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Hughes Cash Buys a DSL Outlet: Telocity

Acknowledging that its DirecPC data service trails other broadband service providers, Hughes Electronics Corp. plunged into the digital subscriber line business by buying Telocity Inc. for $180 million.

In the pre-Christmas announcement, Hughes said it would use Telocity's broadband connections-in 125 markets that cover 40 percent of the United States-to provide DSL-based Internet access at speeds ranging from 500 kilobits per second to 1.5 megabits per second. It will continue to offer DirecPC in areas where DSL isn't available.

"The projected demand for broadband exceeds our existing capacity to deliver by satellite," Hughes chairman and CEO Michael Smith said. "With the addition of Telocity, we achieve nearly unlimited capacity and can offer our customers a choice of DSL where it is available."

The Telocity purchase allows DirecTV Inc. to offer a whole-house solution, said Hughes senior vice president Eddy Hartenstein.

"We will offer consumers the best of both worlds-digital satellite entertainment and high-speed DSL Internet access-through a single portal into their homes," he said.

One Wall Street analyst believes the deal will help DirecTV to reduce video churn through a DSL bundle.

"By offering more value to the consumer, we see the distinct potential of DirecTV subscriber churn being mitigated somewhat," Goldman, Sachs & Co.'s Barry Kaplan wrote in a research note.

DirecTV also announced the fourth iteration of DirecPC on Dec. 21, which will provide upstream bandwidth of either 128 kbps or 256 kbps. DirecPC had offered only a 56 kbps backchannel service.

To underscore DSL's potential, Hartenstein said he expects Telocity to have 3 million to 4 million subscribers in five years, while DirecPC is projected to reach a million to 1.5 million subscribers.

Telocity has been at the forefront of new applications among DSL providers. Funded in part by GE Capital and NBC, Telocity has a deal with NET-36, which allows content providers to send streaming media and content over satellite to broadband homes, bypassing wireless bottlenecks.

PanAmSat Corp. owns NET-36 and, in turn, is 81 percent owned by Hughes.

Hughes is paying $2.15 a share for Telocity in the $180 million deal. The tender offer commences Feb. 1 and expires no later than April 2, 2001, the parties said.

Like other DSL providers, Telocity's stock has been hammered. From a yearly high of $16, the price fell as low as $1.25 in recent weeks. With the Hughes announcement, Telocity's stock price rose to $2.13 per share from $1.41.

The Hughes deal gives Telocity a chance to survive the shakeout among new telecommunications providers.

Telocity chief financial officer Ned Hayes said Hughes would provide Telocity with $20 million to cover operating expenses prior to the closing early next year.

As of Sept. 30, Telocity counted 23,000 subscribers. It reported third-quarter revenue of $2.9 million and a net cash-flow loss of $28.6 million.

At the end of the third quarter, the company said it had cash and cash equivalents of $80 million, giving it room to operate for a few more quarters.

Hayes said the company expects to post cash-flow losses of $100 million to $125 million in 2001 and 2002, before starting to break even in 2003.

But the Hughes purchase should speed up the countdown to profitability. Telocity said it would end the year with 40,000 subscribers, and Hayes expects 150,000 to 200,000 net subscriber additions in 2001.

DirecTV will sell DSL alongside its satellite offerings in outlets owned by RadioShack Corp,, Circuit City Stores Inc., Best Buy Co. and other retailers. It will save costs by combining marketing, back-office and customer-contact functions, Hartenstein said.

Hartenstein said DirecTV also could learn from Telocity's lower churn rate, which is between 1.1 percent and 1.5 percent a month.

Telocity's economics look a lot like DirecTV's, Hartenstein told analysts. The company generates between $45 to $50 in revenue a month, which is lower than DirecTV's $60 plus in revenue per month. Telocity's subscriber-acquisition costs, however, are lower than DirecTV's.

Hayes said it costs Telocity $350 to $400 to land a subscriber, with $220 earmarked for gateway costs and the rest for marketing and advertising.

"The [return on investment] is similar to DirecTV subscribers," Hartenstein told analysts in a conference call. "We see [Telocity's] gross margins at over 40 percent over the next three years," he said, with equipment price drops and more line-sharing kicking in.

Telocity buys DSL lines wholesale from existing regional Bell operating companies and competitive telecom providers like NorthPoint Communications Inc., which reduces its capital-equipment costs, Hartenstein said.

Telocity's focus on consumers rather than companies mirrors DirecTV's business, Hartenstein said. DirectTV said it looked at other struggling DSL providers, but quickly honed in on Telocity because the company's residential gateway technology allows consumers to initiate DSL service without a truck roll.

DirecTV also doesn't see a conflict between its current video alliances with phone companies and the Telocity deal because Telocity buys DSL lines wholesale from RBOCs.

DirecTV executives steered clear of any comment about how the purchase would affect Hughes' plans to sell DirecTV, other than to say the DSL card could add more than $2 billion in value to the company.

DirecTV executives also said Telocity's gateway device that supports home networking and increased security could be integrated into a DirecTV set-top, but it's too early to determine any kind of timetable for that integration.

While NBC's ownership role in Telocity will cease, DirecTV said it would continue the advertising relationship between Telocity and the NBCi electronic-commerce Web site. Smith also said the Telocity deal would not affect Hughes's plan to launch its two-way Spaceway project in late 2002.

"We continue to be on track [with Spaceway]," he said. Spaceway is "fully meshed connectivity" that's designed "primarily as an enterprise system," he said.

Separately, Telocity will launch a 90-day video-on-demand trial with several Hollywood studios and Villa Montage Systems in fewer than 100 homes.

Telocity subscribers will be able to access VOD movies directly from a content provider's Web site, including Hollywood studios.

Village Montage CEO Tony Clark said movies would be delivered through Telocity's telephony network to a switch at Telocity's headend, then into an Internet access server in the consumer's home.

The server houses a 60-gigabyte hard drive, capable of storing 10 to 50 movies, depending on a given movie's encryption rate, Clark said.

In some cases, movies will already be downloaded to the in-home server before a subscriber has ordered them, Clark said. This cuts down on transmission time once a consumer orders a movie.

The studios are testing this concept based on VMS' digital-rights enforcement technology, he said.

The consumer would still be required to make a direct request to a studio's Web site to order the movie, Clark said. The studio's server would send out an authorization command to the VMS server, unlocking the movie for viewing.

Clark said studios could configure movie viewing for 12 hours or 24 hours. Studios also can authorize pause, rewind and replay capabilities.

The studios handle the initial encryption, and pre-downloaded movies remain encrypted while residing in the VMS server.

When a movie is ordered, it's displayed in analog form on the TV, giving studios further piracy protection, Clark said. The VMS system also allows for Macrovision copy protection.

VMS plans to lease its Internet-access server to consumers for the same monthly price as a digital cable set-top. Telocity handles contract negotiations with the studios, he said. VMS generates revenue from selling the headend switch to broadband service providers. Clark said the switch is scalable from several hundred to several thousand subscribers. "At 4,000 to 5,000 subscribers, it makes it cost effective," he said.

Clark envisions most studios pre-downloading hit movies based on the tastes of specific consumers. Ordering and delivering movies from a studio's Web site, even if they are cached regionally, could take five to six hours, Clark said.

"We are supporting caching because broadband networks aren't fast enough to support high-quality content," Clark said.

Consumers won't pay for the movies during the technology trial, according to Bill Chandler, a Telocity spokesman. Telocity relies on local phone companies to provide the last mile connections to residential homes. But Telocity bills and markets to consumers.

Monthly DSL service ranges from $39.95 to $49.95, Chandler said.

Broadcom Corp., Alcatel Alsthom, Motorola Inc., Texas Instruments Inc. and NEC America all contributed hardware and software to Telocity's gateway, Chandler said. NEC supplied its ASIC design to Telocity's I/O needs, while Broadcom offered its "iLine10" Home Phoneline Networking Alliance 2.0 chipset.

Telocity is among the smaller DSL providers at the forefront of delivering video services.