasing less premium packages and pay-per-view titles, particularly in the area of adult and event.

Through the first half of the our premium package penetration rate was in the low to mid 90% range, representing about a 10 point decline from the same period last year. This rate of decline is much deeper than we've seen in recent years, primarily due to the combination of a weaker economy, plus less compelling premium content.

In other words, more customers are finding less value in premium channels, particularly because of the tough economic environment.

To a smaller degree, we have not executed as well as we should have and we have strategies in place to improve performance in the back half of the year.

Despite the slower ARPU growth, we're still targeting a year-over-year increase in our 2009 pre-tax margin, due to the many favorable cost trends as I touched on earlier.

We're expecting cash SAC to stay in the $700 range, and we are targeting our cash upgrade and retention costs to be at or below last year's levels in the second half. We're also anticipating continued strength in managing our programming costs, as we are now estimating cost growth per subscriber of roughly 2% for the year, compared to last quarter's estimate of under 5%.

By achieving these cost targets and excluding the impact from the greater than expected subscriber growth, we remain on track to reach our full year cash before interest in tax targets of around 3 billion for DIRECTV U.S.

Regarding subscriber growth, we're currently on a page to obtain 400 to 500,000 more gross adds in 2009, compared to 2008. As a result, cash flow this year will be negatively impacted by some $150 million to $200 million, versus our original expectations when considering the impact from both the higher acquisition cost and incremental margin attained from these additional subscribers.

Over the long-term however, these new subscribers are expected to greatly increase DIRECTV cash flows, while adding tremendous value to our enterprise. In addition, our Board yesterday approved a new leverage target of 2.5 times for our total debt-to-EBITDA ratio.

We believe a ratio of 2.5 times provides us with sufficient flexibility for raising capital, particularly considering the significant cash flow growth projected over the coming years. Based on our discussions with the rating agencies, we believe this target is consistent with an upgrade to our current rating, which will provide us with access to bigger credit markets and more attractive rates.

So, in summary, I thought we had another solid quarter, further demonstrating the strength of DIRECTV's brand and competitive advantages. Obviously, we're disappointed with our ARPU growth. However, we feel we've taken the appropriate actions to deliver the margin improvement and cash flow targets that we committed to at the beginning of the year.

So with that, I will turn it over to Bruce.

Bruce B. Churchill

Thanks Pat. I am very happy to have the chance here and appreciate the opportunity to speak a little bit about Latin America today. Just a reminder to everybody, although the figures I am about to discuss exclude results for Sky Mexico, which we account for on an equity basis.

Overall, I think DIRECTV Latin America, which I'll refer to as DTVLA, had a good, probably not great, but good quarter. Gross additions of 362,000 were down about 4%, as continued growth PanAmericana was offset by about a 14% decline in gross additions in Sky Brazil.

This reduction however is not all bad news, since it is the result of stricter credit policies that we implemented in Brazil in the second half of last year. In terms of churn, our monthly rate in the quarter of 1.91% was higher than last year, almost entirely due to the rapid growth of our prepaid offers in Brazil.

Excluding churn related to prepaid subscribers, postpaid churn was 1.59% in the quarter, which is roughly inline with the normalized churn rate of 1.52% that we experienced in the second quarter of last year. You may recall that we took a 21,000 subscriber adjustment in that period last year, which brought our reported churn up to 1.73%.

Overall, the DTVLA subscriber base increased 14% over last year to 4.2 million subscribers. In the quarter, net additions were 128,000 and were below the level of a year-ago, due to the gross add and churn results, I discussed previously.

In terms of advanced products, we've experienced a rapid increase in sales and upgrades in both our DVR and HD services throughout the region. About 10% of our subscribers have advanced products up from 3% last year. And about 15% of total gross adds now take advanced products, as compared to only about 2% a year ago. And we expect that number to reach about 20% for the balance of the year.

Our recent launch of HD in Brazil, or with our recent launch of HD in Brazil, we now offer HD in all of Latin America, except Mexico, which is slated for early 2010, and plenty of time before the World Cup.

While our HD offer in Latin America is no where near as robust as it is in United States, in general, we offer more channels than our competitors, and we have the capacity and plans to add more in the months ahead.

Furthermore, we believe that most of our cable competitors face serious challenges in trying to match our offerings given their existing network build out. We also see a continued interest in our standard definition DVR, which we still believe is far superior to anything else offered in the region.

Regarding prepaid, our prepaid gross adds were up about 50% over last year and comprise roughly 20% of total DTVLA gross adds in the second quarter, up from 13% in the prior year. As many of you have heard me say before, we accept higher churn for prepaid subscribers, because our costs are significantly lower than for postpaid subscribers. Our net SAC for a prepaid subscriber is generally less than a $100, and we had no bad debt, and our customer service and building costs are significantly lower.

So all-in-all, I'm pleased with our subscriber growth, and in particular, pleased with the mix of advanced products in prepaid services, which I think demonstrates the appeal of our products across a broad range of household income levels in the region. We remain comfortably on track to achieve the 600,000 plus net add target that I have discussed previously.

Turning to the financials, DTVLA's revenue, earnings and cash flow were all quite strong in the quarter, particularly considering some of the weakened currencies in the region and cash repatriation issues in Venezuela.

Revenues of 680 million were up 11% as our strong subscriber growth, more than offset a 3% net ARPU decline. Excluding the unfavorable impact from foreign exchange, revenues would have increased by about 26%, reflecting price increases and increased penetration of advanced products.

ARPU was negatively affected by somewhere between $7 and $8 in the quarter, due to unfavorable exchange rates, mostly in Brazil. Or looked at another way, to exclude the impact of FX DTVLA's ARPU would have increased about 10% in the quarter.

Operating profit, before depreciation and amortization, was roughly flat at a $160 million in the quarter. But that figure includes a $48 million charge related to the exchange of Venezuelan bolivars into U.S. dollars, as we continue to repatriate cash from Venezuela. Excluding these charges, the OIBDA margin would have been around 30% in the quarter, which reflects the underlying strength of our business.

Year-to-date, we've incurred 120 million in charges from repatriating Venezuelan cash and we're estimating the full year charge will now be around 200 million. Previously, we had indicated the figure might be a 150 million. I might also add that even with these charges in Venezuela, we remain on track to retain our full year OIBDA target of 650 million.

Cash flow before interest in taxes grew 18% in the quarter to a 140 million, due to the strong operational performance and a $61 million dividend from Sky Mexico. All-in-all I'm satisfied with the results of the first half and we're quite bullish about our prospects for an even better second half.

But finally, before I hand the call back to Jon, I would like to note that if you include Sky Mexico, in the month of July we passed 6 million subscriber mark, which puts us well within the ranks of the top five largest ATV platforms in the world outside the United States.

With that, I will turn the call -- actually, turning it back to Larry.

Larry D. Hunter

Thanks Bruce. I'd like to wrap up with a summary of our near term priorities. As we look to the second half of the year, primary operational priorities will be to continue introducing new products and services, and we'll expand our video leadership position. We'll also be looking to continue improving our customer service levels, with a more efficient manner. Also high in our priority list will be the complete the Liberty transactions.

Looking first at further differentiating DIRECTV, some of our more exciting near-term initiatives include, offering NFL games on cell phones and launching the trial using our new broadband rights to deliver NFL games to non-DIRECTV subscribers in Manhattan.

Later this month, we'll launch a new service called TV Apps., which is analogous to Yahoo! Widgets or Google Gadgets.

Like the iPhone, we'll have an App Store where customers can download pre-selected apps or even create their own apps for the big screen. Not only will this new service provide DIRECTV customers with a wealth of information, it will, for the first time, create a real community among DIRECTV customers.

Other highlights later this year include the exclusive airing of our second season of Friday Night Lights and the launching of our satellite D12 which when operational in the first half of 2010, will increase our HD capacity by 50% to over 200 national channels.

On the customer service front, we've made real progress in the first half of the year, but improvements have cost us a bit more than we expected. Second half, we'll be looking to continue improving all aspects of the customer experience, with a greater focus on efficiencies and costs.

With regard to the Liberty transaction, I believe those transactions are proceeding well. We filed the documents required by the regulatory agencies, SEC, FCC and the IRS. We received initial set of comments from the SEC, we responded to those comments.

We believe, well, we continue to believe the SEC is treating this as a pro forma filing to expedite the approval process. We haven't yet received any formal response from the IRS. We hope to do so this month. And we remain very optimistic about getting favorable rulings.

So based on all these factors, we believe we're on track to complete the transactions within the next couple of months. We'll keep you updated as we complete more important events along the way.

Before turning the call back to Jon, I want to highlight a couple of other important milestones we recently achieved. Last month, we at DIRECTV celebrated our 15th anniversary of service. And earlier today, we announced DIRECTV is now the largest pay-TV company in the world, when you combine our U.S. and Latin America operations. That's quite an accomplishment, but I think all DIRECTV employees are, and should be, extremely proud of. Of course, our objective isn't to be the biggest, we have to be the best. And we're committed to continue improving operations, to stay ahead of the competition, while creating shareholder value.

So with that, back to Jon.

Jon Rubin

Thanks Larry. Before moving on to Q&A, 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 that they are not authorized to call at any participants on this call, either directly or in substance other than the representatives of the DIRECTV Group. In addition, we're webcasting this call live on the Internet and an archived copy will be kept on our website. Operator, we're ready for the first question.

Question-and-Answer Session

Operator

Thank you. Today's question-and-answer session will be conducted electronically. (Operator Instructions). We'll take our first question from Jason Bazinet at Citi.

Jason Bazinet - CitiGroup Smith Barney

Hey just had a question on the IRS ruling. Given that 8-K that came up that sort of pushed the deadline after that July 31. Is it fair to assume that you expect it to get a favorable IRS ruling already? And if you don't get favorable ruling, can just you help us think to what the potential scenarios are from there, even if it's a low profitability? Thanks.

Larry Hunter

Yeah originally we did expect that given that this was an amendment to an existing filing that the IRS would have ruled within roughly 10 weeks that we had. And it turned out that summer vacations got delayed, not summer vacations of DIRECTV or Liberty Media.

So we're... in terms of the assessment of the likely ruling, like I said we're still very optimistic. We'll get all the rulings that we requested and need as a condition of the transaction.

If we don't, there are a couple of options. One is that we can accept as a substitute a strong opinion of tax counsel. Obviously, we prefer the IRS to rule on the issues that are most important to us. But again, our Board could consider the alternative of the tax opinion. There's also some structural changes that we could make to depending on what the IRS feedback is, that would resolve the issue. So again, we're very bullish that this transaction gets done.

Jason Bazinet - CitiGroup Smith Barney

Okay, thank you.

Operator

And we'll take our next question today from Rich Greenfield at Pali Capital.

Richard Greenfield - Pali Capital

Hi. You talked about leverage moving up from up to 2.5 times target. Could you give us a sense of in your mind, what's the timeframe for getting to that target and what types of methods are you looking at. Is it just increasing the rate of share buyback on a weekly basis after you close the transaction? So I think you'll be out of the box for a number of weeks after your mail proxies, or is the tender offer kind of the chosen step. That's the first question.

Larry Hunter

I guess, I'd look at it in a different way which is, previously we had kind of talked about 3 to 3.5 target. And in fact, our Board said in the market environment we're in and given the all the considerations associated with our business, we think the 2.5 target is more realistic and better for the company overall.

So, we consider that to be a very supportive view from our Board on the appropriate level of leverage in the market conditions that we're in. In terms of timing of that, we don't have any current plans to go up to 2.5, particularly with the overhang of Liberty transaction we didn't expect to immediately go to that. As a part of Liberty transaction, as you know, we'll be taking on roughly 2 billion in debt that's currently at Liberty, which we take our leverage up to about 1.7.

Patrick Doyle

Yeah, on a gross basis up. Up to about 1.7.

Richard Greenfield - Pali Capital

And then, just a follow-up on, Comcast you made a comment earlier about the impact Comcast, or how you were doing relative to Comcast numbers this morning. Comcast in their conference call actually said that the impact from your box is far more impactful over the past quarter than satellite.

Now I was just wondering, whether when you look at your gross adds which are continuing to outperform expectations, whether you're getting, you sense you're getting more of that from the cable industry broadly or from your competitor in the satellite space et cetera? Thanks.

Larry Hunter

The majority of our new gross adds continue to come from cable. Its coming much more from digital cable than historically, because as they reduce the number of analog subscribers. It's going up. So, we continue to compete very affectively with them. And I think the number speak for themselves in terms of where we are getting our subs from.

Patrick Doyle

Yeah. I think that from our satellite competitor, the numbers remain fairly constant. And now on the other side we actually are -- the percentage that we're starting to get from Telco is actually starting to be measurable, which when they first got started they were all under contract, and now we're starting to see some migration from Telco TV over into our platform.

Richard Greenfield - Pali Capital

Thanks a lot.

Operator

And we'll take our next question from John Hodulik at UBS.

John Hodulik - UBS

Thanks. If you could just talk a little bit about your Telco relationships. It sounds like the AT&T distribution agreement is continuing to ramp. There has been some new promotions through Verizon. Do you expect that the percentage of subs you're getting from these channels to continue to increase as we move throughout the year? And yes, then I'll take it from there.

Larry Hunter

I think, we don't see the percentage increasing, right Pat?

Patrick Doyle

Yeah. No, I mean, I think it's were up to about 25% of our gross adds is Telco. And that could move up or down a little bit on a percentage basis. But again, we're continuing to see also some strong strength in our direct sales channel, which is doing very well.

John Hodulik - UBS

Do you think the new Verizon promotion is going to help within the channel, maybe not the percentage, but to move to overall number of gross adds up from that channel on a sequential basis into the third quarter? And then, can you talk a little bit about the economics of that. Is that a promotion where Verizon is really supporting that from a economic standpoint, or is this something that DIRECTV shares in the cost?

Patrick Doyle

Well, that one, I mean, I do think that we'll probably see some improvement in Verizon alone moving from second to the third quarter, the materiality we'll see.

Their offer is that it's a little bit of kind of just reverse of what we do, where we give five months of premium for free for signing up for NFL Sunday ticket. Verizon, the economics are actually very similar, they just kind of reverse it a little bit and sign up for the package, and then you get NFL for free. So economically, they are not that different.

John Hodulik - UBS

Okay. Thanks.

Operator

And we'll take our next question from Ingrid Chung at Goldman Sachs.

Ingrid Chung - Goldman Sachs

Good morning to you guys. Thanks for taking the question. So you just mentioned the Telcos are taking about or accounting for 25% of your gross adds and direct sales continue to be pretty strong. Are your direct sales still above 50% of your gross adds? And if so, has the share shifted away from your other distribution channels towards Telco?

Larry Hunter

The direct sales continues to run just about to spot on 50% and the main reduction year-on-year is from like NST, the national. And that's a conscious decision. As our direct sales increase those third parties, which are fairly expensive and have higher churn rates, we want to move away from them, unless these continue to perform strong local service local sales.

Ingrid Chung - Goldman Sachs

Okay, great. And just a follow-up on Dish, and any sort of impact. It sounded like you're not getting any additional gross adds from Dish. But I was wondering if they wind their entire piracy efforts down? I guess, they did that in the last quarter. Have you seen a change in terms of the competitive environment versus Dish?

Larry Hunter

Well, we haven't Puerto Rico right now. Piracy was rampant there and we had nice growth in Rico this year. The otherwise, no, we really haven't seen a major change. Again, we're happy, rampant eliminate piracy, it's not good for anybody.

Ingrid Chung - Goldman Sachs

Okay, great. Thank you.

Operator

And we'll take our next question from Jessica Reif Cohen at Bank of America Securities.

Jessica Reif Cohen - Bank of America Merrill Lynch

Thank you. I just wanted to go, two questions on two topics. One is on the balance sheet. Even if the 2.5 leverage target is the reduction from your previous target, you still have massive capacity.

So I was just wondering if you could just be a little bit more clear, if you would, what you would do with the capacity, in what timeframe? Would you consider a dividend in the Liberty's commentary in the past seems to be much more in favor of buybacks. And on Liberty, what happens with the $1.9 billion loan, will you refinance that, or will you take it on the balance sheet and pay the debt balance from cash flow?

Larry Hunter

I'll take the first question and Pat will take the second.

Jessica Reif Cohen - Bank of America Merrill Lynch

Well, that is the first question.

Larry Hunter

I thought they were two there.

Jessica Reif Cohen - Bank of America Merrill Lynch

I, model the park (ph).

Larry Hunter

Okay. The Board -- we don't have any specific plans right now than like I said to move up to 2.5 times. We don't have any specific intention to, at an appropriate time in the future will consider different alternatives for the additional cash, assuming we get up to that level.

Up to this point, we considered stock buybacks to be the best use of our cash, because we consider our stock price to be still undervalued or slightly below where it should be. And so we consider that a good use of cash. As to what we'll do with the additional cash in the future that will be considered at that time, and our Board hasn't made that determination.

Patrick Doyle

Yeah. No, I think that's right. I think we're or our preference is definitely right now to lean towards share repurchases. We do have regular discussions with our Board about our outlook and cash flow and leverage capacity, and talk about things like one-time dividends and regular dividends. But right we don't have any anticipation of paying any dividends in the near future. So we are right now clearly focused on share repurchases.

On the debt that we would assume from Liberty, I think the fact of the matter is the kind of way we look at it, because of the color it's just almost a convertible debt. The rate on the debt is actually very low. But there is kind of the overhang on if the stock, if our stock runs up, that it creates a liability that offsets the benefit you get from the lower rate.

So I think as we get closer, the closing will certainly evaluate that situation. I think the good news is that particularly with our new guidance and our expectation that our ratings will improve is that -- I think we would have access to reasonably priced debt in the market, if we wanted to go out and refinance that debt.

Jessica Reif Cohen - Bank of America Merrill Lynch

Okay. And then just a second topic, maybe that's a better way to phrase it. On your programming costs, could you talk about what's happening in the renegotiations? How are you getting flat fees from certain content providers? I mean how do you get to 2% for sub increases, when everybody else is significantly higher?

Larry Hunter

It really is case by case. I mean, individual programming providers we get different deals done with. We are obviously coming to the end of contracts that we entered into at a time when we had less heft. And so we are able to use a size of our subscriber base more effectively.

And frankly people in our programming department and I think they are a bit more sophisticated about the way they approach these negotiations. And again -- but it is totally case by case. There are some particularly sports content where you see significant increase and re-trends negotiations also are difficult. But otherwise, just a matter of us growing our subscriber base, plus offering additional value, I think to the content providers that they see benefit from.

Patrick Doyle

Yeah I think the, quite clearly Jessica the bulk of the reduction is coming from the fact that the softness we're seeing in some of the revenue, some ads like the premiums and the pay-per-view events carry a fairly high cost of service. So that's helping us.

And then like Larry said, we've been in the first half of the year, we've had some good negotiations and a lot of times its not necessarily flat, but its either very modest increases from kind of what we've seen over the past few years. And I think obviously we'll continue to look at all of our programming contracts, as they come up for renewal and try to make sure in an environment here like we're seeing softness in premiums that we're going to be probably a much tougher in our look at programming contracts that come up.

Jessica Reif Cohen - Bank of America Merrill Lynch

Thank you.

Operator

And we'll take our next question from Marci Ryvicker at Wells Fargo Securities.

Marci Ryvicker - Wachovia

Are you not still taking the subs from Dish. It's just a clarification. And then secondly, when you think about ARPU growth longer term, I know you'd said 4% was maybe what you're aiming to return to. And I got the sense that that was a 2010 event. So are you still thinking about 4% ARPU growth, and is that now pushed out further, or should we see 4% growth in 2010, because its easier comps than 2009?

Larry Hunter

I apologize, I didn't here your first question.

Marci Ryvicker - Wachovia

Are you still taking subs from Dish?

Larry Hunter

Yeah, I mean, as we said, percentage wise we... that's been pretty steady over here, in terms of what subs we're getting from Dish, so that hasn't changed really.

Patrick Doyle

Yeah. And I think and the -- on the ARPU growth, I think as we look out at 2010, I think we clearly feel like our ARPU growth will be higher. And in 2010 and in 2009, I mean, there is just some kind core factors that we were driving our ARPU growth. In 2009 that either don't exist in 2010, or improve. I think it's probably little bit early to kind of tell exactly what that rate is. But clearly as we use do kind of high level looking at 2010, we see the ARPU growth growing from of a bit 2009 rate.

Marci Ryvicker - Wachovia

So you're backing off from that 4% that number or...

Patrick Doyle

I mean, I'm not. Yeah, I just think it's kind of too early. And I would certainly want to have the opportunity in the back half of '09 to kind of see what's going on with the premiums and the pay-per-view. I mean, as we said on in our remarks, we are seeing a kind of an acceleration of downward trend in premiums. And kind of word is that, is it slow or does it flatten? That would give a lot more confidence and what the outlook is for 2010 because it's been a major contributor to 2009.

But I've said, as we get into our later end of the year and get into our 2009 planning process, we have a much better outlook on 2010.

Marci Ryvicker - Wachovia

Thank you.

Operator

And we'll take our next question from Doug Mitchelson at Deutsche Bank.

Doug Mitchelson - Deutsche Bank

Thanks very much. So just sort of further details on the output programming costs. What percentage of revenue now comes from pay-per-view and premium at this point?

And when you gave the new guidance for 1 to 2% growth for full year ARPU, were you presuming that in the back half of the year you would have a similar experience of the first half, where you'd have further cancellations of premium and pay-per-view would come under pressure? Or did you assume that would start to ease? That's sort of the first.

And the second is, if you can give us programming cost growth ex the impact from premium and pay-per-view. That'd be helpful, just to sort of see what the core growth rate is. Thanks.

Patrick Doyle

Yeah. No, I think that from our standpoint, we our assuming in the second half of the year a continued, kind of an acceleration of the decline in premium take rates. I mean, we have put in some, as we mentioned, we've put in some processes and save schemes to try to mitigate the downgrading by customers of the premiums.

We're hoping that that certainly has affect on the trend line. But at this point of the year kind of pushing a rock up a hill a little bit. Now people are right sizing until we're torn a little bit. And this is a way that they can the product and stay on the platform of obviously that's our number one goal.

If they can't afford it, if there is way that we can provide them with offers that either keeps them in one or more premium channels then that's our goal. I think if you take out the premiums out of the ARPU calculation instead of kind of the 2% range, I think we're probably more like in the 4% range or active. And again that's what we've talked about before we have had some positives on rates and some negotiations and MFNs that have helped us get the trend line down a little bit on there.

Doug Mitchelson - Deutsche Bank

And I just want to make sure I understood the first part, are you saying that you're expecting the second half to be worse for the number of cancellations of premium, or I though you said acceleration.

Patrick Doyle

Yeah we do expect to -- I think we were taking about in the first half, we are in the low 90% of our base that takes premiums. We expect that 92% to continue the decline in the second half.

Doug Mitchelson - Deutsche Bank

At a pace of higher than the decline in the first half or similar?

Patrick Doyle

No, no. I mean, again, it's accelerated from what we've seen in the past, but not from the pace of second half.

Doug Mitchelson - Deutsche Bank

Got it, okay thank you.

Larry Hunter

Yeah, just to amplify on that, we have seen a reduction in premiums over the last several years. It's just this year it accelerated.

Doug Mitchelson - Deutsche Bank

Right, got it. Thanks.

Operator

And we'll take our next question from Bryan Kraft at Cross F.

Bryan Kraft - Cross Research

Hi, thank you. First question, maybe you're too early to tell this, because the season hasn't started yet. But are you seeing any customers cancel the NFL ticket package?

And then secondly, if you could just provide an operational update on progress towards the more considered in you, and when you expect that to start to have a meaningful impact in net adds? Is it still a 2010 type of add, or is it more 2011of add? Thank you.

Larry Hunter

NFL Sunday Tickets were off to a really good start. We haven't seen signs that people are giving that up. With regard to MDUs, we do consider that a growth opportunity. And even this year we're having, it's not having the meaningful effect yet. But got a group of people that are really focused on that. We've got the technology solution. We've got the favorable FCC rules, so that some of this exclusive contracts can be undone. And we really are focusing on that for 2010.

Bryan Kraft - Cross Research

When you look at the MDU market, obviously, you have some share in that segment, but fairly limited. How unpenetrated is the MDU market for DIRECTV or maybe put another way, can you tell us roughly what percentage of your subs are in MDUs currently?

Patrick Doyle

Yeah. If you look at the traditional MDU market obviously, we do end up with some customers that show up as residential, just because they can get a dish on a balcony or something. We don't recognize that as MDU.

But, I mean, I think that the opportunity is big. Obviously, we've got a kind of figure an economic model that allows us to go into and put the infrastructure in these apartments and get the right penetration rate. So where we are -- we're right in the middle of really kind of doing a test of some markets and some buildings to really see if we can get the right economic model that allows us to continue to expand more heavily into that area.

Bryan Kraft - Cross Research

Okay, great. Thank you.

Operator

And we'll take our next question from Balbit Drant.

Unidentified Analyst

Hi. Is the line open?

Larry Hunter

Yes. How is it?

Unidentified Analyst

Okay. A couple of questions. One just quick clarification. Is there any -- that you are saying output falling by 1 to 2%. I think you suggest that the growth is now going to be 1 to 2% is that correct?

Larry Hunter

Yes.

Unidentified Analyst

Okay. Most of my questions for Bruce. Just sort of looking at Venezuela, how much of the cash is resides in Venezuela? I mean, is this going to be an issue perpetually. Obviously, there is a whole variance between what the official rates for converting to dollars, and what the market rates are.

So, can you start to talk about how are you going to address that long-term, if that's going to be a problem? And continuing on the prepaid side, can you talk about just generally what the economics of prepaid are, what's the ARPU you're getting? Obviously, churn is much higher there? Just some of the details there. And how do you sort of see that growing as a mix of your business over the next few years? Thanks.

Bruce Churchill

Sure. On the Venezuela cash, I guess, it will continue to the issue as long as we are required to account for revenue and costs with the official rate. And in fact, you can only extricate cash at the legal parallel rate.

Obviously, if the accounting rules were to change and we could report everything at the let's say, legal parallel rate, then revenues and costs would be in those rates, and you wouldn't have this anomaly in that the G&A line, if you will, of extricating cash.

I guess the good news is, the reason we keep generating more cash is because the business continues to do well. So as long as that continues and as I say, as long as we continue to -- we do the accounting at the official rate, then you're going to see this line and this expense continuing down at the G&A line.

With respect to prepaid, I think I've discussed it from conversations in the past. And I said today, our net SAC tends to be less than $100. The programming packages actually are not hugely below our regular ARPUs.

For example in Venezuela, when we introduced the product, we had a, sort of, I think we called them Bronze and Silver, and one was sort of a basic and one was extended basic. And most of the people actually went to the extended basic product.

So, ARPUs and margins, while they may... certainly, on the margins on a percent basis are no different, there may be mildly lower, a touch lower in terms of absolute dollars. But not meaningfully.

I guess, and how do you think about that in terms of the churn. The debate we have had here a lot. And to be honest with you, I think the more relevant metric is sort of the reconnect rate. And where we have found and where the economics were thrust is that we can keep to reconnect rate at about 70%, or that in other words if you retake a cohort, there sell the product.

If on average 70% of them are live or active at a moment in overtime, then the returns are inline with the returns that we get in postpaid business. In Venezuela, where our prepaid business has been in existence for the longest. Our active rate is actually more like 80%.

To be honest, when we launched, we tend to finance reconnect rates were a little lower, which is what we've experienced in Brazil. But they've been below sort of more in the, below 70s in the 60%s percent range.

But we're focusing on that. And in fact, because of that we've had some tremendous improvement in the last month of selling. And I actually, expect to have ironically negative churn in Brazil in prepaid this month.

So it's really about how many people you keep reconnected that's important, as opposed to sort of the traditional churn metric.

Unidentified Analyst

Okay. Thank you.

Operator

And we'll take our next question from Benjamin Swinburne at Morgan Stanley.

Ben Swinburne - Morgan Stanley

Hey, good morning guys. Two questions. One for Larry. Could you just talk about how the Telco partners are viewing your products versus their own in their markets.

I don't think there is difference between AT&T and Verizon. They both seems very happy marketing DIRECTV. But how are they viewing that, where they have their own video services in place. Is that changing the dynamic a lot?

And then for Pat, my favorite topic, deprecation expense. If I can ask it again, your D&A first half for year, I think was up about 25% year-over-year. But if you look at your capital spending, particularly your set-top box spending per sub, that's been following kind of mid to high teens year-over-year for the last six quarters. So the math would tell you that depreciation since start to rollover and fall. I just wanted to check that with you, and see if you can give us any sort of sense of timing on that front? Thank you.

Larry Hunter

The Telco partnerships, I mean, they are very good partners. And they market us aggressively. And we see that relationship across the board as being positive. We're both about getting subs from cable. So as far as we are concerned, its working great.

Ben Swinburne - Morgan Stanley

Larry, are they selling DIRECTV where they have you versus buyers sold out?

Larry Hunter

AT&T is definitely selling where they had viewers, Verizon less so in buyers.

Ben Swinburne - Morgan Stanley

Thanks.

Patrick Doyle

Yeah Ben. And then, on your depreciation, yeah, you're right. I mean, we just -- the second quarter now is third full year where we've -- since we introduced the leased boxes. So, as we look out to the second half of just '09 instead of saying year-over-year increases, and depreciation we're actually seeing, depreciation will be flat, plus or minus in the second half of '09.

And then, I think as we've have talked about, before you get into 2010 and we're seeing D&A probably lower by 200 million to 300 million, because of the rollout of the boxes, some of the amortization on some of our acquisitions years ago. So, yeah, we've kind of now hit the inflection point, where we ought to see the depreciation to not reducing our bottom-line.

Ben Swinburne - Morgan Stanley

Thanks guys.

Operator

And we'll take our next question from Tom Eagan at Collins Stewart.

Tom Eagan - Collins Stewart

Great. Thank you very much. On the Liberty deal, you mentioned that should the FCC approve it on a pro forma basis, you could be up at a close in the couple of months. So does that mean that the gauging factor or the factor that's going to take the longest year is the FCC approval? And then, I have a follow-up thanks.

Larry Hunter

Well, it's really the stockholder approval with them, become getting items assuming the IRS rolling is obtained in the next month or so. So it's really completing the FCC review process, which we hope to complete this month. And then they will, the stockholders with them in the next couple of weeks. And so have the stockholders meeting probably October issue or early October.

Tom Eagan - Collins Stewart

Right. So it could close, excuse me, right after the shareholder meeting, if you already have the FCC approval?

Larry Hunter

Yes, that's correct.

Tom Eagan - Collins Stewart

Okay.

Larry Hunter

And then, again provided the IRS.

Tom Eagan - Collins Stewart

Right. And then secondly, on premium take up, you mention that you've seen a decline in the premium take rate. You mentioned adult, you mentioned the pay-per-view events. But what about the movies services like HBO, Starz and Cinemax. What have you seen in terms of the take rate of those services?

Larry Hunter

That's the premiums we're talking about HBO, Starz, Cinemax.

Patrick Doyle

Yeah, when we say premium, that's...

Tom Eagan - Collins Stewart

Oh, right. I figured. But you mentioned though, when you mentioned the adult and you mentioned, I wasn't sure if that was offered just yet, the other movie services as well.

Larry Hunter

Yeah, no, its really the premium, the Showtime HBO and Stars that were seeing, kind of an accelerating decline from the trend we've seen over the last years.

Tom Eagan - Collins Stewart

Alright. Okay, thank you.

Larry Hunter

This year it's accelerating.

Tom Eagan - Collins Stewart

Right.

Operator

And we will take our next question from Jeff Wlodarczak at Hudson Square Research.

Jeff Wlodarczak - Hudson Square Research

Hey guys that might be the worst translation of my name I’ve ever heard.

But I think it might have been better than Vijay's. Just two quick questions for Bruce on Latin America, I mean prepaid is obviously driving your churn higher. Can you give us an idea, you briefly touched on this, but can you give us more of an idea what a reasonable target level of churn is for Latin America?

And then the second question is, given the fact that SAC is starting to come in, is there any intent to start building HD capability into every box, so instead of rolling the truck when someone goes HD, they can just switch? Thanks.

Bruce Churchill

On the churn question. I guess, overtime frankly, you would expect the churn in prepaid to not be a lot different than the postpaid when you have a large enough base of subscribers.

I would say however, the caveat to that that we find there is a little more seasonality in prepaid than there is in postpaid, just because in that the class of household that has a prepaid product often times of cash constraint from around holiday season, kids are going back to school et cetera. So there's a little different there.

On the other hand, in the near term as we continue to grow it, it will probably have a negative impact on churn, because we do find that there is a... very tends to be high churn rate within the first month. When people buy the product, they get one month programming. And they tend not to reconnect this as until they get into the habit if you will down the road.

So I don't hesitate to give you any sort of forecast. But when I think prepaid churn is going to look a lot like postpaid churn. And your other question was really for the U.S.

Jeff Wlodarczak - Hudson Square Research

Oh yes. Thanks.

Larry Hunter

And with regard to just rolling HD boxes, that's something we look at steadily as we look at our subscriber base. And we haven't reached the conclusion that it's the right time to pull to trigger on that debt. But we're evaluating it. We'll look at it going forward.

Jeff Wlodarczak - Hudson Square Research

Thanks.

Operator

And we will take our next question from Matthew Harrigan with Wunderlich Securities.

Matt Harrigan - Wunderlich Securities

Good morning. First question is for Bruce. I always had a pretty soft consumer satellite launch down in Brazil. But I mean there is still monster longer term in terms of financial capacity. I think the demographic is somewhat different than yours.

But could you see Brazil evolving in a more terms of toxic competitive situation, you had five years ago? And then secondly, when you look at 4G, is there anything that you are doing on this Skunkworks basis, at least to integrate some of that into your own CPE prospectively, with some of your current Telco partners?

Bruce Churchill

Prospective in Brazil, I assume what you mean is by having multiple DTH platforms that we have invested situation, is that what you're getting at?

Matt Harrigan - Wunderlich Securities

Yeah. Do you think the market down there is getting much more competitive? I mean they just got the regulatory approval last year. And I think as of July, they haven't launched in a lot of markets. I know they haven't launched in Rio yet. Is that something that you think longer term is really going to be a significant competitive element, or do you think there is just so much room to roam there in terms of the incremental pay-TV upside that you're really not going to see it too much in your numbers?

Bruce Churchill

I don't think it will effect on our numbers. I don't mean to dismiss any competitor. But as you probably aware, that they've taken a turnkey service from Telefonica. I don't think that service is really competitive with ours. Our main competitor continues to be net service.

Matt Harrigan - Wunderlich Securities

Thank you.

Larry Hunter

Your other question I assume again is the U.S. first.

Matt Harrigan - Wunderlich Securities

Absolutely. That's a U.S. question. And it is really just kind of relating to, are you looking at it, and at least on a technical base, is to see how some things might work out in your longer term?

Larry Hunter

I guess, by definition if it was Skunkworks, we wouldn't want to talk about it. So, but, yes, we are working to see what's the... how we could best integrate with 4G, bundling that with satellite really does provide we think a robust opportunity for the future.

Matt Harrigan - Wunderlich Securities

And that would include incorporate some of it into your equipment?

Larry Hunter

That's one alternative, yeah.

Matt Harrigan - Wunderlich Securities

Great. Thank you.

Operator

And at this time, we time for one more question. That last question will from Spencer Wang at Credit Suisse.

Wang Spencer - Credit Suisse

Thanks for squeezing me in. So just going back to the pay-per-view question. Can you tell us what ARPU growth looked like maybe ex-pay-per-view on the year-over-year basis?

And then on the programming cost, do you guys have any major re-affiliations coming up over the next 12 months or so? And then just a last related question on this is, given your commentary about the declining value premium channels, can we interpret that I mean, it unlikely that you guys will carry the FX channel? Thank you.

Larry Hunter

I think without getting into too much detail on the ARPU, I mean, it's the I think the change in the premium, the lower premiums has affected us by at least a full point on our ARPU growth, so it's meaningful. And then your other question was

Bruce Churchill

Yeah, we have several, we have a few coming up this year before the end of the year NBC. That is normal course.

Larry Hunter

Yeah, I mean there is nothing really a concerning I think in those that are coming up.

Wang Spencer - Credit Suisse

Right. And then just on FX?

Larry Hunter

FX, I am not going to say, well, that's the another one, where we I don't think we see that that will be something we will be interested in.

Patrick Doyle

Yeah. I mean, I think we kind of feel like there is enough of out there. We certainly made a figure at our position now, and we just don't see the value of adding another movie channel.

Wang Spencer - Credit Suisse

Great. Thank you very much.

Operator

Thank you. This concludes today's DIRECTV Group's second quarter 2009 earnings conference call. You may now disconnect your line. And have a pleasant afternoon.

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