Description

DISH Network Corp. (NASDAQ: DISH)

Recommendation: Buy DISH (Current price – $60)

DISH Network (DISH) is the owner-operated second-largest satellite TV company in the U.S. Over the last several years, DISH has opportunistically amassed the fourth-largest wireless spectrum position in the country in anticipation of a scarcity of wireless spectrum due to the rapid increase in mobile data usage. While this asset is widely acknowledged in the market, investors ascribe little value to it given the uncertainty over the timing of monetization and the wide range of possible outcomes. We have identified what we feel are the three most likely outcomes, all of which should provide patient, long-term investors with above-average returns. While we acknowledge the risk that the spectrum assets are not monetized in a value-creating and efficient manner, our range of expected values is $85-140, 40-135% above the current price of $60. We feel that the current price already embeds a very bearish outcome, and see ~25% downside to $43 in a very low probability worst-case scenario.

Business Overview

DISH Network provides advanced digital satellite television services to nearly 14 million customers and satellite broadband services to nearly 1 million customers across the U.S. The DISH Network is widely regarded as the low-cost video service provider in the industry. DISH’s core demographic base of value-conscious, suburban/rural customers results in only moderate competition. More importantly to our investment thesis, the company has also amassed a significant wireless spectrum position of ~88 MHz, which is the fourth largest spectrum position behind AT&T, Verizon, and Sprint. Chairman and CEO Charles Ergen founded DISH in 1980 and holds 50% of the A shares and 93% of the B shares.

Investment Thesis

Valuable, dormant wireless spectrum assets

We believe that DISH holds valuable, scarce wireless spectrum assets that are not being properly valued by the market due to misunderstanding the spectrum assets, uncertain timing, and a wide range of possible outcomes. The current wireless infrastructure in the U.S. will be unable to accommodate the continued growth in consumer demand for mobile data. Mobile data traffic tripled over the last two years, according to Cisco, and is expected to grow at a ~50% CAGR over the next 5 years, according to Cisco, Gartner, and Ericsson. This growth will continue to be driven by the explosion of mobile video, including recent and forthcoming OTT video offerings. Growth in machine-to-machine communications (Internet of Things) provides further upside optionality.

DISH owns the licenses to four blocks of spectrum:

• 700 MHz licenses – acquired in February 2009 for $712 million

• AWS-4 licenses – DISH acquired satellite companies DBSD North America and TerreStar out of bankruptcy in March 2012 for $2.86 billion

• H-Block licenses – Purchased at auction in February 2014 for $1.564 billion

• AWS-3 licenses – Purchased at auction in February 2015 for $13.3 billion

The majority of DISH’s spectrum is mid-band, which is well-suited to provide capacity in both urban and suburban markets. A significant portion of it is congruous with the typical mid-band spectrum already in use by the wireless companies. For instance, DISH’s AWS-4 spectrum is very complimentary to Verizon’s current spectrum and could be deployed quickly. This also means it should be relatively straight forward to integrate DISH’s spectrum bands into device chipsets.

Source: Wells Fargo

DISH has a more optimal 2.2x ratio of downlink to uplink spectrum

According to Cisco, with the exception of short-form video and video calling, most forms of internet video do not have a large upstream component. Therefore, traffic is not becoming more symmetric, as many predicted when user-generated content first became popular. Subscribers still consume far more video than they produce and thus upstream traffic has been declining as a percentage for years. In today’s data centric world, downlink (see appendix for glossary of key terms) wireless usage is roughly 4-9x larger than uplink usage. The challenge for incumbent carriers is that the rigid allocations of paired spectrum greatly limit the ability to reallocate uplink spectrum to downlink to match data usage patterns.

To date, DISH has spent ~$18.5 billion to purchase various blocks of spectrum, but we estimate that its spectrum holdings are worth as much as $75 billion. DISH’s spectrum represents the only available large block of spectrum. The four national wireless carriers have consolidated most of the spectrum available in the secondary market through the recent purchases of Metro PCS, Leap, SpectrumCo, Clearwire, and Aloha.

Supply of spectrum is limited and demand is growing rapidly with no current viable alternative

Other sources of spectrum include the upcoming Broadcast Incentive auction, further auctions of AWS spectrum currently occupied by the Department of Defense, and Sprint’s excess 2.5 GHz spectrum. The FCC currently plans to auction 60-120 MHz of 600 MHz spectrum currently occupied by TV broadcasters in early 2016. This low-frequency spectrum provides better propagation and inbuilding support than DISH’s mid-band spectrum, however it could take as many as six years to clear for wireless use. Beyond the Incentive auction, the FCC would have to go back to Congress and get approval to repurpose spectrum currently occupied by the DoD, which would also take a number of years to free up. The AWS-3 uplink, which is currently occupied by the DoD, is not expected to be cleared before 2020. Meanwhile, the effectiveness of Sprint’s 2.5 GHz spectrum is still very much in question, with Sprint adopting a third iteration in three years of its deployment strategy, so it is unlikely that Sprint’s excess spectrum is a viable alternative.

Wireless data capacity can be added by adding cell sites (either building more towers, aka “cell splitting,” or deploying “small cells,” i.e. rooftop antennas) or deploying more spectrum to existing sites. The use of additional spectrum is generally more attractive than building cell sites because it is cheaper to build, incurs lower incremental recurring expenses, and can be deployed faster. In theory, you can postpone spectrum demands for a period of time through so called “cell splitting,” but only up to a point. Smalls cells don’t have the coverage of a tower, so you need A LOT of them, which becomes prohibitively expensive. In order to increase data capacity in line with fixed broadband, spectrum must be part of the equation.

Another alternative to wireless spectrum is deploying LTE in unlicensed spectrum bands, such as those used for WiFi (commonly referred to as U-LTE or LTE-U). “WiFi offloading” would give carriers additional capacity during peak usage. However, for various technological reasons, U-LTE could crowd out other unlicensed services such as WiFi and Bluetooth in these frequency bands. Further, it is tough for carriers to manage traffic, prioritize time sensitive data types, and guarantee service levels in the unlicensed bands, not to mention that it is impractical to place a WiFi hotspot every 50 yards. Other technological solutions, such as “pCells,” require a massive amount of backhaul and are very expensive to deploy.

Proven owner-operator aligned with shareholders

DISH is run by a proven owner-operator with a tremendous track record of value creation. Charlie Ergen, DISH’s co-founder, Chairman, and CEO, holds a 50% economic interest in the company. Since founding the company in 1980 and going public in 1995, Ergen has created tremendous value for DISH shareholders, outperforming the S&P 500 Index by ~12% per year. This does not include the value of Echostar, the satellite business that was spun out of DISH in 2007. Charlie recognized the attractive attributes of satellite leasing and the hidden value of his satellites and took steps to maximize shareholder value, similar to what we believe is unfolding at DISH. Echostar has since outperformed the S&P 500 Index by ~5% per year.

Despite the size and success of DISH, Charlie still has an entrepreneurial, upstart mindset. DISH has been an industry innovator for years. It drove down the cost of buying and installing satellite TV from $900 to less than $200. DISH led the regulatory battle that allowed the satellite companies to include local TV stations in its packages. DISH was the first to offer two-way high-speed internet access and the first to build a DVR into a set-top box. In the past few years, the company introduced the Hopper, which lets users automatically skip commercials on recorded shows, and SlingTV, an OTT video offering featuring 20 of the most popular channels, including ESPN. Charlie even tried to buy DirecTV in 2002, arguing that the companies could save billions of dollars on infrastructure and use its combined limited spectrum to deliver more services. More recently, Charlie (via DISH) has accumulated a war chest of wireless spectrum at mostly distressed values. His vision is to combine terrestrial video and broadband with mobile video and phone service.

Why this opportunity exists/market misperception

The timing and path of spectrum monetization is uncertain and therefore many investors either don’t try to value the various scenarios or they apply an “uncertainty discount” to the spectrum value.

We believe that the three most likely outcomes (lease of spectrum, sale to Verizon, or acquisition of T-Mobile) are all positive for shareholders, resulting in per share value of $85-140 (see valuation section). We are comfortable with the uncertain timing and outcome due to the presence of a proven owner-operator with a substantial economic stake. On the most recent conference call, Charlie indicated that a sale or lease of the spectrum could be more of a near-to-medium term possibility now. Meanwhile, wireless carriers have to anticipate their spectrum needs years in advance, giving us confidence that value will be realized within our investment time horizon of 3-5 years.

One of the biggest risks is that DISH incurs capital expenditures to build out the spectrum and enter the mature wireless market as a fifth carrier, or that, faced with looming buildout requirements, DISH will be forced to sell the spectrum at depressed prices. We do not believe, based on Charlie’s comments to date, that DISH has any desire to enter the market as an independent wireless carrier given the upfront capex, time to market, and the lack of available cell sites. The company would constantly be playing catch-up on coverage and quality. We believe that fears of a $5-10 billion wireless buildout are exaggerated. Further, we question the validity of spectrum buildout requirements, the soonest of which is April 2020. There have been many instances where companies have gotten extensions to the buildout requirements. The only instances where the FCC has reclaimed spectrum are those where the license holder refused to pay for the license. In fact, Verizon recently sold 700 MHz spectrum to T-Mobile at a substantial profit where the buildout requirement had lapsed. The problem that spectrum companies often run into is that they burn cash and are eventually forced to sell at whatever price they can. DISH, on the other hand, should be able to generate upwards of $1 billion of free cash flow per year from its core satellite business, thereby preventing a firesale of the spectrum assets.

Some investors believe that DISH’s use of Designated Entities and coordinated bidding in the most recent AWS-3 auction (January 2015) artificially inflated spectrum values.

DISH participated in the AWS-3 auction through SNR Wireless and Northstar Wireless, two small businesses in which it owns an 85% economic stake but which it does not control, in order to qualify for 25% discounts from the FCC. This is a tactic that had been successfully used in past auctions by AT&T and Verizon. Some people contend that this drove auction prices higher than they otherwise would have been if DISH had operated under the assumption that it would have to pay full price for the spectrum. However, Wells Fargo recently held a “Wireless Symposium” where several spectrum experts said that the AWS-3 clearing price would not have been much lower had DISH not been involved via the Designated Entities. According to Wells Fargo, these experts were involved in auctions and private transactions where AWS spectrum changed hands at values equal to or even higher than AWS-3. Indeed, AT&T and Verizon bought two-thirds of the available AWS-3 paired spectrum for $2.90 per MHzPop, which is above the price that DISH paid ($2.86) after adding back the DE discounts. In a recent Canadian auction of AWS spectrum, the clearing price of unrestricted spectrum was $2.40 per MHzPop. This auction was a one-round blind auction, versus the multi-round non-blind AWS-3 auction, suggesting the latter is likely more representative of the actual price of AWS spectrum.

Just because DISH provided competition in the auction that may have resulted in a higher clearing price than otherwise would have come to pass, does not mean that the prices were artificially high. DISH’s involvement simply revealed the true value that wireless carriers assign to mid-band spectrum in a competitive auction relative to the incremental cost of splitting cell sites. On the most recent conference call, Charlie commented, “that may have been the only competitive auction that I’ve been involved in where people had to pay the market price.” AT&T and Verizon had the option to bow out of the bidding if it was economically superior to split cells instead. In fact, it is likely that the two carriers were constrained more by how much they told the rating agencies and their investors that they would spend on spectrum than their assessment of the true value of spectrum. During its 3Q14 earnings call, Verizon CFO Fran Shammo referenced an S&P report that estimated that Verizon could spend $10.5-17 billion between the AWS-3 auction and the Broadcast Incentive auction (currently scheduled for early 2016). Verizon ended up with $10.4 billion of AWS spectrum, though if it had gotten all the spectrum it wanted, it would have ended up at the top of that range and skipped the incentive auction.

We believe that the two dominant wireless carriers have historically paid less than market value for spectrum because there was nobody with the financial wherewithal to challenge them in the spectrum marketplace. Indeed, DISH experienced this exact dynamic when it purchased the H-block spectrum at auction. The H-Block is an odd piece of spectrum that works best with DISH’s AWS-4 spectrum because of its close proximity. When Sprint – the only other viable bidder for the spectrum – decided not to bid because of its already massive spectrum holdings, DISH ended up walking away with an additional 10 MHz of spectrum for a fraction of the going rate

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Some investors feel that between the recently completed AWS-3 auction and the upcoming Broadcast Incentive auction (currently estimated for early 2016), the wireless carriers will have met their spectrum needs for the foreseeable future.

With smartphone penetration over 70% in the U.S., the only way that wireless carriers can grow revenue and earnings is to get people to use more data. This, in turn, requires more capacity, which comes in the form of more cell sites or additional spectrum. Adding capacity through cell site densification, or another similar solution such as WiFi deployment, costs a tremendous amount of money. Therefore, there is a cost at which it makes more sense to buy spectrum, which we know from the AWS-3 auction is at least $2.90.

Anticipating spectrum needs is not an exact science. Immediately prior to acquiring the AWS-1 spectrum in December 2011, Verizon said it would not need additional spectrum until 2015. That spectrum was subsequently deployed more than a year ahead of schedule in 4Q13. The carriers must anticipate their spectrum needs years in advance because it takes time to have enough capable devices in the subscriber base as well as time to clear the incumbent users from the spectrum.

We know that Verizon is currently in a disadvantaged spectrum position compared to its competitors, on both a total and a per postpaid subscriber basis. Verizon currently has the most subscribers, but the least amount of spectrum per postpaid sub, while controlling less than 20% of available spectrum in the largest markets. Meanwhile, in the top 20 markets, Verizon has already converted 60-70% of its spectrum to LTE. Verizon has built a reputation as the quality leader, and therefore it makes intuitive sense that in order to maintain that advantage going forward, they need to catch up in terms of spectrum.

Mobile data growth is exploding. Cisco estimates that North American data traffic will grow at a 47% CAGR between 2014 and 2019, driven by growth in mobile video consumption. As consumers increasingly consume video on their mobile devices, the wireless carriers will be in direct competition with cable company broadband. Conversely, over the last couple years, cable companies are increasingly talking about their mobile strategies. In order to offer mobile broadband at comparable speeds and data capacity to fiber, wireless carriers need not only more, but wider spectrum bands. The average cord-cutting household consumes twice as much data as the average broadband household. DISH’s AWS-4 spectrum represents the largest unused band that can be deployed near-immediately to support LTE. In addition, machine-to-machine communications (Internet of Things) will further strain wireless networks going forward.

Regardless of how soon any particular carrier needs more spectrum, there is also game theory at work. DISH has the fourth-most spectrum among the wireless carriers, more than T-Mobile. None of the incumbents want to see a competitor acquire this large amount of capacity, and therefore we believe that the spectrum could be acquired far in advance of any actual need.

Possible Outcomes

We believe the three most likely outcomes are:

1. Wholesale lease of the spectrum

2. Sale to Verizon

3. Acquisition of T-Mobile

1. Wireless Spectrum Leasing

We believe the most likely near-term outcome is that DISH leases its spectrum to one or more wireless carriers (possibly accompanied by a spinoff of the spectrum assets from the retail satellite TV business). Wireless spectrum leasing has several attractive attributes that are being vastly undervalued by the market:

• Recurring cash flows and automatic price escalators lead to high EBITDA multiples for similar business such as the tower companies (AMT – 21; CCI – 19; SBAC – 23).

• There is a large universe of potential customers, including the four national wireless carriers, in addition to the cable companies and technology companies such as Apple, Google, Amazon, Facebook, etc.

• The wireless data market is growing rapidly, and we estimate the spectrum assets could earn almost $12 billion in EBITDA over the next decade.

• DISH’s spectrum is fallow and will therefore use the latest technologies, which means its services could be superior to those of the incumbents.

DISH’s 700 MHz spectrum has been generating revenues since 2Q11, which would allow the spectrum to be spun out tax-free as soon as 2Q16. By leasing the spectrum in the near-to-medium term, DISH leaves its other options open, such as a sale to Verizon or an acquisition of T-Mobile. On the most recent conference call, Charlie indicated that a sale or lease of the spectrum is the most likely outcome due to what he perceives as anti-competitive behavior by the FCC.

2. Sale to Verizon

As discussed earlier, we feel that Verizon is in the most disadvantaged spectrum position, and also has the most to lose by allowing DISH’s spectrum to be acquired by a competitor. Most of the recently auctioned AWS-3 spectrum is cluttered, will take years to clear, and may have power restrictions so as not to interfere with other bands. Moreover, those bands already have networks and must use specific technology, whereas much of DISH’s spectrum is virgin and can be designed any way they want. Verizon is also likely to be limited by the FCC in the upcoming Broadcast Incentive auction due to its already dominant holding of low-band spectrum. Verizon would need ~80 MHz of spectrum to match AT&T on a MHz per postpaid sub basis, while perhaps 30-60 total MHz will be available for Verizon and AT&T to bid on in the upcoming incentive auction.

Meanwhile, Verizon will launch an OTT video service this fall, which would benefit from DISH’s mass of subscribers in order to leverage content costs. AT&T is already talking about the reduction in content costs from DirecTV’s critical mass of subs. The DISH DBS business can also be milked for free cash flow to pay for any acquisition as the business runs off. We estimate that, if Verizon was willing to increase leverage from 2.5x to 3.5x, combined with free cash flow generation over the next two years, the company would have upwards of $85 billion to put toward an acquisition of DISH (AT&T would also have ~$85 billion to spend on an acquisition using similar assumptions). This would be enough to cover our estimated value of ~$78-95 billion in a tax-free sale of the entire company.

3. Acquisition of T-Mobile

This has been rumored for over a year now and is the scenario that probably offers the most options and would be Charlie’s preferred choice. T-Mobile does not need DISH’s spectrum today because its relatively small customer base and dense cell site construction offer ample current capacity where it has coverage. However, they will eventually need more spectrum if they continue to have success and grow the customer base. A tie-up between DISH and T-Mobile would immediately strengthen T-Mobile’s distribution and product bundling. It would also allow for meaningful cost synergies and cross-selling opportunities between the two subscriber bases. Further, it would open the door to several additional services such as fixed-wireless broadband and mobile video. Charlie indicated that the denial of the Designated Entity discounts in the most recent AWS-3 auction presents a sizeable hurdle to M&A.

Valuation

I. Market-implied Valuation

DISH currently trades for ~$60, which is ~14.5x FY1 EBITDA. However, this is highly skewed as DISH has spent ~$18.5 billion over the last several years to acquire wireless spectrum that is essentially generating zero earnings. The current price implies a valuation of ~5x 2017E DBS EBITDA and ~$1.39 per MHzPop. Relative to recent AWS-3 auction prices of $2.90 per MHzPop, DISH’s current stock price embeds the assumption that its spectrum is worth over 50% less than the most recent market clearing price which took place in a competitive and transparent bidding process.

II. Paired Spectrum Valuation

Next, we assume that DISH’s AWS-4 and H-block spectrum is worth what DISH paid for paired AWS-3 spectrum at auction. We also hold the AWS-3 spectrum at cost and apply a $1 per MHzPop value to the 700 MHz spectrum, in line with precedent transactions. Finally, we apply a 6x EBITDA multiple to the core satellite business. We feel this properly accounts for the headwinds facing the core business, as the cable and wireless companies trade for 8-10x EBITDA while DirecTV was bought by AT&T for 7.5x EBITDA. This implies that DISH shares are worth $85 after-tax, or $110 in a tax-free sale of the entire company, discounted back two years at 10%.