Pegasus Balloon Is Pricked

Addressing a nasty little complication in News Corp.'s planned deal for DirecTV, the DBS company's designated CEO signaled that News Corp. isn't willing to pay nearly as much for Pegasus Communications as feverish investors seem to believe.

News Corp. lieutenant Chase Carey, who will become CEO of DirecTV once the deal is done, stuck a pin in Pegasus' stock-price balloon, seeking to damp the huge run-up that has occurred since News Corp. finally cut its deal to take control of DirecTV parent Hughes Electronics.

Pegasus shares have as much as tripled to around $30 since News Corp. made its DirecTV deal in April. The reason? Pegasus has exploited an oddity in DirecTV's structure in which the DBS company essentially franchised rights to sell the service in rural areas to the National Rural Telecommunications Cooperative, which comprises primarily small-town telephone companies. The NRTC licensed territories out to hundreds of small dealers.

Pegasus, in turn, has bought out dozens of those dealers and now has rights to sell DirecTV to 8 million of 105 million U.S. TV homes. Currently, it serves 1.2 million subscribers, about 10% of DirecTV's base.

Investors expect that News Corp. will want to reclaim the Pegasus rights to resell the DBS service in the bulk of U.S. rural markets.

That valuation, Carey said, ignores operating problems and substantial debt load at Pegasus. Speaking at the SkyForum conference in New York last Tuesday, Carey said a takeover is "not a decision for News Corp. to make" until it completes the deal for Hughes.

But, he added, a Pegasus takeover would be based on "the fair value of the cash flows," and "current valuations of Pegasus defy the reality of these cash flows."

Even with the stock run-up, buying 100% of Pegasus' shares wouldn't be all that much, only about $175 million. The problem is the company's leverage: It's carrying $1.4 billion worth of debt.

According to Fahnstock & Co. media analyst Tom Eagan, that's about 7.6 times annual cash flow and $1,100 or so per subscriber. Debt-rating agency Standard & Poors rates Pegasus a low CCC+ and expects it to get worse.

Further, the Pegasus subscriber base is shrinking, probably dropping 200,000 this year. That's partly because the company had been signing up too many low-paying and bad-debt customers and is now focusing on higher-quality "A" and "B" customers.

Asked why his operation is shrinking when DirecTV and rival EchoStar's Dish Network are adding a few million units this year, Pegasus CEO Mark Pagon questioned the quality of those companies' new subs. In an earnings conference call, he also noted that DirecTV hasn't been carrying the signals of local TV stations in many of Pegasus' markets.

"We are somewhat disadvantaged vis-à-vis Dish and DirecTV currently in that approximately two-thirds of our subscribers live in TV markets in which local broadcasters are not currently available." That is scheduled to change as DirecTV adds broadcast signals from more markets by year-end.

But one media bond analyst thinks News Corp. will pressure Pegasus' operations until it falters further, and then pick the company up much more cheaply— possibly after it is reduced the hard way, through a restructuring. "News Corp. doesn't need to buy them," the analyst said.

Damping the stock speculation is doubtlessly also aimed at the court fight. Pegasus and the NRTC are suing DirecTV over pay-TV and other marketing rights in rural territories, a case that has been knocking around for years and is due to go to trial in June.

Such cases often settle right before trial, but apparently not this time. A court-ordered round with a mediator went nowhere during the winter, and DirecTV Chairman Eddy Hartenstein said recent conversations have no proved to be any more successful: "I guess we're going to court."