Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

The DIRECTV Group, Inc. (NASDAQ:DTV)

Q3 2007 Earnings Call

November 7, 2007 2:00 pm ET

Executives

Jonathan Rubin - Investor Relations

Chase Carey – President, CEO

Patrick Doyle – CFO

Bruce Churchill - President of DIRECTV Latin America

Mike Palkovic – VP, Service

Analysts

Analyst for Jeff Wlodarczak - Wachovia Securities

Anthony Noto - Goldman Sachs

Doug Mitchelson - Deutsche Bank

James Radcliffe - Lehman Brothers

Craig Moffat - Sanford Bernstein

Benjamin Swinburne - Morgan Stanley

Jason Bazinet - Citi

Tom Eagan - Oppenheimer

April Horace - Janco Partners

Kit Spring - Stifel

Operator

At this time I would like to welcome everyone to The DIRECTV Group’s third quarter 2007 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Jonathan Rubin, Vice-President of Investor Relations. Sir, you may begin your conference.

Jonathan Rubin

Thank you, operator, and thank you everyone for joining us for our third quarter 2007 financial results and outlook conference call. With me today on the call are Chase Carey, our President and CEO; Pat Doyle, CFO; Bruce Churchill, President of DIRECTV Latin America; and we also have Mike Palkovic on the call.

In a moment I’ll hand the call over to Chase and Pat for some introductory remarks, but first I’m obligated to read to you the following:

On this call we make statements that may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve known and unknown risks, uncertainties, and other factors that could cause actual results to be materially different from those expressed or implied by the relevant forward-looking statements.

Factors that could cause actual results to differ materially are described in each of the DIRECTV Group’s and DIRECTV US’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, and in accordance with SEC Regulation G which 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 available and attached to our earnings release which is posted on our website at DIRECTV.com.

With that I’m pleased to introduce Chase.

Chase Carey

Thanks, John and good day, everybody. The third quarter was really a good one for DIRECTV and we delivered strong results really across the majority of our key metric s. Clearly one of the Q3 highlights was the strong growth in net subscribers additions. While the numbers were good, the real story was the high quality of those subscribers. Just to try to give you a sense of that quality through a couple of insights:

Over half of our new subscribers in Q3 took our HD and DVR product versus about 25% to 30% a year ago.

We had the highest percentage of our customers with annual income over $75,000 which is one of our key quality measures in a number of years, and it was well above national average.

One of the really important factors in our success and targeting the right customers has become our increasingly strong direct sales channel which generated almost 45% of our new customers in Q3, and this channel has really become an increasingly effective tool for both targeting customers and targeting the right customer asks taking advantage of market opportunities.

One of the most encouraging metrics for us in Q3 was churn and certainly we have expressed our frustration with churn in prior quarters, and while it is still not where it should be, the third quarter was one where we made real progress in terms of getting on top of churn with almost a 0.2% reduction in the monthly churn rate.

Clearly the quality of the subscribers we brought in, the demand for advanced products were key factors in this progress on churn and other recent initiatives including social security numbers and credit card measures also began to pay dividends.

ARPU was another really strong metric for us Q3. ARPU was bolstered a bit by timing benefits driven by Sunday Ticket, we had an extra game in September, but even if you take that benefit out, our ARPU was up about 7% year on year. This result is all the more impressive when you realize that our year-on-year ARPU growth was actually adversely affected by the increase of use of discounts and credit attributable to market competition and by decrease in ARPU from premium services; essentially HBO Showtime and Stars programming services in that category. So ARPU I think was a metric we really felt very good about in the third quarter. In addition, we’re also just speaking about revenue. We’re also finishing off another successful season of Sunday Ticket with results in line with our targets.

We also began to make a bit of progress on key costs like service, broadcast, operations, and G&A, although they weren’t that meaningful in the third quarter and we do expect more significant improvements in the coming quarters. Again, one way we have to ensure we improve our efficiency in the service area is to put our now ex-CFO Mike Palkovic in charge of service which we did last month, so we expect to see progress quickly there.

Two costs that clearly increased in Q3 were SAC and upgrade costs. These increases were driven by the enormous growth and demand for advanced products. Although they’re not the only factor, they’re clearly areas of both SAC and upgrade where we have room and need to improve. If I was going to try and visual it I’d say using an old 80/20 rule probably about 80% in both those categories, 80% of the increase was really attributable to demand for advanced product and 20% -- again as a rough visualization – was probably due to issues where we have to improve and tighten up some of the things we’re doing.

On the SAC side I already mentioned the almost doubling of advanced product take rate. However this advanced products wallet drove the SAC increase, we are pursuing initiatives to tighten up spending in sales and installation which should help us continue to manage SAC. In addition, we will get SAC savings in the coming months as hardware costs, particularly hardware costs for advanced products, decline significantly over the next few months.

In the upgrade side, we saw the same increase in demand for advanced products with a number of customers adding advanced products up over 35% year on year in Q3. If you focus on the most expensive upgrade, the HD DVR, the number of customers upgrading with an HD DVR was up over 80% year on year.

Now as we have said many times before, we view the increase costs for advanced products to be a value-creating investment as the higher revenue and lower churn generates a great return on that incremental investment, so we really do continue to view this as an important dynamic in driving our business forward and the success we had certainly in the quarter.

That being said, there are still issues in upgrade and retention that we need to address. Our upgrade and retention costs for servicing customers replacing boxes are too high. We’re doing too many of them and we have a lot of initiatives focused on bringing that down.

We’re also finding more and more customers taking more than one advanced product so we’re taking steps to address the economics of these upgrades since we really charge on a household basis for HD and DVRs.

Before turning over to Pat, spending a minute on Latin America, much like the US, DIRECTV Latin America had an extremely strong third quarter in most of its key metrics more than doubling gross adds to 289,000; a significant reduction of churn from up 1.55% to 1.41%; a fourfold increase in net additions to 161,000 and an 18% increase in ARPU to $48.84. As a result, revenues were up 67% to $442 million and operating profit before depreciation and amortization, excluding a one-time gain booked last year, was three times higher at $105 million.

Clearly the completed merger in Brazil is behind much of this success, however we’re also seeing really strong performance in many of our other key countries like Venezuela, Argentina, Columbia. I’ll also add that while we don’t consolidate SKY Mexico’s results, they also had a solid quarter and we saw good growth in places like revenue and net subscribers.

With that I’ll turn it over to Pat and then I’ll come back and make a few closing comments.

Patrick Doyle

Thanks, Chase. As you just heard, the rapid growth in consumer demand for HD and DVR services is having a material impact on both our top line and bottom line results. We’re getting the desired economic benefit from these advanced services in terms of better subscriber growth, ARPU, margin and churn, but at the same time we’re also investing to upgrade customers’ homes.

The benefits from this strategy are particularly evident when looking at DIRECTV US revenues which increased 14% to $3.9 billion. Much of this increase was due to our best ever ARPU growth rate of 8.3%, bringing ARPU to $78.79 in the quarter.

In addition to the usual ARPU growth we get from annual price increases, we’re continuing to see strong equipment and service revenues from the significant increase in HD and DVR customers.

For example, in the third quarter we added a record 600,000 new HD and/or DVR subscribers, up over 60% both sequentially and versus last year. To provide some perspective on this number, Comcast reported that they added 325,000 HD and DVR customers in the third quarter. We now have advanced product penetration of just under 40% for our subscriber base compared to a little under 30% a year ago.

As Chase mentioned, this quarter we had an extra week of NFL Sunday Ticket revenues versus last year, and we also booked some additional revenues this quarter related to a lease we had with Telestat on one of our older satellites. If you exclude these items, our ARPU growth was around 7% in the quarter.

Turning to subscribers, the improvement in both gross subscriber additions and churn reflects favorably on our competitive strength in the marketplace as well as the higher advanced product sales. As you saw in the earnings release, the better gross adds in churn drove a 45% increase in net additions to 240,000 in that quarter.

The increase in gross additions to a little over 1 million was largely due to the significant growth in both advanced products and sales through our direct channel. Over half of our gross adds in the quarter signed up for HD and/or DVR services. This is quite an impressive statistic particularly if you consider that the previous high for this metric was in the prior quarter when sales of advanced products were just under 40% of gross additions.

Also contributing to the increase in gross adds was the continuing strong performance from our direct sales channel which attained 40% more gross additions than a year ago. This increase drove our contribution to nearly 45% of total gross adds in the third quarter, up from 33% a year ago. These absolute and relative levels represent all-time highs for this channel.

This is important because the direct sales channel brings in higher value subscribers including a richer mix of HD and DVR subscribers which helps drive better ARPU and churn.

In terms of our monthly churn rate of 1.61%, we’re pleased that we’re finally starting to capture the improvements that we had talked about when we first provided our 2007 outlook earlier this year. Over half of the decline in third quarter churn was due to lower voluntary churn which as I mentioned earlier, reflects our competitive strength and appeal of our advanced services.

However, we also saw a nice reduction on our involuntary churn resulting from the ongoing efforts to refine and tighten our credit policies. For example, we recently implemented a mandatory credit card policy for new subscribers, and also increased our minimum commitment from 12 months to 18 months for subscribers with basic services. We have also implemented new systems and procedures to improve our screening of new customers.

As a result of these ongoing changes, we are seeing a material improvement in the credit quality and income levels of new subscribers. With these trends, we remain confident in our ability to continue reducing churn going forward.

Moving on, operating profit before depreciation and amortization was up 11% to just over $900 million. OPBDA margin of 23.6% was down 600 basis points from a year ago, due in large part to the increase in both new and existing subscribers upgrading to HD and DVR services and in particular upgrading to the HD DVR combination receiver. Also included in our upgrade and retention expenses were higher cost of about $52 million for MPEG-4 swaps compared to only $19 million a year ago.

I’ll remind you that for customers upgrading to advanced services, we continue to charge upfront fees ranging from $99 to $299 while also requiring a two-year commitment. These investments remain a high priority for us because we continue to earn roughly twice the return from households with HD and/or DVR services due to the materially lower churn and higher ARPU generated. To be clear, it is these customers that are driving a significant portion of the improved ARPU and churn results that I talked about earlier.

In addition to the upgrades and marketing, programming costs were also higher leading to a lower programming margin in the third quarter. This is consistent with the outlook we provided earlier in the year when we predicted lower programming margins in 2007, due mostly to the NFL Sunday Ticket, the NFL Network, Fox News and the absence of the Showtime purchase accounting. It’s also worth mentioning that we’re starting to gain some of the efficiencies we had expected to see in subscriber services and G&A.

Looking at costs as a percentage of revenues, subscriber services improved due in part to increased scale and efficiency at call centers and billing. Similarly, G&A costs as a percentage of revenues were also lower due to improved bad debt expense. Looking quickly at our cash and balance sheet, The DIRECTV Group generated a bit over $300 million in cash before interest and taxes in the quarter, bringing our year-to-date total to about $970 million, or flat with last year.

On a consolidated basis, the main use of cash in the quarter was for the repurchase of about 35 million shares for $849 million. At the end of the third quarter, we had approximately $480 million remaining on our current $1 billion share repurchase program. Also in the third quarter, capital expenditures of just over $700 million were higher than last year, primarily due to the increased number of HD and DVR set-top boxes that were capitalized at DIRECTV US. In the quarter, DIRECTV US’s CapEx for set-top boxes was $417 million compared to $325 million a year ago.

Finally we ended the quarter with net debt at the corporate level of about $2.2 billion.

With that, I’d like to turn the call back to Chase for some closing remarks.

Chase Carey

Thanks, Pat. Looking forward over the next couple of months as we round out the year, our focus on HD certainly remains our top priority. We intend to continue to adding channels, HD channels to the nation’s already best HD service, and do expect to end the year with close to 100 HD national channels and we will also continue during this period to continue to add more HD locals as we launch more markets, add markets to the mix in terms of HD local signal availability.

We’re also excited about launching our new VOD service which is now publicly available in a beta format.

In terms of the financial outlook for the fourth quarter, in many ways it should look a lot like the third quarter. We expect to continue to attain strong sales of HD and DVR services. As a result, we expect most of the key metrics: net subscribers, ARPU, SAC, upgrade, to be similar to the third quarter.

In summary, I believe the third quarter results provide us with a good gauge of our competitive positioning in the marketplace and the strength we have, and we obviously feel very good about our ability to compete head on against both the cable and telco bundles.

We also believe that over the coming months our video advantage increases as we continue to add more HD and other features to our line-up. I’m also very confident in our ability to continue to increasing margins on a quarterly basis going forward.

Next year will be an extremely exciting year for us as we finally begin to tap into DIRECTV’s potential and most importantly begin generating the significant cash flow growth that we all expect.

Finally, before turning the call back to John, I’d like to briefly mention that as far as we know, the Liberty transaction while frustratingly slow, remains on track to be completed this year. Of course predicting what happens in Washington is never easy, but we’re optimistic that we’re in the final stretch, and we’ll get approval before year end.

With that I’ll turn it back to John.

Jonathan Rubin

Thanks, Chase. Before moving into 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 quote any participants on this call either directly or in substance other than the representatives of The DIRECTV Group.

In addition, we are webcasting this call live on the Internet and an archived copy will be kept on our website.

Finally, I’d like to ask callers to limit their questions to one or two until everyone has had a chance to ask their questions.

Operator, we’re ready for the first question.

Question-and-Answer Session

Operator

Your first question comes from Jeff Wlodarczak - Wachovia Securities.

Analyst for Jeff Wlodarczak - Wachovia Securities

Recently you have been very aggressive in your new HDTV marketing. Is this driving a big pickup from your existing MPEG-2 base looking to switch to MPEG-4? If so, how are you managing this process? Clearly the long you hold off the cheaper the boxes will be.

Can you provide more color on your higher upgrade and retention costs? How do you think about the total upgrade and retention cost as a percent of revenue for Q4 in 2008?

Chase Carey

First managing the MPEG-2 upgrade, we are continuing to upgrade. I think Pat actually gave you the financial number which gives you some sense. I think it was roughly from $20 million going to about $50 million year on year and so it has picked up. I think we expect to see it continue to pick up, though again, this is something at this point that will continue through coming quarters.

I think in terms of managing it, at this point I’d end up saying largely letting it be demand driven and letting customers that have that equipment that obviously are not getting the full 100 channels now that they have become more aware they’re not receiving something they could, to let them pursue us. I think selectively we’ll try to pick, like in LA’s market where we’re reaching out a bit more proactively to try to educate those customers that there is HD programming that they’re not receiving that they could.

But I’d say it’s been pretty manageable. We continue to work that universe down but have a ways to go. But again, mostly what we do at this point is let it be demand driven by the customer and depending on that level of demand will determine how proactive we are to pushing the switch. We do want to make sure we’re educating, we’re providing on the websites and other places information for the customers so when they read the hundred channels and they’re not confused and sort of saying, where is it? I’m only getting 20, which may be the case with somebody with an older box.

In terms of upgrades and retention, as I said, clearly demand for advanced product which we think is a good thing is the largest force there, and demand will drive that. I think you’ll see pretty good demand through the holiday season. You usually do with HD, and I think we are now expecting demand certainly in the third quarter demand exceeded our expectations if I looked at what I would have thought what was the take rate of advanced product at the beginning of the year. I’d say that it’s probably above our expectations, which in many ways is a good thing, and I think it has pretty good momentum.

In terms of managing it, I think what we will continue to do is make sure we capture all the inherent savings we should. One of the biggest ones will be hardware cost. In the next few months, our HD DVR which we’re still putting out as we’ve been working through inventory is still a $430 or $440 box, and by the end of the first quarter, I think that HD DVR is down a bit over $250. So you get real savings that are coming through on the hardware side.

I think we can tighten up some of the policies around the truck rolls to upgrade those customers. There are places we can probably move more towards drop shipping a box to a home that is already set up for the upgrade and not require a truck roll so we can look at ways to manage that.

There are areas which are not as large as the upgrade that again we’re not as effective and efficient as we should be. The one I would cite is we’re rolling too many trucks to replace boxes and fix boxes in a home and better than we were, but we have got real room for improvement and certainly with Mike going into the service area, it’s one of the top priorities.

He’s got to bring that number down and get it improved significantly, what we’re spending on the equipment replacement side of the upgrade and retention process. Those are factors that will help us manage it, probably in ‘08 more than in the fourth quarter. One of the benefits that will really start to come through an area like that will be the benefits of the box leasing program we put in place in ‘06. In many ways, it takes a while to accumulate and work through and start to recapture some of that inventory, and so we do think in ‘08 we’ve gotten some benefits in ‘07, but we knew they would not be as significant. I think in ‘08 we really start to capture some of the benefits from the redeployment of set-top box as we get a larger percentage of our universe out there that we’re recapturing and redeploying.

I’d say on the upgrade and retention side, it is making sure we’re as efficient as possible, it is making sure we capture the savings like hardware costs we should, it is fixing some of the problems where we’re not operating as effectively as we should and capturing some of the benefits inherent in some of the things we’ve invested in over the last year plus like the leasing program to capture the benefits inherent in that.

Operator

Your next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

You mentioned that half of the churn reduction was due to voluntary churn. I was just wondering, do you think that represents the fact that a smaller percent of your subscriber base had a catalyst to change?

I’ll throw in an anecdote to illustrate what I’m getting at. A year ago there was probably a higher percentage of your subscriber base that was in the process of making a transition from narrow band to broadband and in that transition they had a triple bundle offering that may have been more appealing. Now a year later a smaller percentage of your existing sub base is not making that transition because they’ve already made it to broadband and so by definition, there is less of a reason for them to be open to a new offering from a competitive service.

The second question I have is on your gross adds. How much of the gross adds do you think is due to the benefit of your high definition HD offering versus your outbound marketing?

Chase Carey

I guesses in terms of the first question, churn which I’m not sure I fully got the connection to the anecdote, but I’ll try and address it. I do think that the churn, clearly one of the significant benefits is the quality of the subscriber base we have and the advanced products, that again when you look at the churn that exists on an advanced product customer, it’s still well below 1% so as that universe grows, we get customers that have a richer experience.

It is certainly one of the things I think that is helping manage voluntary churn. I think the terms in the bundling, what is the impact on the bundling aspect, I think there is in general the marketplace has gotten more educated and informed about the choices that are available there. Again, as you said, many have taken the choices, have already done the upgrade. I think as some of the cable guys have said, the telcos have now really gotten well established in the market with alternatives for broadband that match up well with us, whether it’s just matching up by definition as opposed to through a contractual relationship.

I think we said all along and continue to believe that the bundled is mostly about price. That is the attraction of it. I think customers have increasingly gotten educated and informed about the ability to find solutions for their needs for broadband in a way that is compatible with us and at a reasonable price.

So I do think the maturing of the broadband market and the sophistication of the broadband market and the education of the broadband market and the education of the consumer in the broadband market are all things that have helped us and have helped the customers get smarter about how do they meet their demands. No question they want broadband, but meet that in a way that is compatible with us and again, I think we continue to believe we’re in the right price in the market that video is the place people care deeply about, has the richness, has the ability to differentiate, and the broadband telephony side continues to struggle with being more commoditized and being more dependent solely on priced to compete.

As we have established and tried to move to build a leadership position in video, obviously adding things like HD on top of what was already we believe a very strong position, it has enabled us to continue to drive that advantage.

In terms of HD, it’s certainly a big part of it. We talked about the advanced product growth, and I think that’s a testament to the HD. I mean it’s not the only thing that is driving it. Again, I think we tried to make leadership in television a multidimensional story, certainly content, sports, HD DVRs, service I think are all parts of establishing leadership and certainly the HD is a very important part and I think in many ways HD has become the top of the list in today’s marketplace.

If you ask customers, what is at the top of the list of what they want to have? HD sits right there, and I think DVR sits right beside it, so I do believe that those two forces HD and DVR are going to continue to be the forces that drive the video marketplace.

Operator

Your next question comes from Doug Mitchelson - Deutsche Bank.

Doug Mitchelson - Deutsche Bank

Good afternoon, gentlemen. First are there any negotiations taking place with AT&T related to your distribution relationship with them or strategic in nature?

Second question, to the extent you talked about programming margins falling this year, it seems to be it kind of follows a pattern for the past five years or so where you have made a pretty massive investment in programming, you had a rash of new RSNs get developed. You’ve had the sports box obviously, you’ve had step ups in successful networks but it seems like you carry just about every channel under the sun and you carry all the RSNs that have been created.

So looking forward, should we expect either next year or the year after return to programming margins expanding? Thanks.

Chase Carey

We certainly are talking to AT&T about the bundling relationship. I think they have said at least my recollection is they said they were trying to somewhere around year-end try and make decisions about where they were going and I’m sure they’re talking to EchoStar. I think those are the substantive conversations are really around where they’re going to go in terms of the bundling relationship going forward. Not a whole lot more than that to add.

On the programming, this year I think as Pat said, we had I don’t know that they’re what you call uniques. We certainly had a handful of significant programming increases that I guess they were outside the ordinary, I think we cited them. The Showtime agreement, the Fox News, and NFL Network kicking in. We don’t have long visibility, but certainly as we look out at ‘08, there aren’t things like that coming, so clearly that is a benefit.

I think you will continue to have dynamics that are more of an ongoing nature like sports teams going out and launching regionals and which I don’t know whether I want to call those ordinary course, but put them more in the world of the ordinary course, but probably certainly don’t have the magnitude of the three I mentioned that we encountered in ’07. I think it’s a place we expect to make headway as we go forward.

Operator

Your next question comes from James Radcliffe - Lehman Brothers.

James Radcliffe - Lehman Brothers

First off the MSOs have been saying that a lot of their net subscribers loss has been lower end customers, the life line video customers, but you’re showing greater than 50% take rates for new customers for advanced services. Can you help me reconcile that? I’m trying to figure out how that works. Where are those other subs going?

Chase Carey

They’re certainly not the ones coming to us, because I don’t have the cable guys’ numbers. I gave you a couple of the metrics. We got over half our customers upgrading into HD and/or DVRs, and as I said, we obviously track a lot of metrics to measure quality. The one I cited was number of customers above $75,000 income, and we were taking probably in the quarter the highest percentage we’ve had in years, and well above the national average.

So almost anyway I would look at it, when you look at credit ratings, credit risk, we were probably at a low that I can cite going back. I’d have to go back on pages that I don’t even have here anymore to find a number that I think our high credit risk customers were down in the low single-digit percentages. So almost any way I look at it, and I think again the numbers bear it out, when you look at churn and you look at ARPU, these are customers that obviously have the capability and appetite and desire to have a great video product, and a rich video product and stay with it.

I can’t reconcile. All I can do is look at ours, and we feel great about the quality that we’re getting right now.

James Radcliffe - Lehman Brothers

Are you seeing any difference in the kind of subs you’re getting from people switching from for example cable versus switching from dish or people who are new to pay TV?

Chase Carey

I probably don’t have great visibility in that. The deeper you try to get into it, we do track where they come from and we track where our customers come from and where they go to and try to look a bit at the differences amongst those versus coming from dish coming from cable coming from analog versus digital cable still some obviously coming from no paid TV service. Certainly there is nothing in the cable number there that would reconcile that either. It’s not certainly like we’re getting low end customers from cable and all the quality is coming through from dish. It just doesn’t work that way in reality. Cable is too big a chunk of it overall.

We’re getting a pretty good slug still of digital cable customers so it’s not just like we’re getting analog cable customers. We’re getting customers coming from digital cable.

Operator

Your next question comes from Craig Moffat - Sanford Bernstein.

Craig Moffat - Sanford Bernstein

About a year ago your analyst day you talked about retention marketing costs of around $1.2 billion, and then I think you raised that guidance to about $1.4 billion as I recall last September. Your run rates currently close to about $2 billion, I guess, total. I’m wondering if that has any impact on your expectations of free cash flow that you guided to at the analyst day back in ‘06?

Chase Carey

First the $2 billion is certainly not the run rate we’re looking at, so I don’t know what you’re extrapolating too, and I guess just to correct a couple of them, the $1.2 billion also did not include the MPEG-2 swaps on top of it which is a number on top of it, so the $2 billion probably isn’t right and the $1. 2 probably isn’t apples to oranges on it.

That being said, is it running higher than I expected a year ago? Yes. Most of it is a higher level of demand, and I’m not saying everything is right where we thought it would be, but I think we actually hopefully tried to be pretty clear all the way along in saying that if demand for HD and DVR product exceeded our expectations, then there is a cost to it. We think it’s a good investment, and we are not going to turn away those customers for the sake of managing to a number.

Again I think I said 20 minutes ago those numbers have exceeded our expectations. We think it’s a testament to the strength of our service and we think we’re creating value by doing it. That being said, I think there are certainly things we can improve. I’m not going to be a broken record. I think we cited the replacement of boxes in a home is an area we have to improve, and I think as we go forward next year we’ll get other significant benefits like the benefits from leasing that really will start to come through in a meaningful way that really has not been material in the ‘07 numbers that will help us manage that number. I think we feel still in general, again, I’m not going to get too far into re-updating investor day here, but I think our vision of that business that we laid out we still feel very good about.

I think there will always be ebbs and flows when you get into quarter and factors, so we’ve got a really high demand and in many ways is mostly a good thing for us. But we do feel confident as well that we will continue to find ways to manage it, but you painted a view of extremes that probably is high on one end and don’t take some factors into it on the other end.

Craig Moffat - Sanford Bernstein

How much do you expect to get in terms of recovery of set-top boxes? Is that starting to help significantly at this point given that you just started that program about a year ago, I think that’s starting to improve significantly now and into next year?

Chase Carey

I think it becomes a meaningful factor in ‘08. We get a little bit now and it will get a little bigger but it’s certainly not a significant factor if ‘07. I think it will become a much more significant factor in ‘08, and it’s actually starting to sort of between Q2, Q3, Q4 it starts to build and with that growth rate, it really sort of is where it really starts to become material when you look at it in ’08.

So again, it certainly helps a bit in the fourth quarter, but it’s almost a multiplier effect as you start to accumulate that. We do get a little bit of help in ‘07, but it will be a meaningful factor for us in ‘08.

Patrick Doyle

Just as a guide for the third quarter, we ended up with about $55 million of net savings from redeploying boxes in the quarter.

Operator

Your next question comes from Benjamin Swinburne - Morgan Stanley.

Benjamin Swinburne - Morgan Stanley

Just a quick question on the MPEG-2 upgrades. I might have the number off, but I think you ended last year with about 800,000 of those in the field. Just trying to get a sense of how many have been done and how many are left and what you think timing of that remaining upgrade is?

Chase, if you could just talk strategically about your view on owning content or owning programming. It’s not been a part of the DIRECTV business model in the past and I was wondering if you have a different view going forward as the business evolves?

Chase Carey

In terms of the MPEG-2, as I said at this point we’re mostly managing more through letting consumer, largely being consumer demand driven. I think we’ll end the year probably with somewhere a bit over half a million customers that remain. Now, that goes down into sort of 500,000 to 600,000 customers and probably remain at the end of the year. That will go down and continue.

Two forces drive it down. We get churn, so some of them we don’t replace because our HD churn is lower, we still have churn in that category, and then some will swap. I would think we’ll do a fair bit of that in ‘08. I think as somebody said on one of the calls, in many ways the longer we can stretch it out the better it is for us, and I gave you the cost reduction in HD DVR, so of a customer is going to swap out I’d rather be swapping them out on an HD DVR that costs $250 instead of one that costs $440 and I guess today I think our HD box is still about $210 to $220, and I think by end of first quarter beginning of second quarter next year, it will be $140.

So when you get that type of reduction coming in hardware, we certainly would rather stretch it out. We don’t want to stretch it out to a place we’re frustrating customers which is why we try and be selectively proactive to the right customers. But if we’ve got that half million and change, some of those again will churn out and never swap. The majority we will, and I would think we’ll do certainly probably over half of it in ’08.

One of the things we have to say, obviously the noise, the press around and publicity around and the reality around HD has only really been in place for a couple weeks, and we only really sort of went public with it. We have had the campaign, but really the focused campaign that started with the Journal and USA Today ads in the middle of October, so how much that sort of drives customers that haven’t come to us to date to do so, we’ll see. So it may pick up, but then again it would be something we would monitor as we go forward.

I think in terms of content, I wouldn’t say we’re that different today. I think that’s right. With News Corp as a large shareholder we had a unique relationship with a content owner. I think their content, I do believe in synergies between content and distribution, but we’re really not focused on anything specific right now, so I think it’s sort of continuing to evaluate the marketplace and evaluate opportunities as they go.

Obviously part of any sort of where we’re going strategically in the life, we haven’t closed the Liberty thing, so we’ll have a new significant shareholder whenever that closes, and probably look at things afresh there. But for us, we’re probably not doing anything different than we have done in the past at this point.

Operator

Your next question comes from Jason Bazinet - Citi.

Jason Bazinet - Citi

I think most investors agree your balance sheet is pretty lean and most expect you to generate a material amount of free cash flow over the next couple years.

Chase Carey

So do we.

Jason Bazinet - Citi

If I understand the standstill agreement with News Corp that Liberty will inherent is correct, you’re sort of prevented from buying back too many shares that would passively push Murdoch or Malone over 50%. So my question is in that context, what is your priority for free cash flow other than just paying down debt even further?

Chase Carey

As I said before, I think that the discussion that really we look to have post the completion of the Liberty transaction where we have the shareholders in place and the board in place that we will be looking forward in a long-term basis. I agree with the observations on the balance sheet and the cash flow, but I think at this point really I think the where we go and obviously there will be ranges of options is something that we need to have as a discussion we would look to have at a board level once we have the Liberty deal closed and then appropriate representative shareholders and board members.

Operator

Your next question comes from Tom Eagan - Oppenheimer.

Tom Eagan - Oppenheimer

If I could just ask the previous question a different way: Chase, what do you think the company or the board’s willingness is to significantly lever up in order to say not just maybe buy back shares but also provide some sort of cash dividend to shareholders?

Secondly, if you could remind us what the partnership says with Bell South and AT&T about if T decides to choose Dish as their exclusive partner, how long will these existing or the current subscribers get the service? Thanks.

Chase Carey

Again, probably on the question of the cash flow, I think we are comfortable with I’d guess I’d call it an appropriate level of debt, that I think we feel we would feel comfortable on the books. I think we have given some broad base again. We haven’t really gone back into the market to see if it has changed. Since the summer obviously there have been a range of well-publicized issues in the credit markets, but our credit rating, you could probably have 3.5 and change in terms of terms that probably wouldn’t go all the way there, but something that would be more 2.5 and change would certainly leave you flexibility.

What you do with it again is probably for the same reason as I said I’m not going to repeat and probably would not get into far into what are the options of what you do with the liquidity, but I do think we’d be comfortable with an appropriate level of debt on the business.

AT&T, certainly existing customers won’t be affected. I mean it prohibits specifically trying to switch out or target customers for different offers so the existing base will obviously go prospectively, and to the degree we will look to compete, if they choose to go EchoStar, then we compete in that manner, then we’ll compete as we do in the AT&T region today. We find ways to compete and compete pretty effectively in the AT&T region today, and some of our markets that we feel really good about are sitting in the AT&T region now.

I’m not saying the telco relationships don’t have benefits to us, but clearly we would move to make prospectively put other initiatives in place much as we do today competing in a historical AT&T region. But the specific question in terms of customers, that the customer base that would be in place, they would not be affected. There are protections to ensure that.

Tom Eagan - Oppenheimer

Is there a time period by which say AT&T can’t directly market to those DIRECTV customers after they choose their partner?

Chase Carey

I don’t have the agreement in front of me. I think the answer is no. If it is, it’s a long enough time that you’re probably way beyond anything that is relevant. So it’s certainly not measured in months. It’s years and multiple years, so it is really protection that we are very comfortable with in that light.

Operator

Your next question comes from April Horace - Janco Partners.

April Horace - Janco Partners

I was wondering with all the new initiatives that you have got with respect to driving churn down the two-year commitment the upfront payments, do you have some sort of goal as to how far down you can drive that number?

Chase Carey

I think we have had a broad-based vision. I think what I talked about in the past on an annual basis that we would shoot for something that would be down the road -- this is not an ‘08 number -- a 15% to 16% churn, and again I think those targets are ones you always have to continue to reevaluate, so there are sort of visions of where you can get to at a point in time and the competitive factors and those things are part of the market, but if I was going to sit here today what would be our long-term vision of where we would look to get to, I think that probably is still would be my feel for what we would be holding out there as a goal.

April Horace - Janco Partners

Can you also tell me how many telco subscribers or total bundle subscribers that you guys have to date? That would include people like ClearWire and WildBlue.

Chase Carey

Most of them, the large, large majority are telco bundled. It is not the Clear Wire and the WildBlue numbers are quite small.

Patrick Doyle

2.4 million total, about 15% of the base.

April Horace - Janco Partners

Can you give us any thoughts as to what’s going on with Clear Wire and Sprint and how you guys are going to fit in or not fit in and update on the new option?

Chase Carey

In terms of fitting in, we have a deal with Clear Wire, and we will move forward to offer a bundle where Clear Wire is available to offer a bundle of Clear Wire services with DIRECTV. I think that generally is how we’re continuing to approach broadband overall is at this point really looking more to create commercial arrangements with broadband players that enable customers to access a bundle of services, and I suppose to an investment in one particular.

Again, not to say we don’t continue to engage and look at are there other places we should consider an investment, but again our focus is trying to create those commercial arrangements that enable us to provide a bundled service and that’s what we’re doing with Clear Wire.

I think the Sprint side of it, I don’t know much more than you do reading the papers, obviously the Sprint situation has gotten a bit more fluid, and I think we’ll continue to be engaged in monitor and evaluate are there opportunities, issues, what have you, things we should consider as that goes, but I think at this point our focus really the only substance is with Clear Wire where we’re moving forward to provide a bundle of Clear Wire services.

April Horace - Janco Partners

And the 700 megahertz?

Chase Carey

700 megahertz again I think we’ll continue to monitor that. I think that’s a tough field for somebody to compete with the incumbents, and when you look at what the rumored prices are for that spectrum and the benefit the incumbent has in terms of paying for it and deploying it, I think there are obviously challenges for new entrants, but there are an array of players rumbling around and I will use the term opportunistic. If there is something that makes sense, we’ll evaluate it, but I think at this point it seems much more geared from my perspective towards much more realistic that some form of incumbents that bring the existing infrastructure are in the best position and likeliest as players in it.

Operator

Your final question comes from Kit Spring - Stifel.

Kit Spring - Stifel

Hopefully it’s the best for last. Can you talk a little bit about your plans for VOD competing with cable and maybe some new CapEx guidance for this year and next?

Chase Carey

I don’t think we’re going to get into ‘08. I probably will talk about ‘08 at the end of the fourth quarter, so I probably would not get into ‘08.

I with VOD as I said, we’re launching what you call a beta test which is actually we are providing it to customers. It’s probably a quasi-test still that is in our VOD offer willing be a combination of product pushed to a DVR and product pull by customer via broadband connectivity to that DVR. We actually think it’s a great product. We think it will be a very attractive alternative to cable. I think we’re looking to really distinguish ourselves by making it having an ease of use and choice and accessibility being something that is uniquely attractive, so it is structured, it’s packaged, it’s presented, available to customers, and they can find their way through it in a much easier way than other options that exist today, and I think it will help people grow into VOD.

I think VOD is going to be something, we’re not going to rush it into the market. VOD is something that’s still going to take time and you have issues around windows and product and you’re not getting the right movie windows and you have all sorts of complications in terms of availability of product.

I think VOD will continue to emerge, but I think it’s sort of in some ways the bigger forces in the market short-term are certainly HD and DVR. I think the VOD will bring out and really continue to move forward with it as that market evolves, but I think it will take a while longer to evolve and again probably move from an array of players before you get a more attractive VOD offering.

We think we’ve got a very good, competitive product and in some ways we will be opportunistic. We don’t want to be scattered too widely. While we want to be a broad based content leader, we do want to make sure we can focus our resources on the things that give us the biggest bang for the buck, and so I think probably there are places we think in the short term you’re going to get a lot more bang for pushing it than others will let it sort of get led by the consumer and move forward to be more proactive with it as that market evolves.

Kit Spring - Stifel

Have you seen any acceleration in October and November since you’ve actually had the 70 channels I believe for most of 3Q you really didn’t have an HD advantage, you had a coming HD advantage? Have you seen a recent change over the last month since the HD advantage has truly been there?

Chase Carey

I think what I said about the fourth quarter I will probably stick with. We look at the fourth quarter continuing to look a lot like the third quarter with certainly a part of it being strong demand for HD and DVR and for advanced product, and I think at this point probably not get too much deeper into week-to-week numbers.

Patrick Doyle

I think on your CapEx question on DIRECTV US, I think we expect to come in around $2.4 billion total. Still about $800 million of kind of the non-lease so it’s a little bit higher and it’s again driven by the lease set-top boxes, and I don’t think as far as looking forward, we’re not prepared to look into next year yet.

Operator

This concludes today’s DIRECTV Group 2007 earnings conference call.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: DIRECTV Q3 2007 Earnings Call Transcript
This Transcript
All Transcripts