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Pagon: Pity Cable's Rural Ranks

Pegasus Communications Corp. is the third-
biggest provider of direct-broadcast satellite services in the country, with nearly 1.5 million customers. A former rural cable operator, Pegasus chairman Mark Pagon sold off his cable properties over the past several years to concentrate his efforts on DBS. In an interview with Multichannel News marketing editor Monica Hogan, Pagon described the challenges that rural cable operators face, and predicted that many of the smallest operators would disappear over the next five years. That's something Washington might need to heed if it weighs in on a merger between the two largest DBS providers, DirecTV Inc. and EchoStar Communications Corp. Pagon also said the demise of small cable operators makes it increasingly important for DBS to provide local broadcast channels, even in small markets. An edited transcript follows.

MCN:
What is the outlook for small rural cable operators today?

Pagon:
The picture for the very smallest cable operators and cable systems in rural areas is increasingly difficult.

MCN: Why?

Pagon:
The cable industry is made up of about 11,000 cable systems. About 9,000 of those are in rural areas and serve about 18 million customers, so the average rural cable system is about 2,000 subscribers per headend.

There are about 8,000 cable systems in rural areas that serve an average of less than 1,000 subscribers per headend.

If you're looking at upgrading a cable system to provide digital video and broadband Internet access, there are very significant fixed expenses associated with the headend. If you're spreading those fixed investments over 100,000 customers, the individual cost per customer is relatively small.

If you're spreading it over 900 or 1,000 customers, the costs are in many cases in excess of $10,000 a customer. A customer is not worth that.

For the smallest cable systems, those that are smaller than 1,000 customers in the system, they just can't afford to upgrade to digital.

If you don't upgrade, you're offering 30 or 40 or 50 channels of analog and no broadband access, and you're competing against satellite companies that are offering 250 and potentially more. You're competing against somebody who is offering a hell of a lot more and charging typically $2 less a month for the services that you're charging 35 or 36 bucks a month for.

That is a very difficult and challenging environment.

Over the past five years, those small systems have been losing about 3 to as much as 5 percent of their customers a year.

That is accelerating, not slowing down. Whereas the bigger systems continue to grow about 1 percent a year, the small systems have been losing customers at 3 to 4 — now closer to 5 — percent, in many instances, a year, and if you just continue that slide for another couple of years, they're going to be losing money. On an old cable system that needs to be rebuilt, you're in a bad place.

MCN: Is there anything the smallest of operators can do to increase their chances of survival?

Pagon:
If you have a lot of little systems, you can try to find some way to connect them all together or cluster them with fiber. You don't change the challenges of having low home density, but you do change the challenges of amortizing a big digital upgrade cost for the headend over more customers.

The problem with that strategy is the communities that you're tying together have to be reasonably close, and in most rural areas of the country, rural communities are pretty far apart.

It can work in some parts of rural America, particularly the Southeast, where rural communities can be seven, eight, nine miles from each other. But out in the mountain states, in Kansas or most of the West, it just will never work.

The other approaches are if you can't beat 'em, join 'em, either selling systems or customer lists to satellite companies. You get paid for giving your customers up for conversion.

The last alternative is trying to get into the satellite business yourself, which of course is what some of the cable companies did with PrimeStar, and some cable companies are trying to do again with other vehicles.

MCN: Have you offered to buy any of those small cable companies or their customer lists?

Pagon:
We used to be in the cable business. We're not in the cable business anymore. We're not really interested in owning cable systems.

We've talked to people about converting cable subscribers to satellite. Conversions — if a deal makes sense, we'll do [it]. I think you'll see a lot more of those.

MCN: Are there any other exit strategies available to small cable operators today, aside from selling their list to a satellite company?

Pagon:
Perhaps there are. I'm not aware of any.

MCN: How are cable companies trying to get into the satellite business again?

Pagon:
There are a bunch of smaller cable operators who are trying to create extensions to the headend service. HITS2Home in particular is a digital, direct-to-home-satellite service that is attempting to compete with the satellite companies.

MCN: Do you think that's a viable option?

Pagon:
If you can make the transition to a satellite company, as opposed to a cable company, you can convert your own customers, as opposed to selling them to somebody else to convert them. And you might have a future. In essence, that's what Pegasus did six or seven years ago.

MCN: How did you decide that it was time to leave the cable side of the business?

Pagon:
Back then, the economics were still pretty good. But in our analysis of making the upgrade to digital, which we thought would be necessary, we just couldn't figure a way that it made sense to do it.

That's why we got into satellite in the first place. Our experience of satellite was it was a hell of a lot better than we thought, more cost-effective and a better service from [a] consumer standpoint than we ever imagined it would be.

Having gotten into the satellite business and still being in the cable business — and looking at the economics of a digital upgrade — we said, 'Time to get out.' And we got out at a time where you could sell rural cable systems for 2,500 bucks a sub. I think we sold ours for 2,800 bucks a sub, three or four years ago.

Our systems weren't the smallest. They weren't less than 1,000 subs a headend. Ours were typically between 2,500 and 7,000 — where the picture is difficult, but at least there are strategies you can use to protect yourself somewhat.

But even in that case, if we had the systems that we had five years ago and that we sold for $2,700 or $2,800 a sub, if we were selling them today, we'd be fortunate if we got 13 or 14 per sub, I think.

MCN: Really?

Pagon:
Yes. And the smallest

systems, they are being offered for seven or eight hundred bucks [per subscriber], but nobody is buying them.

MCN: Seven or eight hundred dollars?

Pagon:
Per sub, yes, versus big systems owned by the big cable companies. They sell for four to six or seven thousand dollars a sub. If you want the capital market's view of the future for small systems versus big systems, just look at what people are paying for them.

And big systems, people are paying, four, five, six, seven thousand per sub for.

Little bitty systems, systems less than 1,500 or 1,000 subs per headend, they're asking less than $1,000 and they aren't getting bought.

MCN: Do you think the rural market is still a viable business for video overall?

Pagon:
Oh yes, absolutely.

The future opportunity for increase is the same both in rural and in metro areas, and I think that multichannel video penetration will go from about 83 or 84 percent today to 93 to 95 percent over the next five or six years.

The opportunity for satellite companies in rural areas is not just that overall penetration is going to grow. We're going to take an increasingly large share of the multichannel video landscape from cable because a lot of the little bitty cable companies won't upgrade to digital, can't upgrade to digital, and if they don't, ultimately I think they're out of business.

MCN: If small cable operators are not doing well, why is Pegasus starting to experience greater subscriber churn than you have in the past?

Pagon:
Our churn has increased somewhat, as has EchoStar [Communication Corp.'s] and DirecTV [Inc.'s] churn. It's just a function of the increasing maturity of the satellite business.

When you start a new product or a new service, usually what you're getting are early adopters, and usually early adopters are not very price-sensitive. They are very focused on the service, and they tend to be stickier and more loyal.

As you get more mature, the last customers in tend to be people who, by definition, are much more price-sensitive and less loyal. It's a natural thing that as you grow and mature as a service, you're going to have a higher incidence of churn.

In the short-term, there's been some impact. In areas where digital cable is being launched, the cable companies have been very aggressive in terms of offering bounties to consumers, which is a little bit like the phone wars, the long-distance wars of a couple of years ago.

If you're a satellite customer, and the cable company is offering you three hundred bucks to switch, you say okay, I can switch, try it, if I don't like it, I'll switch back. Maybe the satellite companies will offer me a couple hundred bucks and I'll keep them going back and forth.

From a cable company standpoint, if it costs you $500 in equipment for a new digital customer-— and on top of that you're giving the customer a $300 bounty to give up their satellite service —you might do that when you're launching the service to make people aware of it. That's not going to be a permanent feature for the long-term.

Our exposure to that is relatively limited because our focus is on rural areas, and in most rural areas, the cable companies aren't upgraded. They're not offering digital video.

MCN: How many direct-broadcast satellite subscribers do you have today?

Pagon:
We have just shy of a million-and-a-half.

MCN
: Do you think the growth has started to level off somewhat for the DBS industry?

Pagon:
The rate of growth is slowing down just because we have a lot more customers. If you have a million customers and you add a million customers, your rate of growth is 100 percent.

If you have 10 million customers and you add 1 million customers, your rate of growth is 10 percent. The industry today is adding somewhat more new customers than it was two or three years ago, but it's being measured off a base of 15 million customers rather than 6 or 7 million customers.

The percentage growth is now slowing down just because of the size of the customer base. The rate of growth — the absolute number of new customers — is 25 or 30 percent higher today than it was true two or three years ago. The industry as a whole this year will add in excess of 5 million new customers versus about 3½ million new customers, I think, three years ago.

But the churn will be higher as well. The churn rate for the industry is 17 percent, and 17 percent of 15 million customers is a churn rate of almost 2½ million customers. Three years ago, 16 percent churn on a base of 7 million customers was a million. You're selling a million-and-a-half more customers than you were three years ago, but you're losing an additional million to million-and-a-quarter a year versus what was true three years ago. That's just because you have more customers overall, and churn is a function of how many customers you have, not how many customers that you don't have.

The bottom line is that the sales activity has increased and continues to be very strong. The combination of a higher customer base and slightly higher churn is masking some of that success in terms of adding net new customers.

MCN: If small cable operators are likely to disappear over the next five or 10 years, doesn't that argue against allowing for a DirecTV merger with EchoStar? If there were only one DBS player, wouldn't that eliminate competition in rural areas?

Pagon:
If there's an issue from a regulatory or antitrust standpoint in terms of a combination of EchoStar with DirecTV, that's it.

MCN: Are there any protections that could be made for small-town television households, if a merger were allowed to go forward?

Pagon:
There are all sorts of legal things that you could put into an agreement to try to protect them. But if you only have one provider, you obviously don't have the benefits of competition.

You are at risk to whatever that one provider wants to do. You can do things to try to protect people legally, but if you don't have competition, you don't have competition.

If there were a combination of EchoStar and DirecTV, there wouldn't be an issue in terms of competition in the metro areas. If you add the share of market of both EchoStar and DirecTV in any of the 100 largest metro markets in the United States, their share together would still be not more than 25 percent of the incumbent cable company.

In rural areas, if DirecTV and EchoStar get together, outside of Pegasus, they're it when it comes to [multichannel video] in the future because of a lot of these cable systems are going under. They would be the monopoly provider.

MCN: Whether or not Direc-
TV and EchoStar do merge, aren't rural television viewers in danger of losing access to their local broadcast stations if local cable operators have to shut down?

Pagon:
If the satellite industry doesn't offer them, then they would be at risk. But I believe that the satellite industry will, as new satellites are launched over the next five years, offer their local television stations in pretty much all of the television markets in the United States.

There is a short-term risk that if [small cable operators] go out of business in the next year or two or three, people might lose their local channels. That's if they're going out of business before the new satellites are launched. But when the new satellites go up over the next couple of years, they'll have spot-beam capability.

The satellite companies are going to be offering all the programming that people want, and people clearly want their local television stations.

MCN: Can the DBS companies really be expected to carry the signals from every broadcast station around the country?

Pagon:
If they have the capacity, yes, I think they will.

MCN: Couldn't one argue that a DirecTV and EchoStar merger would provide extra bandwidth to be able to deliver some of the broadcast stations?

Pagon:
Certainly, [EchoStar chairman] Charlie Ergen has made that argument.

MCN: Can you talk about broadband and how important it is for satellite technology to help bridge the digital divide in rural areas?

Pagon:
For the same reasons that a lot of these small cable systems won't be offering digital video, they won't be offering broadband. If you're not converting to digital, you can't offer broadband access.

As a general rule, broadband access by cable or DSL [digital subscriber line] is just not available in rural areas today.

I don't think in five years time that that's going to be hugely different. I think in most rural areas, in five years' time [consumers] still won't have cable or DSL broadband access.

As a practical matter, if people in most rural areas aren't going to get redlined or basically shut out of the broadband world, they're going to have to get broadband service through something other than DSL or cable. Really the only technology that will enable them to do it affordably in the next couple of years is satellite.

MCN: What kind of demand have you seen so far for your high-speed data product, Pegasus Express?

Pagon:
Our experience in terms of the interest levels is very, very high.

Our challenge in the next couple of quarters is not going to be finding people who are interested. Our challenge is making sure that we can get them set up and installed and do the things from a customer service standpoint that we need to do for a new service.

That's what we're focused on. There is tremendous demand for broadband out there in rural areas — and in many metro areas where I think one of the fallacies out there is created by the cable and DSL industries is that in most metro areas, you can get cable or DSL anywhere.

My experience in most of the major cities on the Eastern seaboard is one in two people can't get DSL or cable broadband today, even though they're in areas where the cable industry and the broadband and the DSL industry says everybody is accessible.

MCN: You mentioned on your earnings call [in early May] that you're planning to pull back on some of your subscriber-acquisition expenditures for the video side of the business.

Pagon:
Right.

MCN: Could one of the reasons for that be because you expect to sell that side of the business off to either DirecTV, EchoStar or News Corp. in the short-term?

Pagon:
Well, sure. Many people are speculating on that. For the real reason why we're doing it, I would say two things. The cable industry has had greater success in persuading the capital markets of the efficacy of their business model than the satellite companies have.

That's why cable companies' cost of borrowing is probably 200 to 300 basis points lower than the satellite industry's.

That's why, even though their video businesses are growing at 1 percent, they're valued at upwards of 20 times their cash flow.

One of the things we're saying is, that's the way the financial markets are inclined to value companies. We have to look at EBITDA. We have to be focused as a company on growing our EBITDA, and on showing people that not only our overall EBITDA margins, but our growth are such that we warrant the cost of funding that cable companies currently enjoy and the multiples that go with that as well.

To the extent to which we do that, we benefit financially in two respects. One is we have significantly more cash flow. Two, we have lower borrowing costs. We have more cost-effective capital to put to work to drive our future growth.

MCN: What else went into the decision?

Pagon:
From an operational standpoint, part of what we are doing is saying, as an industry we need to segment more carefully. You look at the airline industry, and you have a full plane, virtually every seat has a different price associated with it.

At the margin, the last seat filled may be pretty close to nothing, but as an airline, if you're offering a $10 fare for the last person, you're not repricing the deal that you've offered everybody else. You have 100 other people on the plane.

Unfortunately, what we have done in the satellite industry over the past couple of years is we've significantly re-priced our offering to consumers and re-priced what we're offering to retailers, but we haven't segmented it enough. We're offering an increasingly good deal at the margin for consumers, which is a good thing. It drives growth. But we're re-pricing the deals that we were offering everybody else who didn't need such good deals before, and that's inefficient. It costs us a lot of money.

We're going to be focused on lowering our SAC [subscriber-acquisition costs] by segmenting, by continuing to offer to the price-sensitive customer a good deal, but offering people who are less price-sensitive services and features that are more important to them.

One of the important ways we're going to do that is offering the price-sensitive customer a rental option, as opposed to a buying decision, and reserving that for those who are really not price-sensitive but are much more feature-sensitive and brand-loyal.

If you feel strongly about the type of equipment you want, the features you have, we'll sell you the equipment. But if you're buying premium equipment, you should be paying premium prices.

If somebody is riding first class, you don't expect to be paying coach fare.

MCN: Are you starting to do anything with some of the advanced products, such as the set-top boxes with personal video recorders built into them?

Pagon:
We're pretty aggressive going forward with the bundle of broadband with our video product, which is probably the most advanced feature you can see and will have the biggest impact on us. PVRs are a consumer value to people, but the incremental revenue that service providers will get from them in the short term is relatively modest, and the cost up front for the boxes is pretty high.

Our approach is, yes, those are important going forward, but rather than subsidizing that too much, we'll let the consumers who really want those features subsidize them for an initial period of time. We're going to focus on bundling broadband with video because I think there's a very large untapped demand for broadband.

If you put it together with digital television, it's going to make the customer more loyal, more sticky, and the economics are very meaningful.

MCN: Have you been in any talks with EchoStar about selling your subscriber base to them if things don't work out with DirecTV?

Pagon:
I couldn't comment. I can't comment on any conversations we might have with DirecTV or others, including EchoStar.

MCN: If you were to sell the DBS part of the business in the long- or the short-term, would you try to keep other parts of your business operational? Would you keep the broadband part separate from that?

Pagon:
My first comment is, we're not for sale. My second comment is, if parties approach us about buying any portion of our business, we obviously have a fiduciary responsibility to consider the merits of any offer, and obviously, if the offer were something that's very compelling from our shareholder standpoint, we would consider that favorably.

In terms of our history, we started out as a cable company. We were in the cable industry for a long time. We sold our rural cable systems four years ago for the reasons I mentioned earlier. We sold our metro cable system in Puerto Rico last fall because we got a very good price and it was time, we thought, to sell.

But in each of those instances, we had developed other businesses. Our cable business represented 90 percent of our revenues in 1993. By the time we sold it, it represented a minority of our revenues.

When we look at selling any business, we look at Pegasus as being around for the long term. So it may not be the case that in a given business we're going to be in it forever or for the long term. We may elect to sell it because circumstances change or the opportunities become compelling.

Selling any line of business is different than selling the company. If we were selling our satellite video business, we would probably stay in the broadcast television and certainly the broadband business.

It depends on the circumstances. If you have a situation where there was a compelling offer for the whole company, then we would consider that, as well.

Again, I come back to the first thing, which is we're not looking to sell. We are in the business for the long term. But like any business, companies very often get approached by other companies saying, 'We'd like to buy this part of your business or that part of your business.' It's business. You've got to consider it on its merits.