Applauding EchoStar's Execution

Key points from Kaufman Bros. analyst Todd Mitchell's recent note to clients (for a full-length version of this report, click here).EchoStar blew away expectations for 4Q06 sub growth. EchoStar reported 350,000 net adds in 4Q06, up 6% from 330,000 a year ago, and well ahead of our expectation of 285,000. Net adds were driven by a 5% increase in gross adds to 940,000 and a drop in churn to 1.5% from 1.6%. We believe it has a compelling offering and it is executing very well. There is just no other explanation, in our opinion. This is something that has been playing itself out all year. EchoStar added 1.065 million subs in 2006 for a 9% increase in total subs to 13.1 million.

• Sub growth was accompanied by strong revenue gains. A 9% increase in total subs was accompanied by an 11% increase in ARPU to $65.38 from $58.79 for an 18% increase in total revenue to $2.6 billion. ARPU gains in 4Q06 were from sell through of advanced services as EchoStar took minimal price increases. The 18% increase in 4Q06 revenue drove a 16% increase for 2006 to $9.8 billion. EchoStar reported a 26% increase in 4Q06 EBITDA to $608 million, in line with expectations, for an 18% increase for the full year to $2.3 billion.

• Revenue growth is being leveraged to impressive FCF growth. EchoStar saw FCF grow 185% in 2006 to $878 million from $309 million in 2006. Results in 4Q06 were emblematic of the rest of the year. Pre-SAC margins were 39.9%, slightly better than 40.7% a year ago, but SAC per gross add fell 3%, which with an 18% increase in revenues more than offset a 5% increase in gross adds for a drop in total SAC as a percentage of revenues to 26% from 30.5% a year ago. For the year SAC as a percentage of revenues fell to 25% from 28.5% in 2005.

• EchoStar took significant market share from DirecTV in 2006. Net adds of 350,000 for the quarter were also well ahead of DirecTV's 275,000, something that has also been happening all year. EchoStar added 1.065 million subs in 2006, versus DirecTV's 820,000. Moreover, gains on DirecTV were not merely a function of less churn off a lower base. EchoStar saw a 4% increase in gross adds, while DirecTV saw an 8% decline. As a result, Echostar's share of total DBS gross adds was 48% in 2006, up from 44% in 2005.

• EchoStar is, and has always been, a very well run company. EchoStar operates with the highest premarketing cash flow margin in the business, yet it still fields a very compelling consumer offering at all stratum of the market, and executes well in the delivery of these services. We think it has a better CPE set-up than DirecTV, and in many cases, a more elegant installation solution. EchoStar has also been able to maintain a very effective footprint of independent distributors in markets where it has no strong competitor.

• EchoStar's relationship with AT&T is a valuation enhancer. EchoStar is AT&T's bundling partner. DirecTV has a relationship with BellSouth, which remains intact in those markets. We think that AT&T's U-Verse DSL-based IPTV offering will not succeed, and that it will need a hybrid DBS/IPTV offering such as Homezone. Homezone is slowly gaining traction and EchoStar is working on a MPEG-4 version for HDTV. However, DirecTV could also develop the same service for AT&T, so either company could be an acquisition target of AT&T.

• We reiterate our HOLD rating and $44 price target on DISH. We like to recommend stocks based on fundamentals, and DISH is making a real case for an upgrade given the company's stellar fundamentals in 2006. However, the shares have been run up on merger speculation and look fully valued so we are maintaining our neutral stance. We value DISH at $44 per share based on a DCF analysis that employs a terminal multiple of 15.5x 2010E FCF and a discount rate of 10.5% for an EV of just over $20.5 billion, or $1,700 per sub.